Short-Run Exchange Rate

Determination
Issues in Global Trade &
Finance
Prof. Bryson

Part I
Factors Determining Rates

Short-run Exchange Rate

Determination
In the Short Run,
the price of foreign exchange rises when
1. The foreign interest rate rises relative
to ours. Why might this be?
(Mobile, investment funds follow the
higher rates. As they change countries,
they bid up currency values.)

Short-run Exchange Rate

Determination
The price of foreign exchange also rises when
2. The expected future spot exchange rate rises. How come?
(If you expect you will have to pay more for the Euros you will need later
because you expect the Euro/Dollar rate to rise, why not buy now before
it does? Thus, the increased demand for Euros will bid the price up now.)

How It Works

Normally, returns on domestic and foreign

government bonds tend to equality. Why?

Differences cause investors to reposition

their portfolios, affecting exchange and
interest rates.

Currency rates will rise when people buy

in order to invest in foreign, short-term
funds.

Determining Factors in
Foreign Exchange Prices

The role of expectations is extremely

important in forecasting the future.
Lacking other information, what is the
universal law of forecasting?
We extrapolate recent change into
the future. Lacking other information,
the future will look like the present.
The bandwagon effect.

Determining Factors in
Foreign Exchange Prices

Once expectations are positive and

buying goes on, we can begin a
process of destabilizing speculation.
Friedman and bad speculation
(buying high and selling low).
Bad currency speculation can lead
to overshooting, where speculation
may go in the right direction, but
move past the equilibrium point.

Determining Factors in
Foreign Exchange Prices

Expectations can be based on various

kind of news on, e.g.,

policies,
trade data or performance,
international political tensions and situations.

Determining Factors in
Foreign Exchange Prices

An increase in money supply

drives the interest rates down at first,

then prices begin to rise (the chasing
dollars thing, and
currency values are driven down in
the long run.

Determining Factors in
Foreign Exchange Prices

When movements in exchange

rates are not explainable as a
function of the economic situation,
they are referred to as speculative
bubbles.

Markets, Exchange, and Interest

Rates

Investing abroad has two steps.

First, get the exchange (DM, F, , , )

P

P$

Sell Dollars (P$ declines).

Buy Euros (P increases).

Second, invest in foreign government bonds at high i rates

Buy
S1 S2
P
P
European
Sell US
(high i)
(low i)
bonds. Their
bonds,
D1
D2 price rises, (i
their p
falls).
falls (i
rises).

Part II.
Short-term Rates
and Investment Options

Short-term Investment
Options

Should we pursue higher interest

rates abroad? Check out the options

1. Invest at .05 (= ius) for 90 days (annual

yield divided by four) in the U.S. at (1 + ius)
$1 million invested = $1,050,000 in 90
days.

SHORT-TERM INVESTMENT
OPTIONS
Invest at .08 for 1 year in the U.K.
A. Buy s in spot market at 1/ rs.
B. Invest at (1 + .08)/ rs
C. At the time of the
investment, hedge the investment by
selling contracted earnings in the
forward market at rf .
2.

SHORT-TERM INVESTMENT
OPTIONS
When we hedge the investment by
selling contracted earnings in the
forward market,
the yield is ( 1 + iuk ) ( rf / rs )
$1,080,000 (0.61/0.63) =
1,080,000 (.97) = $1,045,714

Hot Money Investments

Where we have
$1,080,000 (0.61/0.63) = 1,080,000 (.97) =
$1,045,714,
if the future rate ($1.65) is greater than the
spot rate ($1.63), one expects $ depreciation.

Hot Money Investments

The covered interest differential between the

two investments is the yield from the
(presumably higher) foreign investment minus
the yield from the domestic investment.
It is:
CD = ( 1 + iuk ) ( rf / rs ) - (1 + ius)
$1,045,714 - $1,050,000

Hot Money Investments

3. Invest at .08 in UK.

A. Buy s in spot market at 1/ rs.
B. Invest at (1 + .08)/ rs
C. Do not hedge, but speculate.
Wait for the investment to pay out,
take the yield and at that point (in 90
days or a year) purchase dollars with
the pounds earned.

Hot Money Investments

If the goes up (or the value of the

dollar vis--vis the pound declines, i.e.,
rs > rs , ($3/ > $2/ ), we make more
money.

But if the dollar appreciates, the will

buy back fewer dollars at the end of the
investment period.

More Generally, Uses of the

Future
Future
Future $

Change earnings in 90 days at rs

Change earnings forward (covered)

Invest in UK
Invest in U.S.
Borrow in UK
Borrow or
sell assets
in U.S.

Present
US

UK

Current $

currencies

Current

Future

Part III.
Exchange Rates in the Long
Run

Purchasing Power Parity:

Money and Exchange Rates in the
Long Run
The money supply determines the
rate of inflation, which impacts the
value of a currency. What is the
impact?
Why must an inflating currency
depreciate in value (or be devalued)?

Purchasing Power Parity:

Money and Exchange Rates in the
Long Run
Demand for a currency will decline if
the commodities it will purchase are
continually increasing in price.
Currency demand = f(transactions
demands).

Purchasing Power Parity:

Money and Exchange Rates in the
Long Run

People must hold money balances to

make purchases. In general, Md for a
particular national currency shows that
holding money is like holding tickets
for the GNP.
Md = f (national GDP/yr).

Money and Exchange Rates in the

Long Run
The Quantity Theory of Money
The Cambridge or Marshallian Quantity
Theory
M = k (P) (y)
y = real national
or domestic product
Mf = kf ( Pf ) (yf)
k = behavioral ratio
(coefficient) related to
velocity
f = foreign
M = Money Supply

Money and Exchange Rates in the

Long Run

The Quantity Theory of Money

In M = k (P) (y) and Mf = kf ( Pf ) (yf)

If k and kf are fixed, these quantity
equations determine domestic and
foreign price levels, the price ratio
between national money and national
product.

Price levels and exchange

rates

Internationally traded goods

will have similar price
movements when measured
in the same currency through
trades arbitrage effect.

Price levels and exchange

rates

non-traded goods (e.g.,

those with large transport
costs will not necessarily
converge in price terms.

Price levels and exchange rates

connected by Purchasing Power
Parity
P = rs ( P f )
where rs = exchange rate,
or, rewriting
rs = P/ Pf,
We saw above that M = k (P) (y),
and solving for P, P = M/ky. So
substitute M/ky for P and we have
rs = [M/( k y)]
[Mf/(kf yf )]

Exchange rates and

Purchasing Power Parity

The nation with slower Ms growth and

faster expansion of productive capacity,
should have a currency rising in value.

Rapid Ms growth and slow capacity

expansion would lead to a depreciating
currency.

Exchange rates and

Purchasing Power Parity

This theory has proved empirically

reliable for the long run only. For
the short run, this is not a good
predictor. Expectations and
speculative movements affect the
short run and non-traded goods
also have an impact.

Interest Rates and Foreign

Exchange

Foreign investors want to take advantage of

high interest rates only if the real rates are
high.

They will not want to hold foreign assets,

and the spot rate of currencies will not be
bid up, if real returns are not available
because only nominal interest rates are
high.

Interest Rates and Foreign

Exchange
If interest rates rise merely because
prices are increasing as the money
supply expands, the currency value
must decline.
The real interest rate is the nominal
rate minus the rate of inflation.
Real rate = nominal rate - inflation.
Example: 5% =
16%
11%.

Hopper on What
Determines the Exchange
Rate?

A fundamental belief: exchange

rates are affected by fundamental
economic forces, such as money
supplies, interest rates, real output
levels, or the trade balance.

Hopper on What
Determines the Exchange
Rate?

But these fundamentals dont

affect the exchange rate in the
short run.

The best forecast of the exchange

rate, at least in the short run, is
whatever it happens to be today.

Hopper on What
Determines the Exchange
Rate?

The monetary model fails

empirically except perhaps in
unusual periods such as
hyperinflations. (p. 251)
After it was apparent that the
model couldnt be substantiated,
economists tried to develop other
ideas.

Hopper on What
Determines the Exchange
Rate?

Hopper discusses attempts to extend

the monetary model Dornbusches
overshooting model, the portfolio
balance model. Not much empirical
support for these ideas has been found.
Econometricians found that a nave
strategy of using todays exchange rate
as a forecast works at least as well as
any of the statistical models.

Hopper on What
Determines the Exchange
Rate?

Hopper concludes that if we look

backward or forward over periods
of up to a year, the fundamentals
dont seem to explain the
exchange rate, contrary to what
standard models in international
finance textbooks implyperhaps
economists will discover a model
that works in the future. (p. 253)

Hopper on What
Determines the Exchange
Rate?

The alternative view is that exchange

rates are determined, at least in the
short run (under two years) by market
sentiment. Market participants take
the fundamentals very seriously when
forming exchange-rate expectations.
Economists are just starting to build
models of market sentiment.

Hopper on What
Determines the Exchange
Rate?

The exchange rates are determined

in the long run by fundamentals.
The empirical models do better here.
Long-term market forces, the
fundamentals, tend gradually to
outweigh short-term irrational or
unpredictable speculative forces in
exchange markets.