International Economics By Robert J. Carbaugh 7th Edition

1. International EconomicsBy Robert J. Carbaugh7th Edition Chapter 13: Exchange-rate determination

2. Exchange rates Factors influencing exchange rates • Market fundamentals • Current account balances • Real income • Real interest rates • Inflation rates • Consumer preferences for domestic or foreign products • Productivity changes affecting production costs • Profitability and riskiness of investments Carbaugh, Chap. 13

3. Exchange rates Factors influencing exchange rates • Market fundamentals (cont’d) • Product availability • Monetary policy and fiscal policy • Government trade policy • Market expectations • News about future market fundamentals • Speculative opinion about future exchange rates Carbaugh, Chap. 13

4. Exchange rates When are these factors important? • Short run (days) - financial transfers • Differences in real interest rates • Shifting expectations of future exchange rates • Medium run (months) • Economic cycles Carbaugh, Chap. 13

5. Exchange rates When are these factors important? • Long run (years) - movements of goods, services, investment, influenced by: • Inflation rates • Investment profitability • Consumer tastes • Real income • Productivity • Trade policy Carbaugh, Chap. 13

6. Exchange rates Exchange rate components Technically driven short-run overshooting path Yen’s trade-weighted exchange value Fundamental equilibrium path Fundamentally driven long-run equilibrium path Fundamentally driven medium-run cyclical path Carbaugh, Chap. 13

7. Factors influencing exchange rates Real income differentials • A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal) • Imports rise faster than exports • Real income changes can also reflect other processes, which might lead to rising exports Carbaugh, Chap. 13

8. Factors influencing exchange rates Impact of real income differentials Dollars per Pound S0 B 1.60 1.50 A D1 D0 Carbaugh, Chap. 13

9. Factors influencing exchange rates Real interest rates • Short term real interest rate differences influence international capital movements • Real interest rate is nominal minus inflation • Low short term rates lead to less demand for the currency and depreciation • High rates lead to greater demand for the currency and appreciation Carbaugh, Chap. 13

10. Factors influencing exchange rates Impact of interest rate differentials Dollars per Franc S1 S0 B .80 .75 A D1 D0 Carbaugh, Chap. 13

11. Factors influencing exchange rates Purchasing power parity • In theory, a good should cost the same in all countries (aside from tariffs or transportation costs) • As a result, exchange rates should end up making prices equal across countries • By this theory, if two countries have different inflation rates, exchange rates will move in the opposite direction to keep prices the same Carbaugh, Chap. 13

12. Factors influencing exchange rates Impact of inflation rate differentials Dollars per Pound S1 S0 B 1.70 1.50 A D1 D0 Carbaugh, Chap. 13

13. Factors influencing exchange rates Market expectations • As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates • Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining for a while Carbaugh, Chap. 13

14. Alternative approaches to exchange rates Monetary approach • Focus on exchange rates as the result of supply and demand for money at home and abroad • Demand depends on real income, prices, interest rates • Supply is controlled by central banks • Exchange rates seen as returning domestic money supply to equilibrium after a change Carbaugh, Chap. 13

15. Alternative approaches to exchange rates Asset-markets approach • Currencies are a kind of financial asset that are part of asset portfolios held by investors • Short run exchange rate changes are caused by shifts in the kind and location of financial assets investors want to hold • Investors shift between assets based on market expectations for expected returns Carbaugh, Chap. 13

16. Alternative approaches to exchange rates Equilibrium in assets-markets approach S0 Dollar appreciation A Pounds per Dollar Dollar depreciation D0 Quantity of Dollar-denominated assets ($ bill.) Carbaugh, Chap. 13

17. Alternative approaches to exchange rates Assets-markets approach: shift in demand S0 B Pounds per Dollar D1 A D0 C D2 Quantity of Dollar-denominated assets ($ bill.) Carbaugh, Chap. 13

18. Alternative approaches to exchange rates Assets-markets approach: shift in supply S0 S1 S2 C Pounds per Dollar A B D0 Quantity of Dollar-denominated assets ($ bill.) Carbaugh, Chap. 13

19. Exchange rate markets Short, long run equilibrium: overshooting S0 (short run / less elastic) B Dollars per Pound C S1 (long run / more elastic) A D1 D0 Carbaugh, Chap. 13

20. Exchange rate markets Forecasting exchange rates • Judgmental forecasts • Subjective forecasts based on economic, political and other data for a country • Technical analysis • Uses historical exchange rate trends to project future movements • Fundamental analysis • Includes macroeconomic and policy information into a predictive model Carbaugh, Chap. 13