Ch 13 – Exchange Rate Determination

1. Ch 13 –Exchange Rate Determination If I could find a way to get Saddam Hussein out of there, even putting a contract out on him, if the CIA still did that sort of a thing, assuming it ever did, I would be for it. Richard M. Nixon

2. Ch 13 – Exchange Rate Determination Exchange Rate Determination • Explanation of forces that underlie currency appreciation and depreciation under floating exchange rates (not fixed) • Exchange rates are determined by unregulated forces of supply and demand, as long as central banks don’t step in to stabilize. • Equilibrium is where QD = QS.

3. Ch 13 – Exchange Rate Determination Trade Weighted ER Fundamental Equilibrium Path SR – Speculative Forces LR – Structural Forces Time MR – Cyclical Forces Exchange Rate Determination • Determinants of exchange rates differ with time frames: • Short run • Speculative forces • Medium Run • Cyclical forces (market fundamentals) • Long run • Structural forces

4. Ch 13 – Exchange Rates $1.60 D2 Q2 Effects of Market Fundamentals • Real Income Differentials Consider US dollar and British pound. • At D1, equilibrium exchange rate = $1.50. • If US economy has increase in growth rate, real incomes will increase in US. • As incomes rise, Americans can buy more goods domestically, and can import more goods from UK. • Demand for pounds will increase, pushing exchange rate up to $1.60. $ Price of Pounds S $1.50 D1 Qty Pounds Q1

5. Ch 13 – Exchange Rates S2 Effects of Market Fundamentals • Real Income Differentials Consider US dollar and British pound. • Dollar has depreciated against pound (pound has become more expensive). • If both economies grow, demand for pound will increase due to US growth, and supply of pounds will increase because of UK growth. • Net effect on exchange rate depends on relative magnitude of the growth impacts. $ Price of Pounds S1 $1.60 $1.50 D2 D1 Qty Pounds Q1 Q2

6. Ch 13 – Exchange Rates S2 Effects of Market Fundamentals • Real Income Differentials Consider US dollar and British pound. $ Price of Pounds General Rule of Thumb Ceteris paribus, country with a faster growth rate relative to the rest of the world will tend to have depreciating currency. S1 $1.60 $1.50 D2 D1 Qty Pounds Q1 Q2

7. Ch 13 – Exchange Rates S2 $.0080 D2 Effects of Market Fundamentals • Real Interest Rate Differentials Interest rate diffs influence international K movements, investment funds. Consider US dollar and Japanese yen. • Equilibrium exchange rate = $.0075. • US interest rates fall to 8%, Japan interest rate is 10%. • US investors will demand more yen to move money to Japanese investments, demand will shift to D2. • Japan investors will supply fewer yen because US investments are less attractive. • Both changes will cause the dollar to depreciate against the yen. $ Price of Yen S1 $.0075 D1 Qty Yen Q1

8. Ch 13 – Exchange Rates Effects of Market Fundamentals • Real Interest Rate Differentials Interest rate diffs influence international K movements, investment funds. Consider US dollar and Japanese yen. S2 $ Price of Yen General Rule of Thumb Ceteris paribus, lower relative interest rates cause depreciation of currency. S1 $.0080 $.0075 D2 D1 Qty Yen Q1

9. Ch 13 – Exchange Rates Purchasing Power Parity • Purchasing Power Parity Theory states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each currency. • Example: You buy a market basket of goods with $500. When you go to Mexico, if you convert your $500 into Mexican currency and use it to buy the exact same market basket of goods, the exchange rate is at Purchasing Power Parity (PPP exchange rate). • If you can buy more in Mexico with your $500 than you could in US, the Mexican currency is undervalued (priced below PPP). If you can buy less in Mexico, Mexican currency is overvalued (priced above PPP). • PPP exchange rate is a long-run condition. Exchange rates are always evolving toward PPP, but often never reach it because of changes in market fundamentals, speculative forces, etc.

10. Ch 13 – Exchange Rates Purchasing Power Parity • Basis for PPP theory is “law of one price”: Competitive markets will equalize the price of identical goods when prices are expressed in the same currency. Two Versions of PPP Theory: • Absolute PPP Equalization of prices in absolute terms. Example: PPP exchange rate between Canada and US is equal to Price level in Canada Price level in US = 1.3 CAN per $1 US If current exchange rate is 1.5 CAD per $1 US, Canadian dollar will appreciate, US dollar will depreciate to achieve PPP.

11. Ch 13 – Exchange Rates Purchasing Power Parity • Basis for PPP theory is “law of one price”: Competitive markets will equalize the price of identical goods when prices are expressed in the same currency. Two Versions of PPP Theory: • Relative PPP Rate of appreciation of a currency = difference in inflation rates between foreign and home country. Example: Canada’s inflation rate = 1% United States’ inflation rate = 3% US dollar will depreciate against Canadian dollar 2% per year to achieve PPP.

12. Ch 13 – Exchange Rates Forecasting Foreign Exchange Rates • Necessary for long range planning and short term profits. • Necessary for providing employment for economists. Three Main Types: • Judgmental Forecasting • Subjective • Includes political climate, economic indicators, upcoming elections, Fed policies, etc. • “feel for the market” • Technical Forecasts • Time series forecasts • Best at predicting short term rates • Looks at trends in exchange rates themselves

13. Ch 13 – Exchange Rates Forecasting Foreign Exchange Rates • Necessary for long range planning and short term profits. • Necessary for providing employment for economists. Three Main Types: • Fundamental Analysis • Econometric analysis • Use of statistical analysis of economic theory, economic variables • Limited because of use of predictions of value of variables

14. Ch 13 – Exchange Rates Forecasting Foreign Exchange Rates How accurate are our forecasts? • Assuming foreign exchange markets are efficient, rates should reflect all available information. • Forward rate is market’s expectation of future spot rate. • To forecast successfully, forecasts should be able to predict spot rates better than the market. • In study of several consulting firms: • 5% better than market in 1 month rate • 14% better than market in 3 month rate