Exchange Rates and Their Determination: A Basic Model

1. Exchange Rates and Their Determination: A Basic Model

2. Chapter Organization • Introduction • Exchange Rates • The Demand for Foreign Exchange • The Supply of Foreign Exchange • Equilibrium in the Foreign Exchange Market • Changes in the Equilibrium Exchange Rate • Exchange Rate Volatility and International Trade • Summary

3. Introduction • Why is the exchange rate important? • What causes the exchange rate to change? • What determines the supply and demand for foreign exchange? • What do economists know about the effects of exchange-rate volatility on international markets?

4. The Demand for Foreign Exchange • Demand for Foreign Exchange: • Results from domestic residents demanding foreign goods/services and foreign financial assets

5. $/Pounds Demand for Pounds £1 £2 £3 Pounds The Demand for Foreign Exchange The Demand for Foreign Exchange $3 $2 $1

6. The Demand for Foreign Exchange • Shifts in the Demand for Foreign Exchange • Changes in a country’s income level • Changes in relative price levels • Changes in short term interest rates • Changes in a country’s tastes/preferences • Changes in productivity levels • Changes in the degree of trade restrictions • Most important are income, relative prices, and interest rates.

7. The Demand for Foreign Exchange • Changes in Domestic Income • US income increases. • Demand for all goods including imports increases. • This leads to a shift in demand for foreign currency. • Declines in income will work just the opposite.

8. $/Pounds Pounds The Demand for Foreign Exchange The Change in Demand for Foreign Exchange D1 Demand for Pounds D2

9. The Demand for Foreign Exchange • Changes in Relative Prices • Assume prices for all goods rose in Germany • If exchange rate did not change, then prices of German goods in the US would increase. • If US goods are competitive, then buyers will substitute cheaper (US) goods for more expensive (German) goods.

10. The demand for FX • Interest rates • As domestic interest rates fall (rise), domestic residents will find it more (less) attractive to place their assets abroad (at home) • To do so, they will buy (sell) FX and the demand (supply) will rise.

11. The Supply of Foreign Exchange • Supply of Foreign Exchange: • The amount of foreign exchange supplied in the foreign exchange market.

12. $/Pound Pounds The Supply of Foreign Exchange The Supply of Foreign Exchange Supply of Pounds $3 $2 $1 £1 £2 £3

13. The Supply of Foreign Exchange • Shifts in the Supply of Foreign Exchange • Two important factors: • Changes in Foreign Income • Changes in Relative Prices • Changes in interest rates

14. $/Pound S2 Supply of Pounds S1 Pounds The Supply of Foreign Exchange The Change in Supply for Foreign Exchange

15. Equilibrium in the Foreign Exchange Market • Equilibrium Exchange: • The exchange rate where the quantity demanded of foreign exchange equals the quantity supplied.

16. Equilibrium in the Foreign Exchange Market The Equilibrium Exchange Rate

17. Changes in the Equilibrium Exchange Rate • Increased demand for imports in the U.S. will cause an increase in the demand for foreign exchange. • U.S. incomes could have risen. • If supply is held constant, the exchange rate must increase to clear the market.

18. $/Euro Supply of Euros 2.5 2.0 1.5 Demand for Euros 100 200 300 400 500 Euros Changes in the Equilibrium Exchange Rate A Change in the Equilibrium Exchange Rate

19. $/Euro Supply of Euros 3.0 2.5 New Demand 2.0 1.5 Demand for Euros 100 200 300 400 500 Euros Changes in the Equilibrium Exchange Rate Figure 13.9: A Change in the Equilibrium Exchange Rate

20. Exchange Rate Volatility and International Trade • New equilibrium exchange rate rose but the volume of trade was unchanged. • Exchange rate attempts to correct for changes in relative prices. • Countries with high/low inflation rates have currencies that depreciate/ appreciate over time. • Depreciation is markets way of compensating for differing rates of inflation.

21. Exchange Rate Volatility and International Trade • Changes in exchange rates make international trade different from domestic interregional trade • Changes can be partially mitigated through use of forward or futures markets for foreign exchange. • Reduction of risk has a cost • Difficult to forecast in the long run

22. Exchange Rate Volatility and International Trade • Risk and uncertainty have the result of depressing international trade and investment • Magnitude of effect is not known • Creates a bias toward domestic transactions if exchange rates are allowed to fluctuate

23. Exchange Rate Volatility and International Trade • Fluctuating exchange rates have led to an industry of forecasters. • Need reasonably accurate forecasts for country’s GDP and inflation levels • Also other factors that affect exchange rates not discussed here • This model is good for general comments about exchange over the medium to long run.

24. Summary • The exchange rate is the price of one country’s currency in terms of another country’s currency. • Appreciation of the domestic currency is a decrease in the number of units of domestic currency necessary to buy a unit of foreign currency.

25. Summary • The demand for foreign exchange is related to changes in domestic income, changes in relative prices, and changes in interest rates. • If domestic income rises, then the demand for imports and foreign exchange also will rise, and vice versa. • If domestic prices rise relative to foreign prices, then the demand for imports and foreign exchange will tend to rise. • If domestic interest rates fall relative to foreign interest rates, then the demand for FX will increase to allow residents to obtain higher returning foreign assets.

26. Summary • The supply of foreign exchange is related to changes in foreign income, changes in foreign prices, and foreign interest rates. • A drop in foreign income or an increase in domestic prices relative to foreign prices would tend to cause a reduction in the supply of foreign exchange. • An increase in foreign prices relative to domestic prices will induce foreigners to import more and sell their currency to purchase foreign exchange. • A decrease in foreign interest rates will cause foreigners to want to acquire US assets, which requires them to sell their currency.

27. Summary • A country that has faster economic growth than its trading partners will tend to find that its currency is depreciating in the foreign exchange market. • A country that has slower economic growth than its trading partners will tend to find that its currency is appreciating in the foreign exchange market. • A country with high interest rates will find its currency appreciating in FX markets. • Fluctuations in the exchange rate tend to depress the amount of international trade relative to domestic trade.