Determinants of Exchange Rates PDF

THE DETERMINATION OF EXCHANGE RATES 1 OVERVIEW: I. EQUILIBRIUM EXCHANGE RATES II. ROLE OF CENTRAL BANKS III. EXPECTATIONS AND THE ASSET MARKET MODEL 2  Part I. Equilibrium Exchange Rates I. SETTING THE EQUILIBRIUM A. Exchange...

THE DETERMINATION OF EXCHANGE RATES 1 OVERVIEW: I. EQUILIBRIUM EXCHANGE RATES II. ROLE OF CENTRAL BANKS III. EXPECTATIONS AND THE ASSET MARKET MODEL 2  Part I. Equilibrium Exchange Rates I. SETTING THE EQUILIBRIUM A. Exchange Rates market-clearing prices that equilibrate the quantities supplied and demanded of foreign currency. 3 Equilibrium Exchange Rates B. How Americans Purchase German Goods 1. Foreign Currency Demand -derived from the demand for foreign country’s goods, services, and financial assets. e.g. The demand for German goods by Americans 4 Equilibrium Exchange Rates 2. Foreign Currency Supply: a. derived from the foreign country’s demand for local goods. b. They must convert their currency to purchase. e.g. German demand for US goods means Germans convert Euros to US$ in order to buy. 5 Equilibrium Exchange Rates 3. Equilibrium Exchange Rate: occurs when the quantity supplied equals the quantity demanded of a foreign currency at a specific local price. 6 Equilibrium Exchange Rates C. How Exchange Rates Change 1. Increased demand as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa. 7 Equilibrium Exchange Rates 2. Home Currency Depreciation a. Foreign currency becomes more valuable than the home currency. b. The foreign currency’s value has appreciated against the home currency. 8 Equilibrium Exchange Rates 3. Calculating a Depreciation: Currency Depreciation  e0  e1  e1 where e0 = old currency value e1 = new currency value Note: Resulting sign is always negative 9 Equilibrium Exchange Rates Currency Appreciation e1  e0  e0 where e0 = old currency value e1 = new currency value 10 Equilibrium Exchange Rates EXAMPLE: euro appreciation If the dollar value of the euro goes from $0.64 (e0) to $0.68 (e1), then the euro has appreciated by e1  e0  e0 = (.68 -.64)/.64 = 6.25% 11 Equilibrium Exchange Rates EXAMPLE: US$ Depreciation We use the first formula, (e0 - e1)/ e1 substituting (.64 -.68)/.68 = - 5.88% which is the value of the US$ depreciation. 12 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 1. Inflation rates  Example: If, for example, inflation was lower in the UK, the purchasing power of the Pound Sterling would increase relative to other currencies. UK exports become more competitive and the demand to purchase Pound Sterling for UK goods will increase. 13 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 2. Interest rates There is also a strong correlation between inflation, interest rates and exchange rates.  Governments and Central Banks have the authority to influence exchange rates by increasing interest rates. An example of this is “Hot money”: the higher the interest rate the more attractive the currency offer is to foreign investors.  This involves investors rapidly and frequently moving money from a currency with lower interest rates to a country with higher interest rates, giving a quick return on investment. 14 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 3. Government/Public debt  Foreign investors are less likely to invest in countries with large public deficits and government debt.  Fear of a debt default can result in the selling of bonds denominated in that currency by investors, resulting in a fall in the value of the exchange rate.  Governments may also need to print money to pay parts of a large debt, resulting in inflation. 15 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 4. Political stability  Foreign investors are more attracted to invest in countries displaying a lower propensity for political turmoil. This injection of foreign investment leads to an appreciation of the domestic currency.  Conversely, unpredictable events leading to unstable conditions in a country mean less foreign investment naturally leading to a depreciation in the domestic currency. 16 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 5. Economic recession  Firstly, it is commonplace for interest rates to fall in a recession and when this happens, we see a flow of money out of the country to countries with higher interest rates.  If for example, Canada entered a recession and money started to flow out of the country, its people would sell Canadian dollars to buy other currencies resulting in a fall in the value of CAD (Canadian dollar). 17 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 6. Terms of Trade  The Terms of Trade (ToT) or Balance of Trade as it is sometimes known, is the difference between the monetary value of a nation’s exports and imports over a certain time period.  The terms of trade will improve if the price of a given country’s exports rises by a greater rate than that of its imports.  A greater demand for a country’s exports means an improvement in terms of trade resulting in rising revenues and, consequently, an increased demand for that country’s currency. This will naturally increase the value of that currency. 18 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 7. Current account deficits  The current account measures imports and exports of goods and services but also payments to foreign holders of a country’s investments, payments received from investments abroad, and transfers such as foreign aid and remittances.  If for example, Britain, as a regular trading partner with Canada had a higher current account deficit this could weaken the pound relative to the Canadian dollar.  Countries therefore with lower current account deficits will tend to have stronger currencies than those with higher deficits. 19 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 8. Confidence and speculation  Political events or changes in commodity prices may cause a currency to fall in value. If speculators believe the Euro will fall, they will sell now for a currency they feel will rise in value. For this reason, sentiments in the financial markets can heavily influence foreign exchange rates.  If the markets are alerted to the possibility of an interest rate increase in the Eurozone for example, we are more likely to see a rise in the valuation of the Euro as a result. 20 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 9. Government intervention  China, for example, is reluctant to allow its currency to appreciate because it will negatively impact its exports.  The Chinese government aims to boost its exports and attract foreign investment by keeping the yuan artificially low.  Given China’s large trade surplus, its central bank, the Peoples Bank of China (PBOC) absorbs large inflows of foreign capital. It purchases foreign currency from exporters and then issues that currency in local yuan currency. 21 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 10. The stock markets  Both the stock market and foreign exchange are the most financially traded markets on the globe. To help with price predictions, traders often look for correlations between both markets.  The mood of investors is buoyed when a domestic stock market rises as it is an indicator that the country’s economy is doing well.  As a result, there is increased interest from foreign investors and the demand for local domestic currency also increases.  When the stock market is underperforming, a lack of confidence means investors will take their funds back to their own currencies. 22 Exchange Rate Management Systems (Regimes) Flexible (Floating) Exchange Rate System Markets determine and manage exchange rates Fixed Exchange Rate System Governments manage exchange rates Managed Float Exchange Rate System Combination of Flexible and Fixed Systems Exchange Controls Governments monopolize currency markets The Flexible (Floating) Exchange Rate System The spot price of foreign currency is market-driven, determined by the interaction of private demand and supply for that currency. The market clears itself through the price mechanism. Under the Flexible Exchange Rate System: A fall in the market A rise in the market price (the exchange price (the exchange rate value) of a rate value) of a currency is called a currency is called an depreciation of appreciation of that currency. that currency The Fixed Exchange Rate System Fixed exchange rates (pegged) are not permitted to fluctuate freely on the market or to respond to daily changes in demand and supply. Exchange variations, triggered by changes in the demand and/or supply are permitted only within the band (or spread). Central banks maintain the band through CB interventions. Under the Fixed Exchange Rate System: A discrete official A discrete official reduction in the increase in the otherwise fixed par otherwise fixed par value of a currency value of a currency is called a is called a devaluation. revaluation.  The Managed Float Exchange Rate System Central banks intervene in the foreign exchange markets to influence the exchange rate in a direction they consider desirable. This system is sometimes referred to as a dirty float (manage float). Exchange Controls Exchange controls refer to arrangements by which governments attempt to control purchases and sales of currencies by individuals and firms. Through rules, regulations, and price manipulations, exchange controls attempt to influence who buys and sells currencies, in what quantities, at what prices, and for what purposes. PART II. THE ROLE OF CENTRAL BANKS I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION A. Role of Exchange Rates: LINKS BETWEEN THE DOMESTIC AND THE WORLD ECONOMY 30 THE ROLE OF CENTRAL BANKS B.THE IMPACT OF EXCHANGE RATE CHANGES 1. Currency Appreciation: -domestic prices increase relative to foreign prices. - Exports: less price competitive - Imports: more attractive 31 THE ROLE OF CENTRAL BANKS 2. Currency Depreciation - domestic prices fall relative to foreign prices. - Exports: more price competitive. - Imports: less attractive 32 THE ROLE OF CENTRAL BANKS C. Foreign Exchange Market Intervention 1. Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate. 33 THE ROLE OF CENTRAL BANKS 2. Goal of Intervention: -to alter the demand for one currency by changing the supply of another. 34 THE ROLE OF CENTRAL BANKS D. The Effects of Foreign Exchange Intervention 1. Effects of Intervention: - either ineffective or irresponsible 2. Lasting Effect: - If permanent, change results 35 Part III. EXPECTATIONS I. WHAT AFFECTS A CURRENCY’S VALUE? A. Current events B. Current supply C. Demand flows D. Expectation of future exchange rate 36 EXPECTATIONS II. Role of Expectations : A. Currency = financial asset B. Exchange rate = simple relation of two financial assets 37 EXPECTATIONS III. Demand for Money and Currency Values: Asset Market Model A. Exchange rates reflect the supply of and demand for foreign-currency denominated assets. 38 EXPECTATIONS B. Soundness of a Nation’s Economic Policies - a nation’s currency tends to strengthen with sound economic policies. 39 EXPECTATIONS IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR - exchange rates also influenced by expectations of central bank behavior. 40 EXPECTATIONS A. Central Bank Reputations  A commitment to follow well articulated and transparent rules and policy goals. B. Central Bank Independence  Example: The BSP enjoys fiscal and administrative autonomy from the National Government in the pursuit of its mandated responsibilities. C. Currency Boards  Generally required to maintain reserves of the underlying foreign currency. 41 Sources Greco, Joseph F., Multinational Financial Management. California State University, 7th Edition https://view.officeapps.live.com https://internationalpayments.fexco.com https://www.investopedia.com/trading/fac tors-influence-exchange-rates/ 42 Discussion Questions 1. Give at least two factors affecting exchange rates. Explain. 2. In your observation, what are the steps taken by the BSP to maintain order and stability in the foreign exchange market? 43