Exchange-Rate

Determination

PowerPoint slides prepared b

Andreea Chiritescu
Eastern Illinois University
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1
classroom use

What Determines Exchange

Rates?

Factors that cause the supply and

demand schedules of currencies to
change
Market fundamentals (economic
variables)

Productivity, inflation rates, real interest

rates, consumer preferences, and
government trade policy

Market expectations
News about future market fundamentals
Traders opinions about future exchange rates
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What Determines Exchange

Rates?

Factors affecting exchange rates

Short term: transfers of assets

Differences in real interest rates and to the

shifting expectations of future exchange rates

Interim: cyclical factors

Fluctuations in economic activity

Long term: flows of goods, services, and

investment capital
Inflation rates, investment profitability,
consumer tastes, productivity, and
government trade policy
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FIGURE
12.1

The path of the Yens exchange rate

This figure views the exchange value of a nations currency as being determined by longterm structural, interim cyclical, and short-term speculative forces.

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Determining Long-Term
Exchange Rates

Exchange rate changes

Reactions of traders in the foreignexchange market to changes in

Relative price levels
Relative productivity levels
Consumer preferences for domestic or
foreign goods
Trade barriers

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TABLE 12.1

Determinants of the dollars exchange

rate in the long term

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Determining Long-Term
Exchange Rates

Increase in the U.S. price level

relative to price levels in other
countries
Increase in the demand for foreign
currency
Decrease in the supply of foreign
currency
Depreciation of the dollar
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FIGURE
12.2

Market fundamentals that affect the

dollars exchange rate in the long
term (a)

In the long term, the exchange rate between the dollar and the pound reflects relative price levels,
relative productivity levels, preferences for domestic or foreign goods, and trade barriers.

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Determining Long-Term
Exchange Rates

U.S. productivity growth is faster than

that of other countries
Increase in the supply of foreign
currency
Decrease in the demand for foreign
currency
Appreciation of the dollar

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FIGURE
12.2

Market fundamentals that affect the

dollars exchange rate in the long
term (b)

In the long term, the exchange rate between the dollar and the pound reflects relative price levels,
relative productivity levels, preferences for domestic or foreign goods, and trade barriers.

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Determining Long-Term
Exchange Rates

An increased demand for U.S. exports

Appreciation of the dollar

An increased demand for U.S. imports

Depreciation of the dollar

U.S. imposes trade barriers

Appreciation of the dollar

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FIGURE
12.2

Market fundamentals that affect the

dollars exchange rate in the long
term (c)

In the long term, the exchange rate between the dollar and the pound reflects relative price levels,
relative productivity levels, preferences for domestic or foreign goods, and trade barriers.

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FIGURE
12.2

Market fundamentals that affect the

dollars exchange rate in the long
term (d)

In the long term, the exchange rate between the dollar and the pound reflects relative price levels,
relative productivity levels, preferences for domestic or foreign goods, and trade barriers.

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Inflation Rates, Purchasing Power Parity,

and Long-Term Exchange Rates

Law of one price

Identical goods should be sold
everywhere at the same price
When converted to a common currency
Assuming that it is costless to ship the
good between nations, there are no
barriers to trade, and markets are
competitive

Prevailing market-exchange rate is

the true equilibrium rate
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Inflation Rates, Purchasing Power Parity,

and Long-Term Exchange Rates

The Big Mac Index

An attempt to measure the true
equilibrium value of a currency based
on one product, a Big Mac
Can be used to determine the extent
to which the market exchange rate
differs from the true equilibrium
exchange rate

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TABLE 12.2

Big Mac Index

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Inflation Rates, Purchasing Power Parity,

and Long-Term Exchange Rates

Purchasing-power-parity theory
Exchange rates adjust to make goods
and services cost the same everywhere
An application of the law of one price
If the rate of inflation is much higher in
one country
Its money has lost purchasing power over
domestic goods
Currency depreciation to restore parity
with prices of goods abroad
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Inflation Rates, Purchasing Power Parity,

and Long-Term Exchange Rates

Purchasing-power-parity theory
Trade flows = mechanism that makes a
currency depreciate or appreciate
Changes in relative national price
levels
Determine changes in exchange rates over
the long term

Foreign-exchange value of a currency

tends to appreciate or depreciate
At a rate equal to the difference between
foreign
inflation
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TABLE 12.3

The law of one price applied to a

single product, steel

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Inflation Rates, Purchasing Power Parity,

and Long-Term Exchange Rates

Purchasing-power-parity theory
Used to predict long-term exchange
rates
P - price indexes of the U.S. and
Switzerland
0 - the base period
1 - period 1

S0 - equilibrium exchange rate in the

base period
S1 - estimated target at which the actual
rate should be in the future

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Inflation Rates, Purchasing Power Parity,

and Long-Term Exchange Rates

Purchasing-power-parity theory
Overlooks: exchange-rate movements
may be influenced by investment flows
Problems
Choosing the appropriate price index to be
used in price calculations
Determining equilibrium period to use as a
base

Government policy may interfere with

the operation of the theory
Trade restrictions

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FIGURE
12.3

Purchasing power parity: United

States - United Kingdom, 19732003

This figure suggests that the predictive power of the purchasing-powerparity theory is most evident in the long term. In the short term, the theory
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negligible
predictive
forhas
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22

Determining Short-Term Exchange Rates:

The Asset-Market Approach

Foreign-exchange market activity

Dominated by investors in assets
Treasury securities, corporate bonds,
bank accounts, stocks, and real property

Asset-market approach
Investors deciding between domestic
and foreign investments
Relative levels of interest rates
Expected changes in the exchange rate
itself over the term of the investment
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Determinants of the dollars exchange

TABLE 12.4
rate against the pound in the short
term

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GLOBALIZATI
ON

Inflation differentials and the exchange

rate

Purchasing-power-parity theory
Changes in relative national price levels
Determine changes in exchange rates, long
term

A currency is expected to depreciate

By an amount equal to the excess of
domestic inflation over foreign inflation

A currency is expected to appreciate

By an amount equal to the excess of
foreign inflation over domestic inflation
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FIGURE
12.4

Inflation differentials and the dollars

exchange value

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Determining Short-Term Exchange Rates:

The Asset-Market Approach

Level of the nominal (money) interest

rate
A first approximation of the rate of
return on assets that can be earned in
a particular country

Differences in the level of nominal

interest rates between economies
Likely to affect international
investment flows
Investors seek the highest rate of return

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Determining Short-Term Exchange Rates:

The Asset-Market Approach

If interest rates in U.S. > interest rates

abroad
Increase in the demand for dollars
Dollar appreciation

If interest rates in U.S. < interest rates

abroad
Decrease in the demand for dollars
Dollar depreciation

Real interest rate

Nominal interest rate minus the inflation
rate

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FIGURE
12.5

Factors affecting the dollars

exchange rate in the short term (a)

In the short term, the exchange rate between the dollar and the pound
reflects relative interest rates and expected changes in the exchange rate.
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Short-term nominal and real interest

TABLE 12.5
rates, 2007

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FIGURE
12.6

Interest rate differentials and

exchange rates

An increase in the U.S. real interest rate increases the expected return on dollar assets,
such as Treasury bills and certificates of deposit. This increase encourages flows of
foreign investment into the United States, thus causing the dollars exchange value to
appreciate. Conversely, a decrease in the U.S. real interest rate reduces the expected
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profitability
onindollar
assets,
which
aordepreciation
of the
exchange
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Determining Short-Term Exchange Rates:

The Asset-Market Approach

Expected change in the exchange

rate
Future expectations of an appreciation
of the dollar can be self-fulfilling for
todays value of the dollar

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FIGURE
12.5

Factors affecting the dollars

exchange rate in the short term (b)

In the short term, the exchange rate between the dollar and the pound
reflects relative interest rates and expected changes in the exchange rate.
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Determining Short-Term Exchange Rates:

The Asset-Market Approach

Other factors affecting investment

flows among economies
Size of the stock of assets
denominated in a particular currency
in investor portfolios
Significant safe-haven effect behind
some investment flows

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The Ups and Downs of the

Dollar

The 1980s, appreciation and then

depreciation
1979, dollar appreciation
Sharp tightening of monetary policy
Reagan administration - sizable tax cuts
along with increased government
spending

Peak in1985

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The Ups and Downs of the

Dollar

The 1980s, appreciation and then

depreciation
Second half of the 1980s, dollar
depreciation
Speculators expected dollar
depreciation
Sizable currency interventions aimed at
weakening an overvalued dollar
Expansionary monetary policy
Fiscal policy - to reduce the size of
budget deficits

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The Ups and Downs of the

Dollar

The 1990s

Weakening economy, recession in

1991
Expansionary monetary policy
Fiscal policy - increased government
spending and dampened tax receipts
Dollar depreciation

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The Ups and Downs of the

Dollar

The 1990s

Mid-1990s, the U.S. economy was

growing rapidly
Sharp increase in the pace of investment
spending by business
Market acceleration in productivity growth
Strong consumer demand
Deregulation; Trade liberalization; Computer
era

Declining rate of inflation

Dollar appreciation
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The Ups and Downs of the

Dollar

First decade of the 2000s

2002-2004, depreciation of the dollar

Weakening of the demand for dollardenominated assets
Recession in the U.S. in 2001
Declining stock market
Uncertainty about corporate accounting
practices
Steady decline in interest rates
Uncertainty due to the ongoing war on
terrorism and the war with Iraq

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The Ups and Downs of the

Dollar

First decade of the 2000s

By 2005, dollar appreciation

Current and prospective strong performance of
the U.S. economy
Restrictive monetary policy higher interest
rates

20062007, weakening dollar

Slackening of private investment flows

By 2008, stronger dollar

U.S. - safe haven; economic crisis of 2007
2008

2009, weakening dollar

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Exchange-Rate Overshooting
Exchange-rate overshooting
When exchange-rate short-term
response (depreciation or
appreciation)
To a change in market fundamentals
Is greater than its long-term response

Helps explain why exchange rates

depreciate or appreciate so sharply
from day to day
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FIGURE
12.7

Short-term/long-term equilibrium
exchange rates: overshooting

Given the short-term supply of pounds (S0), if the demand for pounds increases from D0 to
D1, then the dollar depreciates from $2 per pound to a short-term equilibrium of $2.20 per
pound. In the long term, the supply of pounds is more elastic (S 1), and the equilibrium
exchange
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at Reserved.
$2.10 per
Because
of or
the
difference
in or
these
elasticities,
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the short-term depreciation of the dollar overshoots its long-term depreciation.
42
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Exchange-Rate Overshooting
Exchange-rate overshooting
Can be explained by
Tendency of elasticities to be smaller in
the short term than in the long term
Exchange rates tend to be more flexible
than many other prices

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Forecasting Foreign-Exchange
Rates

Forecasting exchange rates

Is very tricky, especially in the short

term
Necessary for exporters, importers,
investors, bankers, and foreignexchange dealers
Consulting firms

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TABLE 12.6

Exchange-rate forecasters

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Forecasting Foreign-Exchange
Rates

Judgmental forecasts

Subjective or common sense models.

Require
Wide array of political and economic data
Interpretation of these data in terms of the
timing, direction, and magnitude of
exchange-rate changes

Projections based on a thorough

examination of individual nations
Economic indicators; Political factors
Technical factors; Psychological factors
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Forecasting Foreign-Exchange
Rates

Technical forecasts

Technical analysis
Use of historical exchange-rate data
to estimate future values
Ignoring economic and political
determinants of exchange-rate
movements
History repeats itself
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FIGURE
12.8

Technical analysis of the Yens

exchange value

When forecasting exchange rates, technical analysts watch for new highs
and lows, broken trend lines, and patterns that are thought to predict price
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48
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Forecasting Foreign-Exchange
Rates

Fundamental analysis

The opposite of technical analysis

Considerations of economic variables
that are likely to affect the supply and
demand of a currency
Computer-based econometric models
For individual nations
Attempt to incorporate the fundamental
variables that underlie exchange-rate
movements
Interest rates, balance of trade, productivity,
inflation
rates
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Forecasting Foreign-Exchange
Rates

Limitations of econometric models

used to forecast exchange rates

Rely on predictions of key economic

variables
Factors affecting exchange rates that
cannot easily be quantified
Precise timing of a factors effect on a
currencys exchange rate may be
unclear
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50

GLOBALIZATI
ON

International comparisons of GDP:

purchasing power parity

Gross domestic product (GDP)

Add up the market values of the
goods and services its economy
produces

Use market exchange rate

Misleading: not all goods and services
are traded in a world market

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51

GLOBALIZATI
ON

International comparisons of GDP:

purchasing power parity

Exchange rates
Overstate the size of economies with
relatively high price levels
Understate the size of economies with
relatively low price levels
Subject to sizable fluctuations

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52

GLOBALIZATI
ON

International comparisons of GDP:

purchasing power parity

Purchasing power parity

Takes into account the relative cost of
living and the inflation rates of different
countries

GDPs of countries converted into a

common currency using purchasing
power parities
Are valued at a uniform price level
Reflect only differences in the volumes of
goods and services produced in countries
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TABLE 12.7

Comparing GDPs internationally, 2008:

top 8 countries (billions of dollars)

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TRADE
CONFLICTS

Comercial Mexicana gets burned by

speculation

October 2008, Comercial Mexicana

was prospering
Mexicos third largest retailer and a
competitor of discount giant Wal-Mart
Few days later, it went bankrupt,
Foreign currency losses

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TRADE
CONFLICTS

Comercial Mexicana gets burned by

speculation

Comercial Mexicana
Made bad bets using currency
contracts - linked to the dollar/peso
exchange rate
Expectations of a stronger peso
World credit crisis of 2008
depreciation of the peso

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56