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Exchange rate determination

Overview of exchange rate determination

Exchange rates are determined by the interaction of many forces, some of a long run in nature while others of a short-run nature. when the exchange rates are free to fluctuate, the exchange rate is determined at the intersection of the market demand and supply curves of foreign exchange. But saying concretely, exchange rates are affected by many important forces.

Continued: Overview of exchange rate determination 1. Relative rates of economic growth If the U.S. grows more rapidly than the rest of the world, its demand for imports will increase more rapidly. By itself, this should increase the demand for foreign currency and lead to depreciation of the dollar. 2. Relative rates of inflation If U.S. inflation is greater than the rate of inflation in the rest of the world, the dollar will decrease in value.

Continued: Overview of exchange rate determination

3. Changes in interest rates If U.S. interest rates fall relative to interest rates in the rest of the world, the demand for U.S. interest bearing assets will fall. By itself, this will lead to a fall in international demand for the dollar and a depreciation of the dollar. 4. Expectations If it is expected that the dollar will fall in value, people will move out of dollar holdings.

12.3 Trade of elasticity approach Trade or elasticitys approachThe theory or approach that stresses the role of trade or the flow of goods and services in the determination of exchange rates. This model is more useful in explaining exchange rates in the long run than in the short run. The trade approach to exchange rate determination focuses on the role of international trade in determining exchange rates.

Continued: 12.3 Trade of elasticity approach

If the value of the nations imports exceeds the value of nations exports (i.e., if the nation faces a trade deficit), the exchange rate will rise (i.e., the domestic currency will depreciate). This makes the nations exports cheaper to foreigners and imports more expensive to domestic residents. The result is that the nations exports rise and its imports fall until trade is balanced.

Continued: 12.3 Trade of elasticity approach Since the amount and speed of adjustment depend on how responsive (elastic) imports and exports are to price (exchange rate) changes, this approach is referred to as the trade or elasticity approach. If the nation is at or near full employment, a larger depreciation of the nations currency is required to shift domestic resources to the production of more exports and import substitution than if the nation has unemployed resources.

Continued: 12.3 Trade of elasticity approach Alternatively, domestic policies may be required to reduce domestic expenditures (absorption) to release domestic resources to produce more exports and import substitutes, and thus allow the elasticity approach to operate.

12.3 Purchasing-power parity theory

1. Purchasing-power parity (PPP) theoryThe theory that postulates that the change in the exchange rate between two currencies is proportional to the change in the ratio in the two countries general price levels.

Continued: 12.3 Purchasing-power parity theory

2. Absolute purchasing-power parity theory postulates that the equilibrium exchange rate between two currencies is equal to the ratio of the price levels in the two nations. Specifically: R=P/P Where R is the exchange rate or spot (defined as the domestic-currency price of a unit of the foreign currency) and P and P are, respectively, the generally price level in the home nation and in the foreign nation.

Continued: 12.3 Purchasing-power parity theory

3. law of one price, a given commodity should have the same price (so that the purchasing power of the two currencies is at parity) in both countries when expressed in terms of the same currency. If the price of a given commodity is not equal, the commodity arbitrage would cause the price of the commodity to be equalized. Commodity arbitrage thus operates just as does currency arbitrage in equalizing commodity prices throughout the market.

Continued: 12.3 Purchasing-power parity theory

4. Relative purchasing-power parity theory The theory that postulates that the percentage change in the exchange rate is equal to the difference in the percentage change in the price level in the two countries.

12.5 The monetary model of exchange rates

1. Monetary model of exchange ratesThe theory that postulates that exchange rates are determined in the process of equilibrating or balancing the stock or total demand and supply of money in each nation.

Continued: 12.5 The monetary model of exchange rates

According to the monetary model of exchange rates, an increase in the nations money supply leads to a proportionate increase in prices and depreciation of the nations currency in the long run, as postulated by the PPP theory. For example, if U.S. monetary authorities increase the money supply by 10 percent but the EMU does not, the general price level in the United States should increase by 10 percent and the dollar exchange rate increase (i.e., the dollar depreciate) by 10 percent, say from R = 1 to R = 1.1, in the long run. The nominal and real exchange rates of the dollar should then move together by the same percentage over time.

Continued: 12.5 The monetary model of exchange rates

An increase in the U.S. money supply (assuming no change in other money supplies) will depreciate both nominal (spot) and real exchange rates.

Continued: 12.5 The monetary model of exchange rates

2. Nominal exchange rateThe exchange or the domestic currency price of the foreign currency.

Continued: 12.5 The monetary model of exchange rates

3. Real exchange rate is the nominal exchange rate weighted by the consumer price index of the two nations.

12.6 Asset or portfolio model of exchange rates

1. Asset or portfolio model of exchange rates The theory that postulates that exchange rates are determined in the process of equilibrating or balancing the demand and supply of financial assets in each country.

Continued: 12.6 Asset or portfolio model of exchange rates

Starting from a position of portfolio or financial and trade balance, the asset or portfolio model postulates that an increase in a nations money supply leads to an immediate decline in the interest rate in the nation and to a shift from domestic bonds to the domestic currency and to foreign bonds.

Continued: 12.6 Asset or portfolio model of exchange rates

The shift from domestic bonds to domestic currency arises because the cost of holding cash has now diminished, while the shift to foreign bonds results from their relatively higher interest rates now that the domestic interest rate has fallen on domestic bonds.

Continued: 12.6 Asset or portfolio model of exchange rates The shift from domestic to foreign bonds causes an immediate depreciation of the home currency as individuals and firms exchange domestic for foreign currency in order to purchase more foreign bonds. Over time, this depreciation stimulates the nations exports and discourages the nations imports. This leads to a trade surplus and appreciation of the domestic currency, which neutralizes part of its original depreciation.

Continued: 12.6 Asset or portfolio model of exchange rates Thus, the asset or portfolio model also explains the overshooting (i.e., the large and frequent fluctuations) in foreign exchange rates that is often observed in the real world. This is discussed next.

12.7 Exchange rate dynamics

Exchange rate overshootingThe tendency of exchange rates to immediately depreciate or appreciate by more than required for long-run equilibrium, and then partially reversing their movement as they move toward their long-run equilibrium levels.

Continued: 12.7 Exchange rate dynamics

Figure 12.6. Overshooting of Dollar exchange rates

Continued: 12.7 Exchange rate dynamics To summarize, we can say that since financial markets clear or adjust to disequilibria much faster than commodity markets, exchange rates are much more sensitive from day to day and from week to week to capital market imbalances than to commodity market and trade imbalances. The latter, however, are critical determinants of medium-run and long-run exchange rate trends, as postulated by the elasticity approach and the PPP theory.

Continued: 12.7 Exchange rate dynamics By considering both financial and trade adjustments, the asset or portfolio model has become the centerpiece for the analysis of exchange rate determination. In its present form, however, the model still does not provide a complete and unified theory of exchange rate determination that fully and consistently integrates all the financial and commodity markets forces that affect exchange rates over the immediate, the short, and the long runs.