the determination of exchange rates2
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The determination ofexchange rates
2011
Group 1Astari IndraputriAhmad Fajarudin
Yogi Ardisa
Management International Class Program
Introduction
Setting the Equilibirum Spot Exchange Rate
Expectations and the Asset Market Model of Exchange Rates
The Fundamentals of Central Bank Intervention
The Equilibirum Approach to Exchange Rates
Table of Content
Introduction
Introduction
The purpose of this chapter is to provide an understanding of what
an exchange rate is and why it might change.
It also examines the different forms and consequences of central bank
intervention in the foreign exchange market.
Settingthe Equilibrium Spot
Exchange Rate
Setting the Equilibrium Spot Exchange Rate
Definition
An exchange rate is the price of one nation’s currency in terms of
another currency, often termed the reference currency.
Example:
the yen/dollar exchange rate is just the number of yen that one dollar
will buy.
Setting the Equilibrium Spot Exchange Rate
Demand for a Currency
The demand for the euro, in the foreign market derives from the American
demand for German goods and services and euro-dominated financial
assets.
Supply for a Currency
The supply of euros is based on German demand for U.S. goods and
services and dollar-dominated financial assets.
Setting the Equilibrium Spot Exchange Rate
Factors that Affect the Equilibrium Exchange Rate
1. Relative Inflation Rates
The supply of currency increases relative to its demand. The
excess growth in the money supply will cause inflation.
2. Relative Interest Rates
Interest rate differentials will also affect the equilibrium
exchange rate. The distinction between nominal and real interest
rates is critical in international finance.
Setting the Equilibrium Spot Exchange Rate
Factors that Affect the Equilibrium Exchange Rate
3. Relative Economic Growth Rates
A nation with strong economic growth will attract investment
capital seeking to acquire domestic assets.
A nation with poor growth prospects will see an exodus of capital
and weaker currencies.
4. Political and Economic Risk
low-risk currencies are more highly valued than high-risk currencies.
Setting the Equilibrium Spot Exchange Rate
Calculating Exchange Rate Change
Depending on the current value of the euro relative to the dollar, the
amount of euro appreciation or depreciation is computed as the
fractional increase or decrease in the dollar value of the euro.
Calculating Exchange Rate Change
The general formula by which we can calculate the euro’s appreciation
or depreciation against the dollar is as follows:
Amount of euro = New dollar value of euro – Old dollar value of euro
appreciation Old dollar value of euro
Setting the Equilibrium Spot Exchange Rate
Setting the Equilibrium Spot Exchange Rate
Calculating Exchange Rate Change
The general formula by which we can calculate the euro’s appreciation
or depreciation against the dollar is as follows:
Amount of euro = New euro value of dollar – Old euro value of dollar
depreciation Old euro value of dollar
Expectations andthe Asset Market Model
of Exchange Rates
Asset Market Model
The asset market model argues that exchange rates are
determined by the supply and demand for a wide variety of financial
assets:
1. Shifts in the supply and demand for financial assets alter exchange
rates.
2. Changes in monetary and fiscal policy alter expected returns and
perceived relative risks of financial assets, which in turn alter
exchange rates.
Expectations and the Asset Market Model of Exchange Rates
Asset Market Model
The asset market model assumes that whether foreigners are
willing to hold claims in monetary form depends on an extensive set of
investment considerations or drivers (among others):1. Prospects for economic growth2. Capital market liquidity3. A country’s economic and social infrastructure4. Political safety5. Contagion (spread of a crisis within a region)6. Speculation
Expectations and the Asset Market Model of Exchange Rates
Monetary Theory of Exchange Rates Currencies are, primarily monies. Hence, a theory of
exchange rates would do well to consider the nature of a money.
1. Money provides liquidity – it can be exchanged for goods and
services, or for other assets.
2. Money represents a store of value and a store of liquidity.
3. The demand for money is affected by the demand for assets
denominated in that currency.
4. Factors that increase the demand for the home currency also
increase the price of home currency on the foreign exchange market.
Expectations and the Asset Market Model of Exchange Rates
The Nature of Money and Currency Values
The economic factors that affect a currency’s foreign
exchange value include:
1. Its usefulness as a store of value, determined by its expected rate of
inflation
2. The demand for liquidity, determined by the volume of transactions
in that currency
3. The demand for assets denominated in that currency, determined by
the risk-return pattern on investment in that nation’s economy and
by the wealth of its residents.
Expectations and the Asset Market Model of Exchange Rates
Central Bank Reputations and Currency Values
The central bank uses instruments of monetary policy to create price
stability, low interest rates or a target currency value.
Most money today is fiat money – nonconvertible paper money, not tied
to any commodity value.
Hence, trust in the central bank translates into trust in the currency’s
future value.
Expectations and the Asset Market Model of Exchange Rates
Price Stability and Central Bank Independence In order to retain public credibility, central banks have to be like
company managements or boards of directors:
1. They need to adopt rules for price stability that are verifiable,
unambiguous and enforceable.
2. This requires independence and accountability.
3. Central banks that lack independence are often forced by the
government to pursue political goals, such as lower interest rates
or higher economic growth.
4. Often the bank is forced to monetize the deficit.
Expectations and the Asset Market Model of Exchange Rates
Price Stability and Central Bank Independence
Paradoxically, though, these goals are achievable only to the extent that
the central bank is trusted – and a consistent attempt to put political
objectives over economic ones will cause people to lose trust in the
central bank.
Expectations and the Asset Market Model of Exchange Rates
Maintaining Trust in the Currency
Currency Board
1. There is no central bank. The currency board issues notes and
coins that are convertible on demand at a fixed rate into a foreign
reserve currency
2. The currency board holds high-quality, interest-bearing securities
denominated in the reserve currency
Expectations and the Asset Market Model of Exchange Rates
Maintaining Trust in the Currency
Currency Board
3. Its reserves are equal to 100% or more of its notes and coins in
circulation.
4. A currency board forces a government to follow a responsible fiscal
policy. It cannot force the central bank to monetize the deficit.
Expectations and the Asset Market Model of Exchange Rates
Maintaining Trust in the Currency
Dollarization
1. This is the complete replacement of the local currency with the
U.S. dollar
2. The central bank loses seignorage.
3. However, monetary discipline is easier to maintain – with a
currency board, the market might not believe in the government’s
commitment to maintain full reserves.
Expectations and the Asset Market Model of Exchange Rates
The Fundamentalsof Central Bank
Intervention
How Real Exchange Rates Affect Relative Competitiveness
The important point for now is that an appreciation of the exchange rate
beyond that necessary to offset the inflation differential between two
countries raises the prices of domestic goods raletive to the price of
foreign goods.
Home currency depreciation results in a more competitive traded-goods
sector, stimulating domestic employment and inducing a shift in
resources from nontraded to the traded-goods sector.
The Fundamentals of Central Bank Intervention
How Real Exchange Rates Affect Relative Competitiveness
The bad part is that currency weakness also results in higher prices for
imported goods and services, eroding living standards and worsening
domestic inflation.
The Fundamentals of Central Bank Intervention
Foreign Exchange Market Intervention
Foreign exchange market intervention refers to official purchases
and sales of foreign exchange that nations undertake through their central
banks to influence their currencies.
• Mechanics of Intervention
The general purpose : to increase the market demand for one currency
by increasing the market supply of another.
• Sterilized versus Unsterilized Intervention
The Fundamentals of Central Bank Intervention
The Effects of Foreign Exchange Market Intervention
The basic problem with central bank intervention ia that it is likely to
be either ineffectual or irresponsible.
Sterilized intervention could affect exchange rates by conveying
information or by altering market expectations.
Unsterilized intervention can have a lasting effect on exchange rates,
but by creating inflation in some nations and deflation in other.
The Fundamentals of Central Bank Intervention
Open-Market Operations
Open-market operation affect the equilibrium exchange rate in a
manner analogous to unsterelized intervention, primarily through their
impact on inflation rates.
To sumarize the empirical evidance, real exchange rates are determined
primarily by real economic variables, such as relative national incomes
and interest rates between countries.
The Fundamentals of Central Bank Intervention
The EquilibirumApproach to
Exchange Rates
The Equilibirum Approach toExchange Rates
Disequilibrium Theory and Exchange Rate Overshooting
The correlation between nominal and real exchange rate
changes is supplied by the disequilibrium theory of exchange rates.
The sequences of events associated with overshooting is as
follows:
1. The central bank expands the domestic money supply.
2. This monetary expansion depresses domestic interest rates.
3. Capital begins flowing out of the country because of the lower domestic
interest rates, causing an instantaneous
The Equilibirum Approach toExchange Rates
The Equilibrium Theory of Exchange Rates and Its
Implications
The equilibrium approach has three important implication
for exchange rate :
1. Exchange rates do not cause changes in relative prices but are part of
the process through which the changes occur in equilibrium.
2. Attempts by government to affect the real exchange rate via foreign
exchange market will fail.
The Equilibirum Approach toExchange Rates
The Equilibrium Theory of Exchange Rates and Its
Implications
The equilibrium approach has three important implication
for exchange rate :
3. There is no simple relation between changes in the exchange rate
and changes in international competitiveness, employment, or the
trade balance.
Thank You
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