dale r. deboer university of colorado, colorado springs 12 - 1 an introduction to international...
TRANSCRIPT
Dale R. DeBoerUniversity of Colorado, Colorado Springs
12 - 1
An Introduction to International Economics
Chapter 12: Exchange Rate Determination
Dominick Salvatore
John Wiley & Sons, Inc.
12 - 2Dale R. DeBoerUniversity of Colorado, Colorado Springs
Forces the determine exchange rates
• 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.
12 - 3Dale R. DeBoerUniversity of Colorado, Colorado Springs
Forces the determine exchange rates
• Relative rates of economic growth
• 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.
12 - 4Dale R. DeBoerUniversity of Colorado, Colorado Springs
Forces the determine exchange rates
• Relative rates of economic growth
• Relative rates of inflation
• 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.
12 - 5Dale R. DeBoerUniversity of Colorado, Colorado Springs
Forces the determine exchange rates
• Relative rates of economic growth
• Relative rates of inflation
• Changes in interest rates
• Expectations– If it is expected that the dollar will fall in value,
people will move out of dollar holdings.– As dollar holdings fall, the dollar will depreciate.
12 - 6Dale R. DeBoerUniversity of Colorado, Colorado Springs
Trade approach
• The trade approach to exchange rate determination focuses on the role of international trade in determining exchange rates.– Also known as the elasticities approach– Works better as a long-run model of exchange
rate determination.
12 - 7Dale R. DeBoerUniversity of Colorado, Colorado Springs
Trade approach
• The trade approach to exchange rate determination focuses on the role of international trade in determining exchange rates.
• In this approach, the equilibrium exchange rate is the rate that balances imports and exports.– If the nation has a trade deficit, its currency will
depreciate.– If the nation has a trade surplus, its currency will
appreciate.
12 - 8Dale R. DeBoerUniversity of Colorado, Colorado Springs
Purchasing power parity theory
• The law of one price– The idea that in the absence of barriers to trade
the price of homogenous traded commodities will be identical in all markets.
– Example• Suppose that glassware sells in the U.S. for $1/unit.• If the exchange rate is ¥100/$1, the price in Japan
should be ¥100/unit.• If this does not occur, then profitable opportunities for
arbitrage exist.
12 - 9Dale R. DeBoerUniversity of Colorado, Colorado Springs
Purchasing power parity theory
• The law of one price– The idea that in the absence of barriers to trade the
price of homogenous traded commodities will be identical in all markets.
– In other words, $P = ¥P•R where R is the dollar price of one unit of foreign currency, $P is the dollar price of the homogenous commodity, and ¥P is the foreign currency price of the homogenous commodity.
12 - 10Dale R. DeBoerUniversity of Colorado, Colorado Springs
Purchasing power parity theory
• The law of one price• If the law of one price holds for all goods, then
absolute purchasing power parity (PPP)will hold.– Absolute purchasing power parity holds that
equilibrium exchange rates are equal to the ratio of price levels in the two nations.
– In other words, P = P*•R where R is the dollar price of one unit of foreign currency, P is the price level in the U.S., and P* is the price level in the foreign nation.
12 - 11Dale R. DeBoerUniversity of Colorado, Colorado Springs
Purchasing power parity theory
• The law of one price
• If the law of one price holds for all goods, then absolute purchasing power parity (PPP) will hold.
• Absolute purchasing power parity does not hold in absence to perfect free trade.– Non-traded commodities– Barriers to trade– Transaction costs
12 - 12Dale R. DeBoerUniversity of Colorado, Colorado Springs
Purchasing power parity theory
• The law of one price
• If the law of one price holds for all goods, then absolute purchasing power parity (PPP) will hold.
• Absolute purchasing power parity does not hold in absence to perfect free trade.
• Relative purchasing power parity postulates that the change in the exchange rate is equal to the difference in the change in the price levels (rates of inflation) of the two countries.
12 - 13Dale R. DeBoerUniversity of Colorado, Colorado Springs
The monetary model of exchange rates
• The monetary model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of currency.
12 - 14Dale R. DeBoerUniversity of Colorado, Colorado Springs
The monetary model of exchange rates
• The monetary model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of currency.
• An increase in the U.S. money supply (assuming no change in other money supplies) will depreciate both nominal (spot) and real exchange rates.– The real exchange rate is the nominal exchange
rate weighted by the consumer price index of the two nations.
12 - 15Dale R. DeBoerUniversity of Colorado, Colorado Springs
The asset model of exchange rates
• The asset model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of financial assets.– It is also known as the portfolio model
12 - 16Dale R. DeBoerUniversity of Colorado, Colorado Springs
The asset model of exchange rates
• The asset model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of financial assets.
• An increase in the U.S. money supply (assuming no change in other money supplies) will lower interest rates in the U.S. and shift investors from domestic to foreign assets and lead to a depreciation of the dollar.
12 - 17Dale R. DeBoerUniversity of Colorado, Colorado Springs
The asset model of exchange rates
• An increase in the U.S. money supply (assuming no change in other money supplies) will lower interest rates in the U.S. and shift investors from domestic to foreign assets and lead to a depreciation of the dollar.
• The depreciation in the dollar spurs U.S. exports and discourages imports.– This encourages the formation of a trade surplus.
12 - 18Dale R. DeBoerUniversity of Colorado, Colorado Springs
The asset model of exchange rates
• An increase in the U.S. money supply (assuming no change in other money supplies) will lower interest rates in the U.S. and shift investors from domestic to foreign assets and lead to a depreciation of the dollar.
• The depreciation in the dollar spurs U.S. exports and discourages imports.
• The movement in trade encourages an appreciation of the dollar that partially offsets the initial depreciation.
12 - 19Dale R. DeBoerUniversity of Colorado, Colorado Springs
Exchange rate dynamics
• In adjusting to long run equilibrium values, exchange rates tend to “overshoot” the final equilibrium value.
• Suppose that the exchange rate is initially at $1/€1.
Time$/
€
1
12 - 20Dale R. DeBoerUniversity of Colorado, Colorado Springs
Exchange rate dynamics
• Suppose that the exchange rate is initially at $1/€1.
• At time A, the money supply in the U.S. increases causing the exchange rate to depreciate.
Time$/
€
1
A
12 - 21Dale R. DeBoerUniversity of Colorado, Colorado Springs
Exchange rate dynamics
• If the long run equilibrium exchange rate (determined by the PPP model) is expected to be $1.10/ €1, in the short run the exchange rate will overshoot this value (perhaps to $1.16/ €1).
Time$/
€
1
A
1.16
12 - 22Dale R. DeBoerUniversity of Colorado, Colorado Springs
Exchange rate dynamics
• The overshooting drives an improvement in the balance of trade that will lead to subsequent appreciation of the dollar.
Time$/
€
1
A
1.16
12 - 23Dale R. DeBoerUniversity of Colorado, Colorado Springs
Exchange rate dynamics
• The overshooting drives an improvement in the balance of trade that will lead to subsequent appreciation of the dollar.
• Over time, the dollar will fall to its long run equilibrium value.
Time$/
€
1
A
1.16
1.10
12 - 24Dale R. DeBoerUniversity of Colorado, Colorado Springs
Exchange rate forecasting
• Models of exchange rates have not been very successful at predicting future exchange rates.
12 - 25Dale R. DeBoerUniversity of Colorado, Colorado Springs
Exchange rate forecasting
• Models of exchange rates have not been very successful at predicting future exchange rates.
• Reasons– Exchange rates are highly influenced by new
information.
12 - 26Dale R. DeBoerUniversity of Colorado, Colorado Springs
Exchange rate forecasting
• Models of exchange rates have not been very successful at predicting future exchange rates.
• Reasons– Exchange rates are highly influenced by new
information.– Expectations in exchange rate markets tend to be
self-fulfilling (at least in the short-run).• This may generate movements in the market contrary to
what is expected by theory.