Determinants of Exchange Rates

Why Study Exchange Rates?

To understand the economic environment– Forecasting for planning purposes

To understand exposure to currency risk– Financial impact of exchange rate move varies

• With the nature of the asset/liability• With the cause of the move

Outline: Exchange Rate Determination

1. Market Forces1. Real economic effects

2. Monetary effects

2. Role of Government

Exchange rates are determined by supply and demand for the currencies

Market Forces:Real Effects

To focus on real effects assume:

1. No currency market intervention

2. No inflation in either country

Real exchange rates are determined by real economic events affecting supply

and demand for the currencies

Current Event

“Good News Boosts Dollar,

for a Change”

Balance of Payment AccountsComponents:

Current Account - Goods and Services Financial Account - Investment Reserve Account - Government Reserves

Factors Affecting Trade(Current Account)

Real price “shocks”– Example: Oil price shock

Government policy change– Tariff/ Trade policy

Factors Affecting Investment(Financial Account)

Real return “shocks”– example: turn of business cycle

Government policy (affecting real returns)– tax policy– labor law

Perceived risk– war, political risk

Conclusions about real effects

Changes in any of these real factors Shifts supply or demand for currency

– Affects exchange rate– Of interest to currency forecasters

Is also reflected in balance of payments data– Thus BOP data of interest to forecasters

Market Forces:Monetary Effects

Purchasing Power Parity

Logic:

“arbitrage” in market for goods

U.S. Russia Exchange Rate

Now $1.00/loaf 25 Rb/loaf 25 Rb/$ .04 $/Rb

Next year $1.00/loaf 50 Rb/loaf 50 Rb/$ .02 $/Rb

($/ ) US

Rus

PeRb

P

0

1

1

t

USt

Rus

e e

Definitions: PPP

Absolute Purchasing Power Parity

The purchasing power of the dollar is the same everywhere in the world

Relative Purchasing Power Parity

Exchange rates move to offset differences in rates of inflation.

How well does PPP predict in practice?

Absolute PPP – Not at all

Relative PPP Works well

– In the long run– When differences in inflation are dramatic

Works much less well in the short run

(C) 2014 Melvin H Jameson

Zimbabwe

1994: 25%

1998: 48%

2002: 199%

2006: 1,281% August 2006: 1st redenomination ZWD$1,000 → ZWN$12007: 66,212% August 2008: 2nd redenomination ZWN$10b → ZWR$1Dec. 2008 (estimate): 6.5x10108 % or 91% per day March 2009: Zimbabwe dollar suspended: informal (U.S.)

dollarization

Inflation rates and currency redenomination

Real Exchange Rate

Definition: Exchange rate after removing the effects of inflation

If Purchasing Power Parity holds, then real exchange rates never change

Exchange Rate Policy

The role of government

How governments affect exchange rates

Currency market intervention – (intentional)– Central Bank buys/sells home currency in

exchange for its foreign currency reserves. Monetary policy

– (unintentional through impact of inflation)– Central Bank buys/sells home currency in

exchange for bonds

Types of Exchange Rate Policies

free float (no intervention) “dirty”or managed float(some intervention) fixed exchange rate or “peg” (unlimited

intervention at a fixed rate)– through central bank policy– currency board– dollarization

Lessons about Exchange Rate Policy

Policy matters (especially in the short run).

In the long run no policy can overcome market forces.