exchange rates and their determination: a basic model

International EconomicsInternational Economics, Second Editionby W. Charles Sawyer and Richard L.

Sprinkle

Prepared by Iordanis Petsas

Exchange Rates Exchange Rates and Their Determination: and Their Determination:

A Basic ModelA Basic Model

Copyright © 2006 Pearson Education, Inc. Slide 13-2

IntroductionExchange RatesThe Demand for Foreign ExchangeThe Supply of Foreign ExchangeEquilibrium in the Foreign Exchange MarketChanges in the Equilibrium Exchange RateExchange Rate Volatility and International

TradeSummary

Chapter OrganizationChapter Organization


Why is the exchange rate important?What causes the exchange rate to change?What determines the supply and demand for

foreign exchange?What do economists know about the effects

of exchange-rate volatility on international markets?

IntroductionIntroduction


Demand for Foreign Exchange: Results from domestic residents demanding

foreign goods/services and foreign financial assets

The Demand for The Demand for Foreign ExchangeForeign Exchange



Figure 13.2: The Demand for Foreign Exchange

Pounds

$/Pounds

Demand for Pounds

$1

$2

$3

£1 £2 £3


Shifts in the Demand for Foreign ExchangeChanges in a country’s income levelChanges in relative price levelsChanges in short term interest ratesChanges in a country’s tastes/preferencesChanges in productivity levelsChanges in the degree of trade restrictions

Most important are income, relative prices, and interest rates.



Changes in Domestic IncomeUS income increases.Demand for all goods including imports

increases.This leads to a shift in demand for foreign

currency.Declines in income will work just the opposite.




Figure 13.3: The Change in Demand for Foreign Exchange

Pounds

$/Pounds

Demand for Pounds

D1

D2


Changes in Relative PricesAssume prices for all goods rose in GermanyIf exchange rate did not change, then prices of

German goods in the US would increase.If US goods are competitive, then buyers will

substitute cheaper (US) goods for more expensive (German) goods.



The demand for FXThe demand for FX

Interest ratesAs domestic interest rates fall (rise), domestic

residents will find it more (less) attractive to place their assets abroad (at home)

To do so, they will buy (sell) FX and the demand (supply) will rise.


Supply of Foreign Exchange:The amount of foreign exchange supplied in the

foreign exchange market.

The Supply of The Supply of Foreign ExchangeForeign Exchange



Figure 13.5: The Supply of Foreign Exchange

Supply of Pounds

Pounds

$/Pound

$1

$2

$3

£1 £2 £3


Shifts in the Supply of Foreign Exchange Two important factors:

Changes in Foreign Income Changes in Relative Prices Changes in interest rates



Table 13.6: The Change in Supply for Foreign Exchange


Supply of Pounds

Pounds

$/Pound

S1

S2


Equilibrium Exchange: The exchange rate where the quantity

demanded of foreign exchange equals the quantity supplied.

Equilibrium in the Equilibrium in the Foreign Exchange MarketForeign Exchange Market


Figure 13.7: The Equilibrium Exchange Rate

Equilibrium in the Equilibrium in the Foreign Exchange MarketForeign Exchange Market


Increased demand for imports in the U.S. will cause an increase in the demand for foreign exchange.

U.S. incomes could have risen.

If supply is held constant, the exchange rate must increase to clear the market.

Changes in the Changes in the Equilibrium Exchange RateEquilibrium Exchange Rate



Figure 13.8: A Change in the Equilibrium Exchange Rate

Supply of Euros

$/Euro

1.5

2.0

2.5

100 200 400 Euros

Demand for Euros

300 500



Figure 13.9: A Change in the Equilibrium Exchange Rate

Supply of Euros

Demand for Euros

New Demand

$/Euro

1.5

2.0

2.5

100 200 400 Euros300 500

3.0


New equilibrium exchange rate rose but the volume of trade was unchanged.

Exchange rate attempts to correct for changes in relative prices.

Countries with high/low inflation rates have currencies that depreciate/ appreciate over time.

Depreciation is markets way of compensating for differing rates of inflation.

Exchange Rate Volatility Exchange Rate Volatility and International Tradeand International Trade



Table 13.1 Impact of Changes in the Demand and Supply of

Foreign Exchange and the Equilibrium Exchange Rate


Changes in exchange rates make international trade different from domestic interregional trade

Changes can be partially mitigated through use of forward or futures markets for foreign exchange.

Reduction of risk has a cost Difficult to forecast in the long run



Risk and uncertainty have the result of depressing international trade and investment

Magnitude of effect is not known

Creates a bias toward domestic transactions if exchange rates are allowed to fluctuate



Fluctuating exchange rates have led to an industry of forecasters.

Need reasonably accurate forecasts for country’s GDP and inflation levels

Also other factors that affect exchange rates not discussed here

This model is good for general comments about exchange over the medium to long run.



The exchange rate is the price of one country’s currency in terms of another country’s currency.

Appreciation of the domestic currency is a decrease in the number of units of domestic currency necessary to buy a unit of foreign currency.

SummarySummary


The demand for foreign exchange is related to changes in domestic income, changes in relative prices, and changes in interest rates.

If domestic income rises, then the demand for imports and foreign exchange also will rise, and vice versa.

If domestic prices rise relative to foreign prices, then the demand for imports and foreign exchange will tend to rise.

If domestic interest rates fall relative to foreign interest rates, then the demand for FX will increase to allow residents to obtain higher returning foreign assets.

SummarySummary


The supply of foreign exchange is related to changes in foreign income, changes in foreign prices, and foreign interest rates.

A drop in foreign income or an increase in domestic prices relative to foreign prices would tend to cause a reduction in the supply of foreign exchange.

An increase in foreign prices relative to domestic prices will induce foreigners to import more and sell their currency to purchase foreign exchange.

A decrease in foreign interest rates will cause foreigners to want to acquire US assets, which requires them to sell their currency.

SummarySummary


A country that has faster economic growth than its trading partners will tend to find that its currency is depreciating in the foreign exchange market.

A country that has slower economic growth than its trading partners will tend to find that its currency is appreciating in the foreign exchange market.

A country with high interest rates will find its currency appreciating in FX markets.

Fluctuations in the exchange rate tend to depress the amount of international trade relative to domestic trade.

SummarySummary

exchange rates and their determination: a basic model

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