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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
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
PeRbP
0
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1
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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
Real Exchange Rate
• Definition: Exchange rate after removing the effects of inflation
• If Purchasing Power Parity holds, then real exchange rates never change
Interest Rate Parity
• Logic:– Arbitrage in financial markets
– Return on a dollar invested must be the same everywhere
– Called “covered interest arbitrage”
Forward Exchange Rate
An exchange rate agreed upon today for a currency exchange to be carried out at a specified date in the future.
Equal return on $ investment
(1 ) (1 )US Rus
fi i
e
e($/Rb) f($/Rb)
Unbiased Forward Rate
• Definition - forward rates are unbiased predictors of future spot rates
• Logic: Speculation on forward markets
• Consequences– Single most useful rule for currency prediction– With CIA connects interest rates to expected
exchange rates
Rus
US
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iefe
1
1ˆ 01
Predictions based on parity conditions
t
Rus
USt ee
ˆ1
ˆ1ˆ 0
t
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Exchange rate forecasting summary
1. Use forward rates (if available)
2. Interest rates can be used to construct an “implied forward rate”
3. Consider anticipated changes in real factors and monetary policies
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.