Upload
shivendra-kumar-agrawal
View
222
Download
0
Embed Size (px)
Citation preview
8/6/2019 Foregin Exchange
1/21
EXCHANGE RATE DETERMINATION
Introduction
What are the factors that cause supply and demand for exchange to change?
There are
several theories on this topic.
Some theories attempt to explain short run movements in exchange rates
while others
study long run movements. The determinants of equilibrium exchange rates
in the short run
and in the long run tend to be different.
1. Balance of Payments Approach to Exchange Rate Determination
This approach emphasizes the flows of goods, services, and investment
capital that
respond gradually to real economic factors such as GDP. It predicts that
exchange rate
depreciation for countries with deficits in their current accounts and
appreciation for
countries with surplus.
8/6/2019 Foregin Exchange
2/21
Recall D for FX involves all debit transactions in the BPs. S involves all credit
transactions.
D is downward sloping and S is upward sloping.
S and D for FX reflect changes in the domestic D for foreign goods and
services and in the
foreign D for domestic goods and services. These, in turn, are determined by
macroeconomic conditions at home and abroad.
relative prices of domestic and foreign goods
(e.g.) If U.S. inflation rate is higher than U.K.? D for British goods goes up; D
for
American goods down; D for FX up, S down; $ depreciation.
(Figure 1)
the level of real income within countries
(e.g.) If U.S. income grows faster than U.K.? American D for British goods
goes up
(why?); D for FX goes up; S goes down; $ depreciates.
8/6/2019 Foregin Exchange
3/21
technological change
consumer tastes
others including resource accumulation, harvest conditions, strikes, market
structure, and commercial policy.
International capital movement also affects exchange rates in the short run.In general,
easy credit and relatively low short-term interest rates lead to exchange rate
depreciation
for a country. (Short term interest differential is a key determinant of
international capital
movements.)
(e.g.) The case where U.S. interest rate is relatively lower than U.K. due to
the feds
easy monetary policy. American investors will want to invest in London; D forpound
increase; British investors will want to avoid $ denominated assets for
investment; S
8/6/2019 Foregin Exchange
4/21
of pound goes down; the result? $ depreciates.
The balance of payments approach is no longer popular. It cant explain short
run volatility
of exchange rates, as it emphasizes flows of funds that adjust gradually over
a period of
time. It is also difficult to decide which BP account to use to predict exchange
rate
movements.
2. The Monetary Approach to Exchange Rate Determination
This approach views the money supply and money demand at home and
abroad as major
determinants in exchange rate movements. It suggests that an increase in
the domestic
money supply causes the home currency to depreciate, while an increase in
domestic
money demand causes it to appreciate.
The aggregate money supply is controlled by central banks.
The aggregate money demand is a function of real income, prices, and
8/6/2019 Foregin Exchange
5/21
interest rates.
How an increase in money supply leads to depreciation of home currency: As
money supply
goes up, domestic spending and income rise; imports increase; D for FX goes
up. Also, as
money expands, interest rate goes down; Americans invest abroad; D for FX
increases.
The result: $ depreciates.
(Figure 2)
Show how an increase in money demand will lead to an appreciation of home
currency.
The monetary approach suggests that if we can forecast money demands
and money
supplies, we can forecast long run movements in exchange rates.
The monetary approach is criticized for paying too much emphasis on money
while ignoring
other important variables. In addition, empirical support of the theory has
been mixed.
8/6/2019 Foregin Exchange
6/21
3. Expectations and Exchange Rates
Day-to-day movements in exchange rates are closely related to peoples
expectations.
The following are examples of expectations that will lead to appreciation in
the yen and a
depreciation in the dollar:
economy will grow faster than the Japanese economy
interest will be lower than Japans
inflation rate will be higher than Japans
Money supply will grow faster in U.S. than in Japan
All these will, if true, cause $ to depreciate and yen to appreciate.
A graphical illustration of how expectations of future inflation can affect
exchange rates:
Start at initial equilibrium. Suppose people expect a depreciation of $ for
some
reason (e.g., unanticipated growth in money supply in the U.S.); Americans
who
8/6/2019 Foregin Exchange
7/21
intend to buy goods from Germany will purchase DM before $ depreciates. D
for DM
increases (D curves shifts up).
The Germans, having the same expectations, will be less willing to obtain $
whose
value is expected to decline. The supply of DM declines (S curve shifts up).
Both cause the ($/DM) rate to increase now; $ depreciates, DM appreciates.
The
expectations are self-fulfilling.
(Figure 3)
4. The Asset-Markets (Portfolio-Balance) Approach
a. Introduction
This approach extends the monetary approach in that it includes domestic
currencies to be
one among many financial assets that a nations citizens desire to hold (e.g.,
domestic
8/6/2019 Foregin Exchange
8/21
currency, domestic securities, foreign securities denominated in a foreign
currency, foreign
currency, ).
This approach suggests that stock adjustments among financial assets
(reallocating stock
of wealth among assets in various countries) are a key determinant of short
term
movements in exchange rates. It maintains that it is mainly through the
medium of market
expectations of future returns that exchange rates are affected in the short
run. Other
variables such as the CA balance or money supply growth affect exchange
rates to the
extent that they influence market expectations.
This theory explains the movements in exchange rates in terms of the D and
S of assets
denominated in different currencies.
b. The theory
8/6/2019 Foregin Exchange
9/21
1) Exchange rates and a nations money supply (Ms)
If Ms, value of $ will decline. (e.g. During 1922-23, Germanys Ms by trillion
times
(hyperinflation); value of FX in Germany by trillion times.
Ms is controlled by central banks. (e.g. the Fed)
2) Transaction D for money (Md)
Why would people want to hold money? To buy goods and services. (cf. Other
motives for
Md: as an asset, speculation) Why would people demand FX? To buy foreign
goods and
services.
Md is a function of interest rate (r), price level (p) and real income (y). (e.g.
When r goes
up, opportunity cost of holding money increases; Md goes down. When p
goes up, more
money is needed to buy the same basket of goods; Md goes up. When y goes
up, people
demand more goods, and thus demand more money.
8/6/2019 Foregin Exchange
10/21
Md curve is downsloping. Why? Given the y level, real Md and r are inversely
related.
(Figure 4)
What happens to the Md curve when y increases? (Shift to right!)
3) Money market equilibrium
Equilibrium in the money market requires Ms=Md or (Ms/p)=(Md/p). But
Md=p*L(r, y) and
(Md/p)=L(r, y) since Md is directly proportional to p. (Why? A 10% increase in
p means you
need 10% more money to buy the same basket of goods). Thus, equilibrium
requires:
(Ms/p) = L(r, y)
(Figure 5)
4) Effects of changes in Ms and y on the equilibrium r
(e.g.) Ms goes up, [(Ms/p) > (Md/p) at r]; people find that they are holding
more money
8/6/2019 Foregin Exchange
11/21
their desired level; r declines as unwilling money holders try to lend out some
money. A
nations Ms and r are inversely related.
(Figure 6)
(e.g.) y (GDP) from y1 to y2; Md curve shift up to right as people want to hold
more
money for transaction D; r goes up.
(Figure 7)
5) Effects of changes in Ms and y on the exchange rates
Consider world money market equilibrium: S of money = (M*/M), therelative supply of DM
(the FX in question) to $. (Recall Ms in the U.S. and Germany are fixed at any
given time.
Thus, the ratio is also fixed.) D for money = (L*/L), the relative D for DM to $.
This Money
demand ratio is a function of (y*/y), (r*/r), expectations, etc.
(e.g.) As the Bundesbank increases the German Ms, (M*/M) goes up, the
world Ms curve
8/6/2019 Foregin Exchange
12/21
shifts to right; e (exchange rate measure in $/DM rate) would go down. DM
depreciation
($ appreciation)
(Figure 8)
(e.g.) As German real income (y*) increases relative to y in the U.S.; (y*/y)
will increase,
and D for DM will go up. [(L*/L) increases as people need to hold more DM for
transaction
purpose.]; (L*/L) curve shifts up and e goes up (DM appreciation or $
depreciation)
If y* is a result of governments expansionary policy, its main effect may bean increase in
imports so that (L*/L) declines as Germans would want to have more $ to buy
more from
America.
(Figure 9)
6) Other determinants of exchange rate
8/6/2019 Foregin Exchange
13/21
Factors that can shift (L*/L), besides (y*/y), include: (r*-r), expectations, BT
(e.g.) If (r*-r)>0 (i.e., r*>r), more DM will be demanded (why?); (L*/L) will
increase and e
goes up (DM appreciation)
(e.g.) If (M*/M) decline is expected, $ depreciation is expected and people
would sell $ for
DM before its too late. e increases ($ depreciates) today
(e.g.) Government policies toward private assets such as freezing assets,
possible
taxation, . can affect investors expectations.
(e.g.) If deficit goes up in the American BT (or CA) balance, FX market would
react to
bring down $ value. (why?)
5. Purchasing Power Parity (PPP) Approach
Introduction
If the value of a countrys currency rises above the level warranted by its
economic
8/6/2019 Foregin Exchange
14/21
conditions, the exporting industries of the country will become less
competitive in
international markets and a trade deficit will be likely to follow. It is
important, therefore,
for policy makers to have forecasting ability about the equilibrium value of
exchange rate if
an effective exchange rate management is desired. In fact, discussion of
overvalued or
undervalued currency assumes that there exists a stable equilibrium
exchange rate to
which the value of a currency can be referenced. The purchasing-power
parity (PPP)
theory states that the equilibrium value of an exchange rate is determined by
the changes
in the relative national price levels. For example, if the U.S. price level rises
by 10 percent
over a year while Japans price level rises by only 6 percent, then relative PPP
predicts
that the dollar will depreciate against the yen by 4 percent. The dollars 4
percent
8/6/2019 Foregin Exchange
15/21
8/6/2019 Foregin Exchange
16/21
confirm the validity of longrun PPP while Frankel (1985), Kim (1990) and
Abuaf and Jorion
(1990) were able to support it. These and other studies for the test of PPP
employed
various statistical methods using different sample periods and frequencies of
data.
The Law of One Price and PPP
The law states that in competitive markets free of transportation costs and
barriers to
trade, identical goods sold in different countries must sell for the same price
when their
prices are expressed in terms of the same currency.
(e.g.) Let e = $2/ , P of a sweater = 20 in London, $50 (or 25) in New York,
then the
price in NY is higher; arbitrage would bring NY price down and London price
up until the
prices are equal.
Expressing the law in general terms, for any good,
8/6/2019 Foregin Exchange
17/21
PUS = (e$/ ) x PUK.
Carrying the law to all goods, the equation also states PPP.
The Model
The relative version of PPP states that the percentage changes in the
exchange rate
between two currencies over a period of time reflect the differences in the
inflation rates
of the two countries over the same time period. It asserts that exchange
rates and
national prices will adjust in such a way that the ratio of the purchasing
powers of two
currencies remains steady. Relative PPP can be represented by the equation
(Equation 1)
where r is the nominal exchange rate between home and partner country
defined as units of
partner countrys currency per unit of home currency, p* denotes the price
level of the partner
country, p is that of the home country and k is a constant. Relative PPP
8/6/2019 Foregin Exchange
18/21
indicates that k is
stable in the long run. Testing the validity of PPP statistically entails some
modifications of the
equation. First, a random disturbance term needs to be included as the
relation in (1) is not
expected to hold exactly. In addition, the coefficient on the price ratio is
treated as an unknown
parameter rather than a known constant. (Whitt 1988) Finally an intercept
term is usually
included in a linear specification of the PPP equation. The resulting equation
is as follows:
(Equation 2)
where the subscript t denotes the time period t, u is a random error term, a
an intercept term
and b the coefficient of the price indexes to be estimated. Both variables, the
exchange rate
and the ratio of price indexes, are measured in logarithms. In empirical
testing if the coefficient b
is not significantly different from unity, the PPP principle would be confirmed.
8/6/2019 Foregin Exchange
19/21
There are several practical issues to be resolved in testing the PPP
relationship. First, it is
argued that low frequency data are more appropriate for long run PPP. In the
absence of
annual data for a substantially long period, this study will use both monthly
and quarterly
observations. Second, there are at least three alternative price indexes that
can be used
as proxies for the price level: the GNP deflator, the Consumer Price Index
(CPI) and the
Wholesale Price Index (WPI). The GNP deflator is regarded as a poor choice
since it does
not properly reflect the changes in the average price level while the WPI is
biased toward
the PPP hypothesis. The CPI is the primary choice for this study as it is
considered to be a
reasonable choice (Layton and Stark 1990) and is more readily available. For
a comparison
purpose, WPI series will be also used for the countries for which data are
available. Finally,
8/6/2019 Foregin Exchange
20/21
this study will employ the concept of cointegration to test the PPP hypothesis
since the
newly developed method is, as discussed in the following section, considered
to be
particularly suitable in examining longrun equilibrium relationships.
The PPP theory has several limitations: The theory overlooks the fact that
exchange rate
movement may be affected by capital flows. There is a problem of choosing
the
appropriate price index (CPI, PPI, ) and the base year. Government
commercial policy
can interfere with the operation of the theory (trade restrictions).
Empirical evidence on PPP is also mixed. For the countries with high inflation
rates (e.g.,
Latin America), the theory appears to perform well. However, when inflation
differential is
small, factor other than price comparisons can become more important in the
determination
8/6/2019 Foregin Exchange
21/21