Foreign Exchange Rate Determination

Foreign Exchange Rate Determination Exchange rate determination is complex The three major schools of thought are the balance of payments approach (Ch 4), international parity conditions (Ch 7), and the asset market approach The exhibit on the next slide provides an overview of the many determinants of exchange rates In addition to focusing on the asset market approach, the monetary approach and the technical analysis are also introduced in this chapter These are not competing but rather complementary theories, so understanding all of them can enhance our ability to capture the complexity of global currency markets and exchange rates

The Determinants of Foreign Exchange Rates International Parity Conditions (Ch 7) 1. Relative inflation rates (RPPP) 2. Relative interest rates (international Fisher effect) 3. Forward exchange rates 4. Interest rate parity (IRP) Spot Exchange Rate Technical Analysis Monetary Approach Asset Market Approach (Ch 10) 1. Relative real interest rates 2. Prospects for economic growth 3. Supply & demand for financial assets 4. Outlook for political stability 5. Speculation & market liquidity 6. Contagion & corporate governance Balance of Payments (Ch 4) 1. Current account balances 2. Portfolio investment 3. Foreign direct investment 4. Official monetary reserves 5. Exchange rate regimes ※ Most determinants of the exchange rate, e.g., the balance of BOP, the inflation rates, the nominal and real interest rates, and the economic prospects, are also in turn affected by changes in the exchange rate ※ In other words, they are not only linked but mutually determined

Foreign Exchange Rate Determination In addition to gaining an understanding of the basic theories or determining factors for the exchange rate, it is equally important to gain the following knowledge which could affect the exchange rate markets 1. The complexities of international political economy Foreign political risks have been much reduced in recent years because more countries adopted democratic form of government, so capital markets became less segmented from each other and more liquid 2. Societal and economic infrastructures Infrastructure weakness were the major reasons of the exchange rate collapses in emerging markets in the late 1990s 3. Random political, economic, or social events For example, recent occurrences of terrorism may increase the political risks and affect the exchange rate market

Exchange Rate Determination: The Theoretical Thread 10-5

Exchange Rate Determination: The Theoretical Thread Exchange Rate Determination: The Theoretical Thread This section will provide a brief overview of the many different theories to determine exchange rate and their relative usefulness in forecasting The theories discussed in this section include Purchasing power parity approach Balance of payments (flows) approach Monetary approach Asset market approach Technical analysis

Exchange Rate Determination: The Theoretical Thread Exchange Rate Determination: The Theoretical Thread The theory of Purchasing Power Parity states that the exchange rate is determined as the relative prices of goods PPP is the oldest and most widely followed exchange rate theory Paul Krugman, Nobel Prize laureate in Economics in 2008, said that “Under the skin an international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate” Most exchange rate determination theories have PPP elements embedded within their frameworks However, PPP calculations and forecasts are plagued with structural differences across countries (e.g., different tax rules or many non- tradable production factors) and significant challenges of data collecting in estimation

Exchange Rate Determination: The Theoretical Thread Exchange Rate Determination: The Theoretical Thread The Balance of Payments (Flows) approach argues that the equilibrium exchange rate is determined through the demand and supply of currency flows from current and financial account activities The BOP method is the second most utilized theoretical approach in exchange rate determination Today, this method is largely dismissed by academics , but practitioners still rely on different variations of the theory for decision making This framework is appealing since the BOP transaction data is readily available and widely reported Critics may argue that this theory emphasizes on flows of currency, but stocks of currency or financial assets of residents play no role in exchange rate determination The monetary approach considers the currency stocks of residents The asset market approach argues that exchange rates are altered by shifts in the supply and demand of financial assets

Exchange Rate Determination: The Theoretical Thread Exchange Rate Determination: The Theoretical Thread The Monetary Approach states that the supply and demand for currency stocks, as well as the expected growth rates of currency stocks, will determine the price level or the inflation rate and thus explain changes of the exchange rate according to PPP The arguments are all about currency stocks of residents The inference is to link the demand or the supply of currencies with residents’ behavior to adjust the stock of currencies Main results of the monetary approach are as follows: Currency supply ↑  domestic currency depreciation 1. Currency supply ↑  supply of currency > demand of currency  residents’ current currency holding > residents’ desired currency holding  residents spend the currency  price level ↑  according to PPP, domestic currency depreciates 2. Domestic currency supply growth rate > foreign currency supply growth rate  domestic currency depreciates vs. foreign currency

Exchange Rate Determination: The Theoretical Thread Exchange Rate Determination: The Theoretical Thread Interest rate ↑  domestic currency depreciation 1. Interest rate ↑  opportunity cost for residents to hold the currency increases  demand of currency ↓  residents’ current currency holding > residents’ desired currency holding  residents spend the currency  price level ↑  according to PPP, domestic currency depreciates 2. Increase of domestic interest rate > increase of foreign interest rate  domestic currency depreciates against foreign currency Real income ↑  domestic currency appreciation 1. Real income ↑ (= real GDP ↑ = outputs of products and services ↑)  number of transactions ↑  demand of currency ↑  residents’ current currency holding < residents’ desired currency holding  residents decrease the spending of the currency  price level ↓ (or because the supply of products and services ↑, price level ↓ and less currency is spent to achieve the same utility)  according to PPP, domestic currency appreciates 2. Domestic real income growth rate > foreign real income growth rate (domestic economic growth > foreign economic growth)  domestic currency appreciates against foreign currency

Exchange Rate Determination: The Theoretical Thread Exchange Rate Determination: The Theoretical Thread The monetary approach omits a number of factors: The failure of PPP to hold in the short to medium term The change of the interest rate and the real income will affect the economic activities and thus affect the currency supply In the above inference, however, the change of the interest rate and the real income affect only the currency demand Currency demand appearing to be relatively unstable over time There are many factors other than the interest rate and the real income to affect the money demand, e.g., the economic boom or recession, so the money demand is difficult to be predicted

Exchange Rate Determination: The Theoretical Thread Exchange Rate Determination: The Theoretical Thread The Asset Market Approach argues that the exchange rate should be determined by expectations about the future of an economy, not current trade flows Since the prospect of an economy is reflected on the demand of financial assets in that economy, the asset market approach believes that changes of exchange rates are affected by changes of the supply and demand for a wide variety of financial assets: Shifts in the supply and demand for financial assets alter exchange rates (not the demand and supply of financial assets determine the exchange rate) The asset market approach is also called the relative price of bonds or portfolio balance approach

Exchange Rate Determination: The Theoretical Thread Exchange Rate Determination: The Theoretical Thread More specifically, if the demand for domestic financial assets increases, the demand for the domestic currency will increase, which could results in the appreciation of the domestic currency Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter the demand and supply of financial assets and thus exchange rates (In the 1980s, many macroeconomic theories focused on this topic) Later I will introduce the determining factors in the asset market approach in detail

Exchange Rate Determination: The Theoretical Thread Exchange Rate Determination: The Theoretical Thread Technical analysis is based on the belief that the study of past price behaviors provides insights into future price movements Due to the poor forecasting performance of many fundamental theories, the technical analysis draws more attention and becomes popular The primary assumption of the technical analysis is that the movements of any market driven price (e.g., exchange rates) must follow trends More specifically, technical analysts, traditionally referred to as chartists, focus on price and volume data to identify trends that are expected to continue into the future and next exploit trends to make profit