CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES

CHAPTER 2 OVERVIEW: PART n I. EQUILIBRIUM EXCHANGE RATES n II.ROLE OF CENTRAL BANKS n III.EXPECTATIONS AND THE ASSET MARKET MODEL

Part I. Equilibrium Exchange Rates I. SETTING THE EQUILIBRIUM A. Exchange Rates market-clearing prices that equilibrate the quantities supplied and demanded of foreign currency.

Equilibrium Exchange Rates B. How Americans Purchase German Goods 1. Foreign Currency Demand -derived from the demand for foreign country’s goods, services, and financial assets. e.g. The demand for German goods by Americans

Equilibrium Exchange Rates 2. Foreign Currency Supply: a. derived from the foreign country’s demand for local goods. b. They must convert their currency to purchase. e.g. German demand for US goods means Germans convert DM to US $ in order to buy.

Equilibrium Exchange Rates 3. Equilibrium Exchange Rate: occurs when the quantity suppliedequals the quantity demanded of a foreign currency at a specific local price.

Equilibrium Exchange Rates C. How Exchange Rates Change 1. Increased demand as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa.

Equilibrium Exchange Rates 2. Home Currency Depreciation a. Foreign currency becomes more valuable than the home currency. b. Conversely, the foreign currency’s value has appreciated against the home currency. currency’s value has appreciated against the home currency.

Equilibrium Exchange Rates 3. Calculating a Depreciation: Currency Depreciation where e 0 = old currency value e 1 = new currency value e 1 = new currency value Note: Resulting sign is always negative

Equilibrium Exchange Rates Currency Appreciation

Equilibrium Exchange Rates EXAMPLE: dm Appreciation If the dollar value of the dm goes from $0.64 (e 0 ) to $0.68 (e 1 ), then the dm has appreciated by = ( )/.64 = 6.25%

Equilibrium Exchange Rates EXAMPLE: US$ Depreciation We use the first formula, (e 0 - e 1 )/ e 1 substituting ( )/.68 = % which was the US$ depreciation. which was the US$ depreciation.

Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 1.Inflation rates 2. Interest rates 3.GNP growth rates

THE ROLE OF CENTRAL BANKS THE ROLE OF CENTRAL BANKS I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION A.Role of Exchange Rates: LINKS BETWEEN THE DOMESTIC AND THE WORLD ECONOMY WORLD ECONOMY

THE ROLE OF CENTRAL BANKS B.THE IMPACT OF EXCHANGE RATE CHANGES 1.Currency Appreciation: -domestic prices increase relative to foreign prices. - Exports: less competitive - Imports: more attractive

THE ROLE OF CENTRAL BANKS 2.Currency Depreciation - domestic prices fall relative to foreign prices. - Exports: more competitive. - Imports: less attractive

THE ROLE OF CENTRAL BANKS C.Foreign Exchange Market Intervention 1.Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate.

THE ROLE OF CENTRAL BANKS 2. Goal of Intervention: -to alter the demand for onecurrency by changing the supply of another. -to alter the demand for onecurrency by changing the supply of another.

THE ROLE OF CENTRAL BANKS D. The Effects of Foreign Exchange Intervention 1. Effects of Intervention: - either ineffective or irresponsible - either ineffective or irresponsible 2.Lasting Effect: - If permanent, change results

Part III. EXPECTATIONS I.WHAT AFFECTS A CURRENCY’S VALUE? A.Current events B.Current supply C.Demand flows *D.Expectation of future exchange rate

EXPECTATIONS II.Role of Expectations : A.Currency = financial asset B.Exchange rate = simple relation of two financial assets

EXPECTATIONS III.Demand for Money and Currency Values: Asset Market Model A. Exchange rates reflect the supply of and demand for foreign-currency denominated assets.

EXPECTATIONS B.Soundness of a Nation’s Economic Policies - a nation’s currency tends to strengthen with sound economic policies.

EXPECTATIONS IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR - exchange rates also influenced by expectations of central bank behavior.

EXPECTATIONS A.Central Bank Reputations B.Central Bank Independence C.Currency Boards