Factors influencing exchange rates: Supply and Demand for a Currency Short – run … financial transactions Market fundamentals Current account balances Real interest rates Market expectations News about future market fundamentals Speculative opinion about future exchange rates
Factors influencing exchange rates Medium – run Real income … business cycle Monetary policy and fiscal policy Product availability Long – run Inflation rates Consumer preferences for domestic or foreign products Productivity changes affecting production costs … and prices Profitability and riskiness of investments Government trade policy
Impact of interest rate differentials: drop in US interest rate $ depreciation Dollars per Yen S0 B .0080 .0075 A D1 D0
Impact of real income differentials: increase in US income $ depreciation Dollars per Pound B 1.60 1.50 A D1 D0
Purchasing power parity (PPP): The Law of One Price A good should cost the same in all countries (aside from tariffs or transportation costs) Exchange rates should make prices equal across countries P = ER x P* ($/bourbon) = ($/£) x (£ /scotch) = ($/scotch) If two countries have different inflation rates, exchange rates will move keep prices the same The currency of the high inflation country will depreciate (P/P*) ER ($/£)
Impact of inflation rate differentials: high US inflation $ depreciation Dollars per Pound S0 B 1.70 1.50 A D1 D0
Market expectations As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining for a while
Impact of expectations: expectation of $ depreciation $ depreciation Dollars per Pound S0 B 1.70 1.50 A D1 D0
Alternative approaches to exchange rates Monetary approach Focus on exchange rates as the result of supply and demand for money at home and abroad Demand depends on real income, prices, interest rates Supply is controlled by central banks Ms $ depreciates Real income Md $ appreciates Interest rate Md $ depreciates ??!?