Lecture 15 – Foreign Exchange Market Factors influencing exchange rates

Factors affecting exchange rates There are mainly five factors that influence exchange rates. They are: – Domestic prices – Trade barriers – Import demand – Export demand – productivity

Domestic Prices In the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate and a fall in the country’s relative price level causes its currency to appreciate.

Trade Barriers In international trade some barriers to free trade exist – such as tariffs (taxes on imported goods) – And quotas (restrictions on the quantity of foreign goods that can be imported) When trade barriers increase, they increase demand for local goods local currency tends to appreciate because local goods will still sell well even with a higher value of the local currency.

Preferences for Domestic Versus Foreign Goods. Increased demand for a country’s exports causes its currency to appreciate in the long run; conversely, increased demand for imports causes the domestic currency to depreciate EXAMPE: If the Japanese develop an appetite for American goods,the increased demand for American goods (exports) tends to appreciate the dollar, because the American goods will continue to sell well even at a higher value for the dollar.

If a country becomes more productive, businesses in that country can lower the prices of goods relative to foreign goods and still earn a profit. As a result, the demand for domestic goods rises, and the domestic currency tends to appreciate. Productivity

More often, foreign exchange market is not a free market Central bank of the country manages the exchange rate by buying and selling currencies With these interventions, money supply is also influenced Central bank intervention in exchange market

Unsterilized foreign exchange intervention Suppose SBP decides to sell $500 million of its foreign exchange reserves in exchange for pakistani currency, this transaction will have two impacts: – It will reduce the SBP foreign exchange reserves by $500 million – Currency in circulation will fall by the same amount

When the central bank activity in the foregin exchange market results in change in the monetary supply, it is called unsterilized foregin exchange intervention A foreign exchange intervention with an offsetting open market operation that leaves the monetary supply unchanged is called sterilized foregin exchange intervention

Exchange rate regimes Exchange rate regimes in the international financial system are of two basic types: Fixed and floating In a fixed exchange rate regime, the value of currency are kept pegged relative to one currency called the anchor currency so that exchange rates are fixed In a floating exchange rate regime, the value of currencies are allowed to fluctuate against one another

However, countries often attempt to influence their exchange rates by buying an selling currencies, so in this case the regime is refffered to as a managed float regime

When the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate rate fixed, but as a result it loses international reserves With the domestic currency undervalued, the central bank must sell currecny to keep the exchange rate fixed, but as a result it gains international reserves Fixed rate regime