Determinants of Exchange Rates

Why Study Exchange Rates?  To understand the economic environment –Forecasting for planning purposes  To understand exposure to currency risk –Financial impact of exchange rate move varies With the nature of the asset/liability With the cause of the move

Outline: Exchange Rate Determination 1. Market Forces 1.Real economic effects 2.Monetary effects 2. Role of Government

Exchange rates are determined by supply and demand for the currencies

Market Forces: Real Effects

To focus on real effects assume: 1. No currency market intervention 2. No inflation in either country

Real exchange rates are determined by real economic events affecting supply and demand for the currencies

Current Event “Good News Boosts Dollar,Good News Boosts Dollar, for a Changefor a Change”

Balance of Payment Accounts Components:  Current Account - Goods and Services  Financial Account - Investment  Reserve Account - Government Reserves

Factors Affecting Trade (Current Account)  Real price “shocks” –Example: Oil price shock  Government policy change –Tariff/ Trade policy

Factors Affecting Investment (Financial Account)  Real return “shocks” –example: turn of business cycle  Government policy (affecting real returns) –tax policy –labor law  Perceived risk –war, political risk

Conclusions about real effects Changes in any of these real factors  Shifts supply or demand for currency –Affects exchange rate –Of interest to currency forecasters  Is also reflected in balance of payments data –Thus BOP data of interest to forecasters

Market Forces: Monetary Effects

Purchasing Power Parity  Logic: “arbitrage” in market for goods

Definitions: PPP  Absolute Purchasing Power Parity The purchasing power of the dollar is the same everywhere in the world  Relative Purchasing Power Parity Exchange rates move to offset differences in rates of inflation.

How well does PPP predict in practice? Absolute PPP – Not at all Relative PPP  Works well –In the long run –When differences in inflation are dramatic  Works much less well in the short run

Zimbabwe 1994:25% 1998:48% 2002:199% 2006:1,281%  August 2006: 1 st redenomination ZWD$1,000 → ZWN$1 2007:66,212%  August 2008: 2 nd redenomination ZWN$10b → ZWR$1 Dec (estimate):6.5x % or 91% per day  March 2009: Zimbabwe dollar suspended: informal (U.S.) dollarization (C) 2014 Melvin H Jameson Inflation rates and currency redenomination

Real Exchange Rate  Definition: Exchange rate after removing the effects of inflation  If Purchasing Power Parity holds, then real exchange rates never change

Exchange Rate Policy The role of government

How governments affect exchange rates  Currency market intervention –(intentional) –Central Bank buys/sells home currency in exchange for its foreign currency reserves.  Monetary policy –(unintentional through impact of inflation) –Central Bank buys/sells home currency in exchange for bonds

Types of Exchange Rate Policies  free float (no intervention)  “dirty”or managed float(some intervention)  fixed exchange rate or “peg” (unlimited intervention at a fixed rate) –through central bank policy –currency board –dollarization

Lessons about Exchange Rate Policy  Policy matters (especially in the short run).  In the long run no policy can overcome market forces.