1. Lecture 6: Exchange Rate Theory
Based on Sloman Chapter 24

2. Definitions of the Exchange Rate
Price of £1 is 1.49 Euros (Euros per pound)
Price of good in UK= price on continent by exchange rate

3. Definitions of the Exchange Rate
Price in £ (pennies) of 1Euro – .67 per Euro
e= Domestic price of foreign currency
Price of good in UK = price of foreign currency multiplied by the price of good abroad

4. Trade equalises prices of tradable good
But what determines ER
Trade equalises prices of tradable good
Once local prices are determined e is determined.
Conversely, if world prices and exchange rate is determined then local prices are determined

5. What determines Prices
Some people argue that prices are determined by money supply
P.Y= MV
GNP=must be paid for
GNP= Money by the time it changes hands

6. What determines Prices
If so exchange rate is determined by ratio of prices

7. What determines Prices
So if increase Md, prices up, E goes down (a depreciation, worth less)
If Velocity rises) money goes around faster, prices up, depreciation
If Income rises (prices fall!!!), E up

8. Big Mac Index
Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.

10. Purchasing Power Parity
Tradeable goods prices are equal
Need to exclude transport costs,
Looking only at the purely tradable component -have to discount fact that property prices in London are the same as in Skye ( NON-TRADABLE GOODS)
Labour costs – e.g. Hair cuts in Budapest v Birmingham

11. Alternative Theory – Interest rate parity
If I invest money in UK expect same return as invest in France
So Interest rates have to be the same
But not.
SO if invest in UK interest rate +movement on ER = return in France.
So if irf =3% and iruk=5% then
3% =5%-depreciation of 2%

12. Alternative Theory – Interest rate parity
So if irf =3% and iruk=5% then
3% =5%-depreciation of 2%
So can put £1 in UK bank at £1.05
OR buy Euro at .67 per Euro=
Get 3% =
Sell at = *
=1.05

13. So ir reflect EXPECTED depreciation
At start
At end
So price of Euro rises (worth less) at end of period

14. These explanations imply government can control the ER
Do I believe?
ER as a random variable?
OK lets focus in ER as something deterministic driven either by trade or finance flows.
Can government manipulate the ER and why?

15. Exchange rate E = Price in Euros of 1£
The exchange rate as a price for the demand and supply of domestic currency S1
Supply – sell £ to buy Forex for imports or foreign investment – Higher E means buy more abroad
er1
Exchange rate E = Price in Euros of 1£
Demand – Foreigners buy £ to buy exports or inward investment D1 O
Quantity of £s

16. Adjustment of the exchange rate to a shift in demand and supply
UK ER fates fall, EU up switch to Euros – S of £ shifts out
er1
Exchange rate
Depreciation
er2 D2 D1 O
Quantity of £s

17. Adjustment of the exchange rate to a shift in demand and supply
Fall in demand for UK exports
er1
Exchange rate
Depreciation
er2 D2 D1 O
Quantity of £s

18. Adjustment of the exchange rate to a shift in demand and supply
Quantity of £s

19. Adjustment of the exchange rate to a shift in demand and supply
Quantity of £s

20. Adjustment of the exchange rate to a shift in demand and supply
Appreciation
er1
Exchange rate D3 D1 O
Quantity of £s

21. With a floating Exchange Rate the price of £ changes in response to S & D.
What will happen to Balance of Payments?
Fluctuations in E ensure the value of imports always equals value of exports so Balance of payments always in balance

22. Fixed Exchange Rate and Balance of Payments deficit
This creates
external imbalance:
i.e. currency flow deficit
S1 by UK
S2 by UK
Exchange rate r1
Fixed
exchange rate
D by overseas
residents O
Quantity of £s

23. Fixed Exchange Rate and Balance of payments surplus
S by UK
Exchange rate
Fixed rate D2
D from abroad O
Quantity of £s

24. UK balance of payments as % of GDP: 1980–2000
Source: Datastream

25. UK balance of payments as % of GDP: 1980–2000
Current
account
Source: Datastream

26. UK balance of payments as % of GDP: 1980–2000
Current
account
Trade in goods
Source: Datastream

27. $ / £ exchange rate:
Index
1990=100
$ / £

28. $ / £ exchange rate:
Index
1990=100
$ / £

29. $ / £ exchange rate and £ exchange rate index: 1976-99
1990=100
$ / £

30. Exchange rate indices averages for each period (1995 = 100)
Source: Sloman based on data in European Economy Statistical Annex (Commission of the European Union)

31. The crawling peg within exchange rate bands
$1.60
$1.40
Exchange rate O
Time No
intervention
Central bank
buys domestic
currency No
intervention
Central bank
sells domestic
currency No
intervention
Source: Sloman

32. If Government changes ER –depreciation- imports become more expensive (shift in)
S2 (Epf)
S of imports
Price in £ r1
So imports fall helping deficit - but cost more hurting deficit
Demand for Imports O
Quantity

33. If Government changes ER –depreciation- and Exports become competitive (shift out)
S of Exports
Exports rise helping deficit
Price in £ r1
D2 (pd/E)
Demand for Exports O

34. But dedpreciation – import tax (tarrif) and export subsidy
If Government changes –depreciates imports become more expensive (shift in) and Exports become competitive (shift out) O
Price in £
S of imports
Demand for Imports r1
S2 (Epf) O
Price in £
S of Exports
Demand for Exports r1
D2 (pd/E)
Argument is that sales of exports and lower imports outweigh additional expense of remaining imports – SO BOP Better
But dedpreciation – import tax (tarrif) and export subsidy

35. EXCHANGE RATE SYSTEMS IN PRACTICE
UK experience of dirty floating
first oil crisis and its aftermath
second oil crisis and the rise in monetarism
effects of growing US budget and trade deficits in the 1980s
the 1985 exchange crisis
joining and leaving the ERM
experience since leaving ERM
fluctuations in the pound
exchange rate consequences of targeting the inflation rate
The volatility of exchange rates 17