Exchange Rate Determination

1
Exchange Rate Determination

• International Corporate Finance
• P.V. Viswanath

2
Outline

• The concept of an equilibrium Exchange Rate
• Basic factors affecting exchange rates
• Calculating currency appreciation/depreciation
  with a given exchange rate change
• Central bank intervention
• Role of expectations
• Equilibrium Approach to Exchange Rates

3
Equilibrium Exchange Rates

• An exchange rate is the price of one nations
  currency in terms of another currency.
• Exchange rates are market clearing prices that
  equilibrate supply and demand in exchange
  markets.
• A spot rate is the price of the currency for
  immediate delivery
• A forward rate is the price for delivery at a
  specified future date.
• The bid rate is the rate at which a dealer is
  willing to buy
• The ask rate is the rate at which a dealer is
  willing to sell.

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Supply and Demand
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Flow Theory of Exchange Rates

• Factors affecting supply of foreign currency
• Foreign countrys demand for home countrys
  exports (goods and services) supplies foreign
  currency
• Demand for exports (in units of goods) is
  decreasing as a function of foreign currency
  price.
• Supply of foreign currency equals total revenue.
  Total revenue as a function of foreign currency
  price is decreasing if demand is elastic.
• Foreign currency price is decreasing in exchange
  rate.
• Hence supply of foreign currency is increasing as
  a function of exchange rate.
• Home countrys demand for foreign countrys
  imports demands foreign currency
• Normally downward sloping as a function of
  exchange rate

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Factors affecting equilibrium rates

• Terms of trade (price of exports relative to
  price of imports)
• The higher the relative price of exports, the
  less the demand for foreign currency (the greater
  the supply of foreign currency).
• Relative inflation in home and foreign countries.
• If there is inflation in the foreign country, the
  demand curve for the home countrys goods will
  move to the left more will be demanded at a
  given exchange rate this will raise the exchange
  rate, i.e. the number of units of home currency
  per unit of foreign currency.
• Foreign Investment in Home Country
• Relative Real Interest Rates
• Relative Economic Growth Rates
• Political and Economic Risk

7
Calculating Exchange Rate Changes

• If the value of the euro rises from 0.93 to
  0.99 per euro, the amount of euro appreciation
  is computed as(0.99 0.93)/0.93 6.45

The value of the dollar drops from 1/0.93 euros
to 1/0.99. Hence the amount of dollar
depreciation is computed as(1/0.93
1/0.99)/(1/0.93) 6.06
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Asset Market Model of Exchange Rates

• A stock of currency in one country can be thought
  of as a claim on the assets, whose prices are
  denominated in that currency, for a given price
  level. Hence it is, itself an asset a
  financial asset.
• Since an exchange rate is the value of one
  currency in terms of another, it can be thought
  of as the ratio of the prices of two financial
  assets.
• Hence exchange rates are affected by the same
  forces that affect asset values.
• Assets, by their very nature, are forward
  looking, and their value is determined by market
  expectations. Hence, exchange rates, too, are
  affected by market expectations.

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Asset Market Model of Exchange Rates

• The Asset Market Model has predictions that are
  differ from those of the flow theory.
• For example, a fiscal deficit might cause people
  to expect a future expansion of the money supply
  and hence an immediate depreciation of the
  currency.
• In the standard theory, the fiscal deficit would
  lead to greater borrowing from abroad. This
  leads to a greater demand for the local currency
  and a strengthening of the currency.
• This result obtains because it is assumed that
  people do not alter their savings and their
  demands for funds.
• In practice, it is likely that people will
  increase their savings in anticipation of higher
  taxes in the future this will reduce the
  domestic demand for the home currency and lead to
  a drop in the value of the home currency.

10
Monetary Theory of Exchange Rates

• Currencies are, primarily monies. Hence, a
  theory of exchange rates would do well to
  consider the nature of a money.
• Money provides liquidity it can be exchanged
  for goods and services, or for other assets.
• Money represents a store of value and a store of
  liquidity.
• The demand for money is affected by the demand
  for assets denominated in that currency the
  higher the expected real return and the lower the
  riskiness of a countrys assets, the greater is
  the demand for its currency to buy those assets.
• Factors that increase the demand for the home
  currency also increase the price of home currency
  on the foreign exchange market.

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The Nature of Money and Currency Values

• The economic factors that affect a currencys
  foreign exchange value include
• Its usefulness as a store of value, determined by
  its expected rate of inflation
• The demand for liquidity, determined by the
  volume of transactions in that currency
• The demand for assets denominated in that
  currency, determined by the risk-return pattern
  on investment in that nations economy and by the
  wealth of its residents.

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How money supply affects exchange rates

• M money supply P price level y real GNP
  v money velocity.
• i inflation rate m growth rate of money
  supply gy growth rate of real GNP gv change
  in velocity of money
• PPP says
• Combining previous identity with PPP, we get

13
Central Bank Reputations and Currency Values

• The central bank uses instruments of monetary
  policy to create price stability, low interest
  rates or a target currency value.
• Most money today is fiat money nonconvertible
  paper money, not tied to any commodity value.
• Hence, trust in the central bank translates into
  trust in the currencys future value.

14
Price Stability and Central Bank Independence

• In order to retain public credibility, central
  banks have to be like company managements or
  boards of directors
• They need to adopt rules for price stability that
  are verifiable, unambiguous and enforceable.
• This requires independence and accountability.
• Central banks that lack independence are often
  forced by the government to pursue political
  goals, such as lower interest rates or higher
  economic growth.
• Often the bank is forced to monetize the deficit.
• Paradoxically, though, these goals are achievable
  only to the extent that the central bank is
  trusted and a consistent attempt to put
  political objectives over economic ones will
  cause people to lose trust in the central bank.

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Central Bank Independence Inflation
16
Central Bank Independence and Growth
17
Maintaining Trust in the Currency

• Currency Board
• There is no central bank. The currency board
  issues notes and coins that are convertible on
  demand at a fixed rate into a foreign reserve
  currency
• The currency board holds high-quality,
  interest-bearing securities denominated in the
  reserve currency
• Its reserves are equal to 100 or more of its
  notes and coins in circulation.
• A currency board forces a government to follow a
  responsible fiscal policy. It cannot force the
  central bank to monetize the deficit.

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Maintaining Trust in the Currency

• Dollarization
• This is the complete replacement of the local
  currency with the U.S. dollar
• The central bank loses seignorage.
• However, monetary discipline is easier to
  maintain with a currency board, the market
  might not believe in the governments commitment
  to maintain full reserves.

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Real Exchange Rates and Relative Competitiveness

• As the real (inflation-adjusted) value of the
  dollar rises, the dollar prices of imported goods
  and raw materials drop.
• Hence, the prices of imports and of products that
  compete with imports drop.
• The foreign currency prices of US goods rise US
  exports become less competitive in world markets
  and US import substitutes become less competitive
  in the US.
• Unemployment is generated in the traded-goods
  sector and resources are shifted from the traded-
  to the nontraded-goods sector.

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Foreign Exchange Market Intervention

• Some governments will prefer an overvalued
  domestic currency lower import prices and
  potentially lower prices.
• Others will prefer an undervalued currency
  better for employment in the traded goods sector.
• Others might prefer a correctly valued currency,
  but might not believe that the market rate is
  correct.
• For all of these reasons, governments engage in
  foreign exchange market intervention.

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Maintaining a non-equilibrium rate
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Maintaining a non-equilibrium rate

• The equilibrium level of the exchange rate in
  Fig. 2.2 is e1, at which Q1 euros are demanded
  and supplied.
• If the US and German governments decide to
  maintain the old rate, e0, there will be an
  excess demand for euros equal to Q3-Q2.
• Either the American Central Bank or the European
  Central Bank will have to intervene in the market
  to supply this additional quantity of euros.
• The US will face a perpetual balance-of-payments
  deficit equal to (Q3-Q2)e0 dollars, or
  equivalently a German balance-of-payments surplus.

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Maintaining a non-equilibrium rate

• If the US government intervenes by selling euros
  and buying dollars, dollars will become more
  scarce relative to euros and the dollar will
  appreciate relative to the euro, as desired.
• Typically, the government will not sell euros
  directly rather it will sell euro-denominated
  bonds, since that is the form in which foreign
  currencies are normally kept.
• In any case, because of the paucity of dollars,
  the interest rate will be affected it will rise
  and the government may not desire this.

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Sterilized vs. Unsterilized Intervention

• In order to offset this, the government can buy
  Treasury bills and increase the supply of money
  correspondingly. This is called sterilization.
• The net result is that the supply of domestic
  money is kept constant, and so the interest rate
  will not be affected.
• However, the public now holds fewer domestic
  securities and more foreign securities.
• If investors consider domestic and foreign
  securities to be perfect substitutes, then they
  will be happy to hold the new combination without
  any change in the exchange rate. This means that
  the desired lower exchange rate (stronger dollar)
  will not be achieved.

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Sterilized vs. Unsterilized Intervention

• However, if investors believe that domestic and
  foreign securities are not perfect substitutes,
  then they will not want to hold this new
  portfolio that is skewed towards foreign
  securities.
• Investors will try to reduce their holdings of
  foreign securities by selling them.
• Consequently, the euro must fall and the dollar
  must rise in order to move the actual proportion
  of dollar to foreign denominated security
  holdings to the desired level.

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Sterilized vs. Unsterilized Intervention

• Empirically, sterilized interventions do not seem
  to work. This could be because investors dont
  accept the premise of an overvalued euro and
  hence are willing to hold the increased supply of
  euro-denominated securities at the current
  exchange rate.
• Unsterilized interventions can work however,
  they do so by causing a change in fundamental
  variables in our example, there would be
  deflation in the US if it bought up dollars (and
  sold euros) and thus reduced the money supply.
• Hence if the underlying problem is an excess of
  dollars, then unsterilized interventions can
  work.
• On the other hand, in this case, there is no need
  for foreign exchange market intervention. Open
  market purchases of dollars will suffice and the
  foreign exchange rate will automatically adjust.

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Intervention to change the equilibrium exchange
rate

• If the currency is already in equilibrium, but
  the government for political reasons desires to
  depreciate the currency, it might engage in
  intervention, in the hope that a cheaper dollar
  will increase demand for domestic goods.
• However, the intervention in this case will
  ultimately cause inflation because the money
  supply will go up. This will increase domestic
  wages and will erode the temporary gain in
  competitiveness.
• This may drive the currency lower, if markets
  expect further interventions, leading to an
  inflation-devaluation cycle.
• Sterilization in this case is not likely to work
  because investors will simply absorb the
  increased supply of domestic securities without
  depreciating the dollar.

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Nominal and Real Exchange Rates

• The real exchange rate is the exchange rate
  between real units of purchasing power in two
  countries.
• That is, the real exchange rate is simply the
  nominal exchange rate adjusted for inflation
  differences.
• If fundamental factors determine the real
  exchange rate, the nominal exchange rate should
  simply reflect the real exchange rate.
• Changes in the nominal interest rate that are
  caused by changes in relative money supplies
  should have no impact on the real interest rate.
• However, in practice, real and nominal exchange
  rates seem to be correlated. This suggests that
  nominal exchange rates affect real exchange rates.

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Dornbuschs disequilibrium approach to explaining
exchange rate changes

• Suppose the US increases its money supply. In
  the long run, this will cause US prices to be
  proportionately higher, and the value of the
  dollar to be proportionately lower. In the short
  run, however, a larger nominal money supply will
  mean a larger real money supply because prices
  are sticky and dont rise.
• Since this forces investors to hold more real
  money balances than they desire, they will try to
  buy bonds to get rid of this excess cash. This
  causes real US interest rates to be lower.
• Lower real interest rates will cause a
  more-than-proportionate drop in the value of the
  dollar i.e the dollar will drop in real terms.
  However, this drop in real interest rates and the
  real exchange rate is temporary. Once the price
  level adjusts, investors will reverse their
  purchases of bonds. This will cause the real
  interest rate to rise, and the real exchange rate
  along with it.

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The disequilibrium approach

• Along with the drop in the real interest rate,
  the nominal interest rate drops as well, since
  price levels have not changed.
• But why would investors be willing to hold US
  bonds at a lower interest rate, relative to bonds
  denominated in other assets? This can only
  happen if they expect the dollar to appreciate.
• But an appreciation can occur only if the dollar
  initial falls below its equilibrium real value,
  i.e. if it overshoots.
• Hence we have both real and nominal exchange
  rates moving downwards in the beginning and then
  recovering, thus causing a positive correlation
  between the two.

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The Disequilibrium Approach
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The Equilibrium Approach to Exchange Rates

• The disequilibrium approach predicts that as
  domestic prices rise, so should the exchange
  rate. This has not been observed, in practice.
• The equilibrium approach concludes, rather, that
• Exchange rates do not cause changes in relative
  prices rather exchange rates and relative prices
  are determined simultaneously.
• The primary source of exchange rate changes, in
  practice, are not monetary disturbances, as
  assumed by the disequilibrium approach, but
  rather real disturbances.
• Attempts by governments to affect the real
  exchange rate via foreign exchange market
  intervention will fail real exchange rates
  affect nominal exchange rates and not vice-versa.

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The Equilibrium Approach to Exchange Rates

• Real disturbances to supply or demand in the
  goods market cause changes in relative prices,
  including the real exchange rate.
• These changes in the real exchange rate often are
  accomplished, in part, through changes in the
  nominal exchange rate.
• Repeated shocks in supply or demand thus create a
  correlation between changes in nominal and real
  exchange rates.

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The Equilibrium Approach to Exchange Rates

• Consider the following example.
• Suppose there is a fall in the demand for
  domestic goods. This will cause the domestic
  currency to depreciate in real terms.
• However, the currency will also depreciate in
  nominal terms, as well, since there will be less
  demand for the nominal currency.
• This will create a positive correlation between
  real and nominal exchange rates.

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Summary

• The disequilibrium approach assumes that the
  central bank can affect real exchange rates,
  while the equilibrium approach assumes that real
  exchange rates can only be affected by
  fundamentals and not by any kind of intervention.
• If the equilibrium approach is correct, real
  exchange rates should be less variable in an era
  of floating exchange rates in fact, this has not
  been the case.
• The real issues is not whether monetary policy
  has any impact at all on real exchange rates, but
  whether that impact is of first- or second-order
  importance.