CH 4 Exchange Rate Determination

equilibrium

equates the quantity of pounds demanded with the supply of pounds for sale Exhibit 4.4 -below equilibrium there would be a shortage since demand > supply -Above equilibrium there would be a surplus, since supply> demand

Financial institutions can attempt to benefit from the expected appreciation of a currency by

purchasing that currency. -Analogously, they can benefit from expected depreciation of a currency by borrowing that currency and exchanging it for their home currency.

Impact of appreciation in the investment currency

-Increased trade volume can have a major influence on exchange rate movements over a short period. -investors prefer to borrow a currency with a low interest rate that will be expected to weaken and to invest in a currency with a high interest rate that they expect wil strengthen

Factors that influence exchange rate will change over time as the supply and demand schedules change

1. Change in the differential between US inflation and foreign country's inflation 2. Change in the differential between the US interest rate and the foreign country's interest rate 3. Change in the differential between the US income level and the foreign country's income level (GDP) 4. Change in government controls 5. Change in expectations of future exchange rates (speculator)

Government Controls via

1. Imposing foreign exchange barriers 2. Imposing foreign trade barriers 3. Intervening in foreign exchange markets 4. Affecting macro variables such as inflation, interest rates, and income levels.

change in the equilibrium Exchange Rate

1. Increase in demand schedule 2. Decrease in demand schedule 3. Increase in supply schedule 4. Decrease in Supply Schedule

Financial Factors

1. interest rate differential, 2. capital flow restrictions, 3. exchange rate expectations Effect demand for currency

Trade Related Factors

1.inflation differential, 2. income differential, 3. government trade restrictions Effect demand for goods

Increase in demand schedule

Banks will increase the exchange rate to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market -Make the price go up so demand goes down, and supply goes up

Decrease in supply schedule

Banks will increase the exchange to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market -increase the exchange rate (price), amount demanded will go down and supply will increase

Decrease in demand Schedule

Banks will reduce the exchange rate to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market -lower the price so demand goes up and supply goes down

Increase in supply schedule

Banks will reduce the exchange rate to the level at which the amount demanded is equal to the amount supplied in the foreign exchange market -reduce the price of the pound, increase in amount demanded

Depreciation VS Appreciation

Depreciation: decline in a currency's value -A negative percent change indicates that is has depreciated Appreciation: increase in a currency's value -A positive percent change indicates that the currency has appreciated

EX: Euro January 1 $1.18 Euro February 1 $ 1.16 C$ January $0.70 C$ February $0.71

Euro= 1.16-1.18/1.18= -1.7% Depreciation C$= .71-.70/.70= 1.43% Appreciation

real interest rate

Fisher effect Real interest rate= Nominal interest rate- inflation rate -other things held constant, a high US real rate of interest tends to boost the dollars value

influence of liquidity on exchange rate adjustment

If a currency's spot market is liquid then its exchange rate will not be highly sensitive to a single large purchase or sale

Institutional Speculation based on expected depreciation

If financial institutions believe that a currency is valued higher than it should be in the foreign exchange market, they may borrow funds in that currency and convert it to their local currency now before the currency's value declines to its proper level.

Relative Income Levels

Increase in U.S. income leads to an increase in U.S. demand for foreign goods, an increased demand for foreign currency relative to the dollar, and an increase in the exchange rate for the foreign currency Exhibit 4.7 -Equilibrium will rise since supply stays the same and demand increases

Relative Inflation Rates

Increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency, and an increase in the exchange rate for the foreign currency -demand will shift to the right (increase in demand) and supply will shift up (decrease in supply) Exhibit 4.5

Relative Interest Rates

Increase in U.S. rates leads to increase in demand for U.S. deposits and a decrease in demand for foreign deposits, leading to a increase in demand for dollars and an increased exchange rate for the dollar. -Demand for pounds will shift inward and supply will shift out as supply has increased

Speculation by individuals

Individuals can speculate in foreign currencies -a currency's movement on a single day could wipe out their entire cash position

Comparing foreign currency spot rates over two points in time, S and St-1

Percent Change in foreign currency value= (S-St-1)/St-1 AKA new-old/old

There are distinct international trade and financial flows between every pair of countries.

These flows dictate the unique supply and demand conditions for the currencies of the two countries, which affect the equilibrium cross exchange rate between their currencies. -Movement in the exchange rate between two non-dollar currencies can be inferred from the movement in each currency against the dollar.

Institutional Speculation Based on expected appreciation

When financial institutions believe that a currency is valued lower than it should be in the foreign exchange market, they may invest in that currency before it appreciates. -they can then sell it at a higher price once it appreciates and make a profit

The "carry trade"

Where investors attempt to capitalize on the differential in interest rates between two countries Risk: exchange rates may move opposite to what the investors expected "cost of carry"

Explaining Movements in Cross Exchange Rate

changes are affected in the same way as types of forces explained earlier for those that affect demand and supply conditions between two currencies

influence of factors across multiple currency markets

common for European currencies to move in the same direction against the dollar EX: US interest rate is low, US Invests in foreign currencies making upward pressure on these currencies. Vice versa

Movements in Cross Exchange Rates: When currency A appreciates against the dollar by a greater (smaller degree) than currency B, then

currency A appreciates (depreciates) against B

Movements in Cross Exchange Rates: When currency A appreciates (depreciates) against the dollar, while currency B is unchanged against the dollar,

currency A appreciates (depreciates) against currency B by the same degree as it appreciates (depreciates) against the dollar.

MNCs closely monitor exchange rate movements over the period in which they

have cash flows denominated in the foreign currencies of concern.

Expectations: Impact of favorable expectations

if investors expect interest rates in one country to rise, they may invest in that country, leading to a rise in demand for foreign currency and an increase in the exchange rate for foreign currency

The equilibrium exchange rate between two currencies at any time is based

on the demand and supply conditions. -Changes in the demand for a currency or the supply of a currency for sale will affect the equilibrium exchange rate.

Exchange rate movements are commonly measured by the

percentage change in their values over a specified period, such as a month or a year.

The key economic factors that can influence exchange rate movements through their effects on demand and supply conditions are

relative inflation rates, interest rates, income levels, and government controls. -When these factors lead to a change in international trade or financial flows, they affect the demand for a currency or the supply of currency for sale and thus the equilibrium exchange rate.

Interaction of factors

some factors place upward pressure while other factors place downward pressure Exhibit 4.8

Expectations: Impact of Unfavorable expectations

speculators can place downward pressure on a currency when they expect it to depreciate

Expectations: impact of SIGNALS on currency speculation

speculators may overreact to signals, causing currency to be temporarily overvalued or undervalued

If a foreign country experiences an increase in interest rates (relative to U.S. interest rates), then the inflow of U.S. funds to purchase its securities should increase (U.S. demand for its currency increases),

the outflow of its funds to purchase U.S. securities should decrease (supply of its currency to be exchanged for U.S. dollars decreases), and there should be upward pressure on its currency's equilibrium value. -All relevant factors must be considered simultaneously when attempting to predict the most likely movement in a currency's value.

The exchange rate represents

the price of a currency, or the rate at which one currency can be exchanged for another -the price of a currency is determined by the demand for that currency relative to supply

Demand for a currency increase when

the value of the currency decreases, leading to a downward sloping demand schedule Exhibit 4.2 -how many pounds would be demanded at various exchange rates for a given time -slopes down because willing to buy more when price is less

Supply of a currency for sale increase when

the value of the currency increases, leading to an upward sloping supply schedule Exhibit 4.3 -Positive relationship because as the value of a Pound goes up the British are more willing to exchange their pounds for USD, making supply of pounds for sale increase. When pound value goes down, supply of pounds for sale goes down because British are less likely to convert to US dollar

Movements in Cross Exchange Rates: If currencies A and B move in the same direction,

there is no change in the cross exchange rate