Ch. 19: What Determines Exchange Rates?
Consider a simple two country (Home and Foreign) model. If Foreign decreases its money supply by 10% while all else remains constant, relative PPP predicts that over time the _____ currency will _____ by 10%.
Foreign; appreciate
Consider a simple two country (Home and Foreign) model. If Home decreases its money supply by 20% while all else remains constant, relative PPP predicts that over time the _____ currency will _____ by 20%.
Foreign; depreciate
Let the home and foreign quantity theory equations be given respectively as: Ms = k ⋅ P ⋅ Y and Msffs= kf ⋅ Pf ⋅ Yf. Now if purchasing power parity holds so that the exchange rate, e, equals P/Pf, we can express the exchange rate as
MS/MSf ⋅ kf/k ⋅ Yf/Y
Letting Ms be the home country money supply, Y be its real GDP, P be its price level, and k be a variable indicating the ratio of money holdings to nominal GDP, the home country's quantity equation is given as
Ms = k ⋅ P ⋅ Y
Letting P denote the price level in the domestic country, Pf be the price level in the foreign country, and e be the spot exchange rate (foreign currency in terms of domestic currency), the concept of absolute purchasing power parity may be expressed as
P = e ⋅ Pf
Letting P denote the price of a product in domestic currency, Pf be its price in foreign currency, and e be the spot exchange rate (foreign currency in terms of domestic currency), the law of one price can be expressed as
P = e ⋅ Pf
The real effective exchange rate is calculated as a weighted average relative to
a number of other countries.
The empirical evidence shows that absolute PPP holds _____ the law of one price.
about as poorly as
The real bilateral exchange rate is calculated as relative to
another specific country.
Suppose that over the course of several years country A has an average inflation rate of 7% while its neighbor and close trading partner Country B averages 4% inflation. According to the relative PPP concept, Country B's currency will likely _____ during this period.
appreciate
The exchange rate equation obtained from the combination of the absolute purchasing power parity equation and the quantity equations for the home and foreign economies shows that the foreign country currency will _____ if it has slower money growth and/or faster real output growth than the home country.
appreciate
If international financial investors revise upward their expected future exchange rate, eex (of foreign currency in terms of domestic currency), while foreign (if) and domestic (id) interest rates are constant, then the current spot exchange rate, e, will
appreciate.
The view that exchange rates are part of the equilibrium for the markets for financial assets denominated in foreign currencies is known as the _____ approach to exchange rates.
asset market
If all international investors accurately judge the future equilibrium exchange rate, overshooting _____ occur.
can still
The concept of absolute purchasing power parity and the law of one price are
closely related.
According to the law of one price, a product's price (P) in domestic currency will be equated to its price (Pf) measured in foreign currency through the
current spot exchange rate.
Suppose a foreign currency has recently been depreciating relative to the home currency. If an investor extrapolates this trend into the future, he will expect the future spot rate to
decrease.
The analytical framework employed by the asset market approach to exchange rates focuses on pressures exerted upon the spot exchange rate (e) by changes in all of the following variables except
decrease.
Let the exchange rate, e, denote the spot price of foreign currency in terms of domestic currency. If the value of e falls and both the domestic interest rate and the expected future spot exchange rate are constant, then it can be determined that the foreign interest rate has
decreased.
Consider the two countries U.S. and UK, with the exchange rate given as dollars per pound. If incomes in the US rise 20% above trend, relative PPP predicts that over time the UK pound will
depreciate by 20%.
According to the exchange rate equation obtained from the combination of the absolute purchasing power parity equation and the quantity theory equations for the home and foreign countries, if the foreign country has faster money growth and/or slower real output growth than the home country, its currency will
depreciate.
Suppose international financial investors reduce their expected future exchange rate, eex (of foreign currency in terms of domestic currency), while foreign (if) and domestic (id) interest rates are constant, then the current spot exchange rate, e, will
depreciate.
Medium-term trends in some exchange rates have sometimes been counter to the currencies' long-term trends. This would mean, for example, that if a currency's long-term trend is upward, it nevertheless had a period (or periods) of a few years when it
depreciated.
The analytical framework employed by the asset market approach to exchange rates focuses on pressures exerted upon the spot exchange rate brought about by an uncovered interest
differential.
In the quantity theory equation, the demand for money is assumed to be _____ proportional to the money (or nominal) value of GDP.
directly
For most manufactured products, the law of one price
does not work well.
The analytical framework employed by the asset market approach to exchange rates focuses on pressures exerted upon the spot exchange rate (e) by changes in all of the following variables except o domestic and foreign incomes (Y and Yf). o the expected exchange rate (eex). o domestic and foreign interest rates (i and if).
domestic and foreign incomes (Y and Yf).
Relative purchasing power parity is usually defined using an approximation. According to this approximation, the rate of appreciation of the foreign currency equals the
domestic inflation rate minus the foreign inflation rate.
Asset market approach to exchange rates
emphasizes the role of portfolio repositioning by international financial investors
The approach to exchange rates in the long run (formally, the "Monetary Approach") can be viewed as a(n) _____ of the concept of purchasing power parity.
extension
According to the exchange rate equation obtained from the combination of the absolute purchasing power parity equation and the quantity theory equations for the foreign and home economies, if the ratio of the variables linking money holdings to nominal GDP is constant, then a 1% rise in domestic real GDP will cause the exchange rate (the price of foreign currency in terms of home currency) to _____ by ____%.
fall; 1
Let the spot exchange rate, e, denote the price of foreign currency in terms of domestic currency. If the value of e rises and both the foreign interest rate and the expected future spot exchange rate are constant, then it can be deduced that the domestic rate of interest has
fallen.
When applied to the exchange rate experience since the early 1970s, the monetary approach to exchange rates provides a _____ explanation of currency movements.
good
According to available evidence from the early 1970s to the present for a number of major countries, deviations of the actual exchange rate from its PPP value
has been large and has persisted for several years.
For heavily traded commodities (e.g., wheat, crude oil, gold), the law of one price
holds relatively well.
Quantity theory equation
in a country the money supply is equated with the demand for money, which is directly proportional to the money value of gross domestic product
If the exchange rate, e, is the spot price of foreign currency in terms of domestic currency, then a rise in the foreign interest rate (with all else constant) will cause the exchange rate to
increase.
From 1995 to 2002, the U.S. dollar's average value
increased.
Let the spot exchange rate, e, denote the price of foreign currency in terms of domestic currency. If the foreign currency depreciates while both the foreign interest rate and the expected future spot exchange rate are constant, then it can be deduced that the domestic interest rate has
increased.
The asset market approach to exchange rates emphasizes the role of portfolio repositioning by
international financial investors.
For the period from 1985 to 1988, the U.S. dollar fell by a _____ more than it had risen in the previous five years.
little
The available real world evidence suggests that relative PPP holds reasonably well in the ____-run but rather poorly in the _____-run.
long; short
Purchasing power parity (PPP)
measurement tool of calculating exchange rates so that each currency buys an equal amount of goods as every other currency
For the period from 1973 to 1980, the U.S. dollar experienced _____ fluctuation.
modest
In the application of the quantity theory equation to the analysis of exchange rates in the long run, we assume that each country's money supply is controlled by each country's _____ policy alone.
monetary
By combining the absolute purchasing power parity equation with the quantity theory equations for any two countries, we can make exchange rate predictions based upon
money supplies and national products.
By combining the the absolute purchasing power parity equation with the quantity theory equations for any two countries, we can make exchange rate predictions based upon
money supplies and national products.
The approach to exchange rates in the long run rests fundamentally on the belief that national price levels (or inflation rates) are strongly linked to national
money supplies.
During the years of its viability in the post-1973 period, the Italian lira fell because Italy's _____ rose _____ than average.
money supply, faster
According to the quantity theory equation, a country's demand for money is equated with its
money supply.
Short-term variability in exchange rates
movements from month to month, day to day, hour to hour, or minute to minute
Long-term trends in exchange rates
movements over decades
Medium-term trends in exchange rates
movements over periods of several years and sometimes counter to the longer trends
Divergences from absolute PPP (i.e., of e from P/Pf) are exacerbated when _____ goods are included in the product bundles.
nontraded
Consider a simple two country (Home and Foreign) model. If both Foreign and Home increase their money supplies by 10% while all else remains constant, relative PPP predicts that over time the exchange rate will
not change.
Bandwagon
o A fallacy which assumes that because something is popular, it is therefore good, correct, or desirable o Investors who expect that the recent trend in the exchange rate will continue, extrapolating the recent trend into the future o The effect is the basis for fears that speculation can sometimes be destabilizing in that the actions of international investors can move the exchange rate away from a long-run equilibrium value consistent with fundamental economic influences
Law of one price
o A product that is easily and freely traded in a perfectly competitive global market should have the same price everywhere, once the prices at different places are expressed in the same currency o Works well for heavily traded commodities o The price of the product measured in domestic currency will be equated to the price of the product measured in the foreign currency through the current spot exchange rate
Exchange rates in the long run
o Economic fundamentals become dominant, providing an "anchor" for the long-term trends o Based on the proposition that there is a predictable relationship between product price levels and exchange rates o People choose to buy goods and services from one country or another according to the prices they must pay
Monetary approach to exchange rates
o Emphasizes the importance of money supplies and demands as key to understanding the determinants of exchange rates o Incorporates all financial assets
Role of expected future spot exchange rate in the short-run of exchange rates
o If international foreign investors want to shift toward foreign-currency assets because they expect the foreign current to appreciate more, they first need to buy foreign currency in the foreign exchange market. o An increase in demand for foreign currency increase the current spot exchange rate causing the foreign currency to appreciate and the domestic currency to depreciate. o If the expected future spot exchange rate decreased, with the interest rate unchanged, the return differential changes in favor of domestic-currency investments, and the current spot-exchange-rate value of our currency increases.
Role of interest rates in the short-run of exchange rates
o If the exchange rate differential increases, the return differential shifts in favor of domestic-currency bonds, the spot rate tends to decrease, and the domestic currency appreciates. o If the foreign interest rate decreases, the spot rate decreases and the domestic currency appreciates.
Which of the following are reasons why the law of one price fails to hold for most products? (Select all that apply.) o Many markets are imperfectly competitive. o Transports costs are not negligible. o Governments do erect trade barriers. o Incomes are unequally distributed globally.
o Many markets are imperfectly competitive. o Transports costs are not negligible. o Governments do erect trade barriers.
Consider a two country model (Home and Foreign), where the money supply in Home increases unexpectedly. Which of the following are reasons that exchange rate (Home currency per unit of Foreign currency) overshooting occurs after this unexpected event? o Home incomes increase. o Prices are sticky in Home. o Home interest rates decline. o Foreign currency is expected to appreciate.
o Prices are sticky in Home. o Home interest rates decline. o Foreign currency is expected to appreciate.
Expected overall return on an uncovered investment in a bond denominated in a foreign currency is determined using
o The basic return on the bond itself (the interest rate or yield) o The expected gain or loss on currency exchanges (the expected appreciation or depreciation of the foreign currency)
Determinants of the exchange rate in the short run
o Uncovered interest parity (whether exact or approximate) links together four variables: the domestic interest rate, the foreign interest rate, the current spot exchange rate, and the expected future spot exchange rate. o Change in any one of the four variables implies that adjustments will occur in one or more of the other three.
Current spot exchange rate
o e o Domestic currency ÷ Foreign currency
The tendency of international investors to drive the actual (short-run) exchange rate past the value they know to be its long-run equilibrium is known as
overshooting.
The asset market approach to exchange rates emphasizes the role of ___________________ by international financial investors.
portfolio repositioning
Absolute purchasing power parity
price of an item is the same regardless of the currency used to purchase it or where it is selling
The concept of purchasing power parity, (PPP), contains our core understanding of the relationship between _____________________________ in the long run.
product prices and exchange rates
Unexpected new information ("news") either about economic performance or a political situation tends to affect exchange rates
rather quickly.
During the post-1973 period of flexible exchange rates, the Japanese yen appreciated primarily because Japan's _____ rose _____ than average.
real income; faster
Nominal bilateral exchange rates are the _____________ ones quoted in the foreign exchange markets.
regular
Consider the two countries U.S. and UK, with the exchange rate given as dollars per pound. If incomes in both countries rise 10% above trend, relative PPP predicts that over time the UK pound will
remain unchanged.
According to the exchange rate equation obtained from the combination of the absolute purchasing power parity equation and the quantity theory equations for the foreign and home economies, if the ratio of the variables linking money holdings to nominal GDP is constant, then a 1% rise in foreign real GDP will cause the exchange rate (the price of foreign currency in terms of home currency) to _____ by ____%.
rise; 1
The asset market approach to exchange rates reflects the view of economists that the demands and supplies of assets denominated in foreign currencies best explains pressures on exchange rates in the _____ run.
short
Divergences from absolute PPP (i.e., of e from P/Pf) tend to _____ with the passage of time.
shrink
When it comes to predicting exchange rates over long time horizons using the fundamentals stressed by PPP and the monetary approach, forecast errors are
still rather large.
In the period since 1973 the extent of short-term variability in exchange rates has been
substantial.
In the application of the quantity theory equation to the analysis of exchange rates in the long run, we assume that each country's real GDP is governed by
supply-side forces.
Relative purchasing power parity
the difference between changes over time in product-price levels in two countries will be offset by the change in the exchange rate over this time
When it comes to predicting exchange rates in the short run, there is widespread agreement that economic structural models are
totally ineffective.
Changes in the expected future spot exchange rate are said to be self-confirming expectations because the current spot rate tends to change _____ in the expected direction.
very quickly
The nominal effective exchange rate is the ________________ spot-exchange rate of a country's currency.
weighted-average
