Chapter 2: Determination of Exchange Rates 1

Chapter 2 The Determination of Exchange Rates

A. Introduction to Exchange Rates

B. Factors Affecting the Equilibrium Exchange Rate

C. Calculating Exchange Rate Changes

D. Asset Market Model of Exchange Rates

E. Central Banks and Currency Values

F. Central Bank Intervention

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2.A Introduction to Exchange Rates (1)

Exchange rate – the price of one nation’s currency in terms of another.

– If $1 buys ¥100, the ¥/$ exchange rate, or yen value of the dollar, = ¥100/$1 or one yen will $0.01.

– market-clearing prices that equilibrate supplies and demands in the foreign exchange market.

Spot rate e0 – the price at which currencies are traded for

immediate delivery.

Forward rate f1 – the price at which currencies are quoted for

delivery at a specified future date.

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2.B Factors Affecting the Equilibrium Exchange Rate (1)

Factors that influence the supply and demand for one currency in terms of another affect the equilibrium exchange rate.

– Need for goods

– Inflation rates

– Interest rates

– Economic growth

– Political and economic risks

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2.B Factors Affecting the Equilibrium Exchange Rate (5)

Political and economic risk

– Investors prefer to hold fewer riskier assets.

– Political and economically stable countries have lower-risk currencies.

– Low-risk currencies are more highly valued and high-risk currencies.

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Currency appreciation/depreciation =

(new dollar value of currency – old dollar value of currency)

Old dollar value of currency

2.C Calculating Exchange Rate Changes (1)

Using the $/€ as an example, euro appreciation/depreciation is computed as the fractional increase/decrease in the dollar value of the euro – that is in direct quote

General formula for computing currency appreciation/depreciation in dollar terms

E.g.: $/€ increases from $1.25/€1.00 to $1.35/€1.00

($1.35 – $1.25) / $1.25 = 0.08, or 8%

The euro has appreciated 8% against the dollar. That is, the amount of dollars required to buy one euro increased by 8%.

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2.C Calculating Exchange Rate Changes (2)

General formula for computing dollar appreciation/depreciation in terms of another currency

Using previous example: $/€ increases from $1.25/€1.00 to $1.35/€1.00

($1.25 – $1.35) / $1.35 = -0.074, or -7.4%

Dollar appreciation/depreciation =

(old dollar value of currency - new dollar value of currency)

New dollar value of currency

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2.D Asset Market Model of Exchange Rate Determination

The exchange rate between two currencies represents the price that just balances the relative supplies of and demand for assets denominated in those currencies.

Shifts in preferences or expectations of future exchange rate movements affect the exchange rate of two currencies.

The desire to hold currency today depends on expectations of the factors that affect the currency’s future value.

Thus, currency values are forward-looking.

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2.E Central Banks and Currency Values (1)

Central banks use monetary policy, including creating money, to achieve price stability, low interest rates, or a target currency value.

Before 1971, currencies were linked to a commodity, usually gold.

Fiat money – nonconvertible paper money

– Is not linked to a commodity and thus has no “anchor.”

– No standard of value for determining a currency’s future value.

– Central bank determines a currency’s value through its control of the money supply.

– Expectations of central bank behavior affect exchange rates.

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2.E Central Banks and Currency Values (3)

Currency boards

– Replace central banks

– Issue notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency

– Have no discretionary monetary policy – the market determines the money supply

– Promote price stability

Without a central bank to monetize a country’s deficit (buying government debt), a currency board compels a government to follow responsible fiscal policy.

HOWEVER, a run on the currency causes a sharp contraction in the money supply and jump in interest rates, slowing economic activity.

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2.E Central Banks and Currency Values (4)

Dollarization

– A country replaces its currency with the U.S. dollar

– Promotes price stability and thus low inflation

– Eliminates local currency risk

– Results in loss of seignorage, a central bank’s profit on the currency it prints.

– List of countries http://en.wikipedia.org/wiki/Dollarization#U.S._dollar

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2.F Central Bank Intervention (2)

Foreign exchange market intervention

– Whether governments prefer an overvalued, undervalued, or correctly valued domestic currency depends on their economic goals.

– Governments may engage in unsterilized intervention, i.e., intervene in the foreign exchange market, to move e0 to a level consistent with their

goals by buying or selling foreign currencies to influence the value of their own currencies.

• To reduce the value of the dollar against the euro, the U.S. Central Bank (“the Fed”) will sell dollars and purchase an equivalent amount of euros, releasing dollars into the foreign market and reducing the supply of euros.

• To increase the value of the dollar against the euro, the Fed will buy dollars with euros, releasing euros into the foreign market and reducing the supply of dollars.

• Using unsterilized intervention, monetary authorities have not insulated their domestic money supplies from the foreign exchange transactions.

• Unsterilized intervention leads to increases in inflation as exchange rates move out of equilibrium. Inflation will in turn affect interest rates.

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2.F Central Bank Intervention (3)

Foreign exchange market intervention, continued

– In sterilized intervention, the Fed will intervene in the foreign exchange market AND simultaneously engage in open market operations, or the sale or purchase of domestic Treasury bills.

– Example

• To reduce the value of the dollar relative to the euro, the Fed sells dollars for euros in the foreign exchange market to flood the foreign market with dollars AND sells Treasury bills to reduce the number of dollars in the domestic market.

• Net effect: The value of the dollar relative to the euro decreases without changing the domestic supply of dollars, thereby insulating the U.S. from inflation.

– The effects of sterilized intervention are temporary, because the Fed signals a change in monetary policy to the market, not a change in market fundamentals.

– The effects of unsterilized intervention are permanent, because they create inflation in some countries and deflation in others.