Determinants of Exchange Rates

Why Study Exchange Rates?

• To understand the economic environment– Forecasting for planning purposes

• To understand exposure to currency risk– Financial impact of exchange rate move

varies• With the nature of the asset/liability• With the cause of the move

Outline: Exchange Rate Determination

1. Market Forces1. Real economic effects

2. Monetary effects

2. Role of Government

Exchange rates are determined by supply and demand for the

currencies

Market Forces:Real Effects

To focus on real effects assume:

1. No currency market intervention

2. No inflation in either country

Real exchange rates are determined by real economic events affecting

supply and demand for the currencies

Balance of Payment AccountsComponents:

• Current Account - Goods and Services• Financial Account - Investment• Reserve Account - Government

Reserves

Factors Affecting Trade(Current Account)

• Real price “shocks”– Example: Oil price shock

• Government policy change– Tariff/ Trade policy

Factors Affecting Investment(Financial Account)

• Real return “shocks”– example: turn of business cycle

• Government policy (affecting real returns)– tax policy– labor law

• Perceived risk– war, political risk

Conclusions about real effects

Changes in any of these real factors

• Shifts supply or demand for currency– Affects exchange rate– Of interest to currency forecasters

• Is also reflected in balance of payments data– Thus BOP data of interest to forecasters

Market Forces:Monetary Effects

Purchasing Power Parity

• Logic:

“arbitrage” in market for goods

U.S. Russia Exchange Rate

Now $1.00/loaf 25 Rb/loaf 25 Rb/$ .04 $/Rb

Next year $1.00/loaf 50 Rb/loaf 50 Rb/$ .02 $/Rb

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Definitions: PPP

• Absolute Purchasing Power Parity

The purchasing power of the dollar is the same everywhere in the world

• Relative Purchasing Power Parity

Exchange rates move to offset differences in rates of inflation.

How well does PPP predict in practice?

Absolute PPP – Not at all

Relative PPP

• Works well– In the long run– When differences in inflation are dramatic

• Works much less well in the short run

Real Exchange Rate

• Definition: Exchange rate after removing the effects of inflation

• If Purchasing Power Parity holds, then real exchange rates never change

Interest Rate Parity

• Logic:– Arbitrage in financial markets

– Return on a dollar invested must be the same everywhere

– Called “covered interest arbitrage”

Forward Exchange Rate

An exchange rate agreed upon today for a currency exchange to be carried out at a specified date in the future.

Equal return on $ investment

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Unbiased Forward Rate

• Definition - forward rates are unbiased predictors of future spot rates

• Logic: Speculation on forward markets

• Consequences– Single most useful rule for currency prediction– With CIA connects interest rates to expected

exchange rates

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Predictions based on parity conditions

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Exchange rate forecasting summary

1. Use forward rates (if available)

2. Interest rates can be used to construct an “implied forward rate”

3. Consider anticipated changes in real factors and monetary policies

Exchange Rate Policy

The role of government

How governments affect exchange rates

• Currency market intervention – (intentional)– Central Bank buys/sells home currency in

exchange for its foreign currency reserves.

• Monetary policy – (unintentional through impact of inflation)– Central Bank buys/sells home currency in

exchange for bonds

Types of Exchange Rate Policies

• free float (no intervention)

• “dirty”or managed float(some intervention)

• fixed exchange rate or “peg” (unlimited intervention at a fixed rate)– through central bank policy– currency board– dollarization

Lessons about Exchange Rate Policy

• Policy matters (especially in the short run).

• In the long run no policy can overcome market forces.