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7/28/2019 Factors Affecting Spot Exchange Rates
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FACTORS AFFECTINGSPOT EXCHANGERATES
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Two approaches
Balance of payment
Aggregate variables
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Balance of payment
Supply and demand for foreigncurrency
Forecasting of accounts(also used foranalyzing different economic sectors)
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See exhibit 6.1
Trade in merchandise:
1. relative prices
2. relative incomes
3. Responsiveness of consumption andproduction
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Relative prices.
Price of one good expressed in termsof other good.
Prices change due to demand and
supply. Cost determine the price of good.
factors of production
productivity
Growth in income will determine theamount demanded.
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Relative incomes
As income expands, consumption andinvestment also tend to expand.
The increase in demand will put anupward pressure on prices unlessthere is some unutilized capacity in
the economy
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Responsiveness of consumptionand production
Change in price.
Some goods are very sensitive tochange in price.
Change in price also depends on Magnitude of price change
General level of income.
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Trade in services
Travel Transportation
Interest
Dividends
Ps: travel and transportation dependsupon the relative levels of income and
relative prices of vacations etc.
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Unilateral transfers
It is the mirror image of the migration
profile of the country
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Capital accounts
Direct investment
Portfolio investment
Short term investment.
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Direct investment
Investor control the management
Extension of business into foreignlands
Defensive move
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Portfolio investment
Investing in different securities ofmaturities more than one year.
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Short term investment.
Two major types:
1. Those made in connection with other
entries in bop.
2. Those made in search of profit.
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Official reserves
Short term capital account forgovernment of the country.
It depends upon
1. the exchange rate of currency
2. Demand and supply of currency
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Structure of BOP
It measures changes in flows Most similar to a statement of sources
and uses of funds.
Sources = supply of funds
Uses = demand of funds
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Purchasing power parity
Its key idea is that a currency canpurchase the same quantities ofgoods and services in different
countries. The Law of One Price
Example:Suppose again that ahammer costs $10 in Boston. If the
nominal exchange rate is 0.8 eurosper dollar, then $10 is worth 8 euros.The law of one price says a hammer
must cost 8 euros in Paris.
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Comparison of relative inflation ratesamong different countries.
According to PPP, if a countrysinflation rate accelerates relative to theother countries, the countrys currency
would tend to depriciate.
PPP doesnot hold in short term.
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Example
country Germany France
Car price More expensivethan France
Less expensive
Consumer
behavior
Import cars More people willbuy cars fromFrance
Demand and price Demand decreases,price decreases
Demand increases,price increases
Currency valuation
with respect to
other country
Depreciates Appreciates
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FACTORS AFFECTINGINTEREST RATES
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Profit and loss depend upon interestrates.
Two factors influence interest rates1. Creditworthiness of borrower
2. Liquidity of financial instrument
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Demand and supply for funds
interest rate is determined by the supplyand demand for loans.
The demand for loans equalsinvestment. A higher interest ratereduces the quantity of loans demanded.
The supply of loans equals saving plusnet capital inflows.
The equilibrium interest rate, is the rateatwhich the supply and demand forloans intersect.
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demand for loans = investment
supply of loans=saving + capital
inflows - capital outflows =saving + net capital
inflows
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Changes in money supply
Impact on loanable fund
Impact on expectations
inflation
monetary policy
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Impact on loanable funds
Level of money supply increases,
supply of loanable also increases,interest rate decreases.
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Impact on expectations
INFLATION
Money supply increases,
inflationary expectations increases
and observed interest rate tend to
increase.
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Impact on expectations
MONETARY POLICY
Central bank can control the level of
money supply through
a) Discount rate
b) Requires reserve requirement
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Market expectations
When interest rates are expected tolower in future:
1. Investor would prefer to invest
funds in longer maturities2. Borrower would prefer to borrow
funds for shorter maturities.
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Yeild curve
The relationship between interest
rate and term to maturity at aspecific time is describe by yield
curve.
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Short maturities
supply of funds demand for
funds
Longer maturities
supply of funds demand for
funds
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Down ward sloping yieldcurve
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When interest rates are expected torise in future:
1. Investor would prefer to invest
funds in shorter maturities2. Borrower would prefer to borrow
funds for longer maturities.
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Short maturities
supply of funds demand for
funds
Longer maturities
supply of funds demand for
funds
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Other factors
If interest rates remains same thanyield curve would be upward
sloping because
1. Higher uncertainty. (credit risk)2. Higher liquidity risk
3. Compensation for the foregone
investment.
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Credit worthiness and marketliquidity
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The credit worthiness of a borrower
can be improved b securing acollateral.
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Longer term to maturity = higher
credibility risk and lesser itsliquidity.