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CHAPTER 2. THE DETERMINATION OF EXCHANGE RATES. CHAPTER 2 OVERVIEW:. PART I. EQUILIBRIUM EXCHANGE RATES II. ROLE OF CENTRAL BANKS III. EXPECTATIONS AND THE ASSET MARKET MODEL. Part I. Equilibrium Exchange Rates. I. SETTING THE EQUILIBRIUM A. Exchange Rates

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chapter 2

CHAPTER 2

THE DETERMINATIONOF EXCHANGE RATES

chapter 2 overview
CHAPTER 2 OVERVIEW:

PART

  • I. EQUILIBRIUM EXCHANGE RATES
  • II. ROLE OF CENTRAL BANKS
  • III. EXPECTATIONS AND THE ASSET MARKET MODEL
part i equilibrium exchange rates
Part I. Equilibrium Exchange Rates

I. SETTING THE EQUILIBRIUM

A. Exchange Rates

market-clearing prices that equilibrate the quantities supplied and demanded of foreign currency.

equilibrium exchange rates
Equilibrium Exchange Rates

B. How Americans Purchase German Goods

1. Foreign Currency Demand

-derived from the demand for foreign country’s goods, services, and financial assets.

e.g. The demand for German goods by Americans

equilibrium exchange rates5
Equilibrium Exchange Rates

2. Foreign Currency Supply:

a. derived from the foreign country’s demand for local goods.

b. They must convert their currency to purchase.

e.g. German demand for US goods means Germansconvert DM to US $in order to buy.

equilibrium exchange rates6
Equilibrium Exchange Rates

3. Equilibrium Exchange Rate:

occurs when the quantity supplied equals the quantity demanded of a foreign currency at a specific local

price.

equilibrium exchange rates7
Equilibrium Exchange Rates

C. How Exchange Rates Change

1. Increased demand

as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa.

equilibrium exchange rates8
Equilibrium Exchange Rates

2. Home Currency Depreciation a. Foreign currency becomes more valuable than the home currency.

b. Conversely, the foreign

currency’s value has appreciated against the home currency.

equilibrium exchange rates9
Equilibrium Exchange Rates

3. Calculating a Depreciation:

Currency Depreciation

where e0 = old currency value

e1 = new currency value

Note: Resulting sign is always negative

equilibrium exchange rates10
Equilibrium Exchange Rates

Currency Appreciation

equilibrium exchange rates11
Equilibrium Exchange Rates

EXAMPLE: dm Appreciation

If the dollar value of the dm goes from $0.64 (e0) to $0.68 (e1), then the dm has appreciated by

= (.68 - .64)/ .64

= 6.25%

equilibrium exchange rates12
Equilibrium Exchange Rates

EXAMPLE: US$ Depreciation

We use the first formula,

(e0 - e1)/ e1

substituting

(.64 - .68)/ .68 = - 5.88%

which was the US$ depreciation.

equilibrium exchange rates13
Equilibrium Exchange Rates

D. FACTORS AFFECTING EXCHANGE RATES:

1. Inflation rates

2. Interest rates

3. GNP growth rates

the role of central banks
THE ROLE OF CENTRAL BANKS

I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION

A. Role of Exchange Rates:

LINKS BETWEEN

THE DOMESTIC AND THE

WORLD ECONOMY

the role of central banks15
THE ROLE OF CENTRAL BANKS

B. THE IMPACT OF EXCHANGE RATE CHANGES

1. Currency Appreciation:

-domestic prices increase relative to foreign prices.

- Exports: less competitive

- Imports: more attractive

the role of central banks16
THE ROLE OF CENTRAL BANKS

2. Currency Depreciation

- domestic prices fall relative to foreign prices.

- Exports: more competitive.

- Imports: less attractive

the role of central banks17
THE ROLE OF CENTRAL BANKS

C. Foreign Exchange Market Intervention

1. Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate.

the role of central banks18
THE ROLE OF CENTRAL BANKS

2. Goal of Intervention:

- to alter the demand for one currency by changing the supply of another.

the role of central banks19
THE ROLE OF CENTRAL BANKS

D. The Effects of Foreign Exchange Intervention

1. Effects of Intervention:

- either ineffective or irresponsible

2. Lasting Effect:

- If permanent, change results

part iii expectations
Part III. EXPECTATIONS

I. WHAT AFFECTS A CURRENCY’S VALUE? A. Current events

B. Current supply

C. Demand flows

* D. Expectation of future exchange rate

expectations
EXPECTATIONS

II. Role of Expectations :

A. Currency = financial asset

B. Exchange rate = simple relation of two financial assets

expectations22
EXPECTATIONS

III. Demand for Money and Currency Values: Asset Market Model

A. Exchange rates reflect the supply of and demand for foreign-currency

denominated assets.

expectations23
EXPECTATIONS

B. Soundness of a Nation’s Economic Policies

- a nation’s currency tends to strengthen with sound economic policies.

expectations24
EXPECTATIONS

IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR

- exchange rates also influenced by

expectations of central bank behavior.

expectations25
EXPECTATIONS

A. Central Bank Reputations

B. Central Bank Independence

C. Currency Boards

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