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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

THE DETERMINATIONOF EXCHANGE RATES


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CHAPTER 2 OVERVIEW:

PART

  • I. EQUILIBRIUM EXCHANGE RATES

  • II. ROLE OF CENTRAL BANKS

  • III. EXPECTATIONS AND THE ASSET MARKET MODEL


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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.


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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


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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.


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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.


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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.


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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.


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Equilibrium Exchange Rates

3. Calculating a Depreciation:

Currency Depreciation

where e0 = old currency value

e1 = new currency value

Note: Resulting sign is always negative


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Equilibrium Exchange Rates

Currency Appreciation


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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%


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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.


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Equilibrium Exchange Rates

D. FACTORS AFFECTING EXCHANGE RATES:

1. Inflation rates

2. Interest rates

3. GNP growth rates


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THE ROLE OF CENTRAL BANKS

I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION

A. Role of Exchange Rates:

LINKS BETWEEN

THE DOMESTIC AND THE

WORLD ECONOMY


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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


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THE ROLE OF CENTRAL BANKS

2. Currency Depreciation

- domestic prices fall relative to foreign prices.

- Exports: more competitive.

- Imports: less attractive


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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.


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THE ROLE OF CENTRAL BANKS

2. Goal of Intervention:

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


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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


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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


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EXPECTATIONS

II. Role of Expectations :

A. Currency = financial asset

B. Exchange rate = simple relation of two financial assets


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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.


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EXPECTATIONS

B. Soundness of a Nation’s Economic Policies

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


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EXPECTATIONS

IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR

- exchange rates also influenced by

expectations of central bank behavior.


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EXPECTATIONS

A. Central Bank Reputations

B. Central Bank Independence

C. Currency Boards


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