FINC3240 International Finance. Exchange Rate and Determination (Chapter 4,6,7,8). Objectives. A. Explain how the equilibrium exchange rate is determined B. Examine factors that determine the equilibrium exchange rate. Exchange Rate Movements.
Exchange Rate and Determination
A. Explain how the equilibrium exchange rate is determined
B. Examine factors that determine the equilibrium exchange rate
when one currency depreciates against another, the other must appreciate.
Appreciation vs. Depreciation
How exchange rates reach equilibrium?
1. Demand for a Foreign Currency
derived from the local buyers who are willing and able to purchase foreign goods but who must convert their local currencies.
Exhibit 4.2 page 87
2. Supply of a Foreign Currency
derived from the foreigners who are willing and able to supply foreign currency and convert to local currency
Exhibit 4.3 page 88
Exhibit 4.4 page 89
1. Relative Purchasing Power
2. Relative Inflation Rates
2. Relative Interest Rates
3. Relative Income Levels
4. Government Influence
implication 1: Consumers shift their demand to wherever prices are lower for the same or similar goods, considering the transportation costs.
Country Price per pound
US 2 USD
China 5 CHY
Assuming the transportation cost is zero, firms will import chicken from China and need to exchange USD for CHY, until the prices in U.S. and China are close. As a result, demand in CHY will lead to appreciation in CHY and depreciation in USD.
implication 2: Inflation affects currency’s purchasing power. The exchange rate should adjust to offset the difference in the inflation rates of the two countries.
U.S. and U.K. initially had zero inflation. Now assume that the U.S. experiences a 9% inflation rate, while U.K. experiences a 5% inflation rate. What happens to the exchange rate between GBP and USD, considering zero transportation cost?
PPP theory suggests that the British pound should appreciate by approximately 4%, the differential in inflation rates. The reason is that, lower inflation in U.K. means the price of the same goods produced in U.K. is relatively lower. US consumers will buy more UK goods. The increasing consumption of British goods by US consumers would persist until the pound appreciates by about 4% so that the prices of UK good are increased by the same percentage.
Where is the percentage change in the value of the foreign currency.
Assume an initial equilibrium where GBP’s spot rate is $1.60, US inflation and British inflation are both 3%. If US inflation suddenly increase to 5 %, the GBP will appreciate against the dollar by approximately 2 % according to PPP. The rational is, after US prices rises, US demand for British goods will increase, placing upward pressure on the GBP’s value.
The exchange rate will adjust by a sufficient amount to offset the interest rate differential between two currencies.
What is the theoretical price of Euro 6 months from today (Forward Rate)?
Intuition: returns from investing in USD-denominated fixed-income securities should equal returns from such an alternative strategy that exchanging USD for EUR, investing in EUR-denominated fixed-income securities, and then after 6 months exchanging EUR back to USD.
Compare the amount of home currency received at the end of the period
Strategy 1: invest in USD for 180 days
(a) sell USD for EUR at spot rate; buy a forward USD contract
(b) invest EUR for 180 days in Germany
(3) after 180 days sell EUR for USD through the forward contract
Q: Does IRP holds?
When Assessing Interest Rate Parity, should also consider:
a. Transaction Costs
b. Political Risk
c. Differential Tax Laws
A currency’s exchange rate will depreciate against another currency when its interest rate (and therefore expected inflation rate) is higher than that of the other currency.
Because income can affect the amount of imports demanded, it can affect exchange rates.
e.g. Assume US income rises substantially while the British income remains unchanged. The demand for pounds will shift outward, reflecting the increased demand for British goods. The supply of pounds for sale is not expected to change. Therefore, the equilibrium exchange rate of the pound is expected to rise.
Governments influence the equilibrium exchange rate in many ways, including
1. imposing foreign exchange barriers,
2. imposing foreign trade barriers,
3. intervening (buying and selling currencies) in the foreign exchange markets,
4. affecting macro variables such as inflation, interest rates, and income levels.
Easy or Hard?
Chapter 4: Q&A 2,3,4,12,14,19.
Chapter 6: Q&A 6,13,18
Chapter 7: Q&A 8,10,14,15,21,30.
Chapter 8: Q&A 5,18,26,35.