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Factors influencing exchange rates: Supply and Demand for a Currency

Factors influencing exchange rates: Supply and Demand for a Currency. Short – run … financial transactions Market fundamentals Current account balances Real interest rates Market expectations News about future market fundamentals Speculative opinion about future exchange rates.

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Factors influencing exchange rates: Supply and Demand for a Currency

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  1. Factors influencing exchange rates:Supply and Demand for a Currency Short – run … financial transactions • Market fundamentals • Current account balances • Real interest rates • Market expectations • News about future market fundamentals • Speculative opinion about future exchange rates

  2. Factors influencing exchange rates Medium – run • Real income … business cycle • Monetary policy and fiscal policy • Product availability Long – run • Inflation rates • Consumer preferences for domestic or foreign products • Productivity changes affecting production costs … and prices • Profitability and riskiness of investments • Government trade policy

  3. Impact of interest rate differentials: drop in US interest rate  $ depreciation S1 Dollars per Yen S0 B .0080 .0075 A D1 D0

  4. Impact of real income differentials:increase in US income  $ depreciation S0 Dollars per Pound B 1.60 1.50 A D1 D0

  5. Purchasing power parity (PPP):The Law of One Price • A good should cost the same in all countries (aside from tariffs or transportation costs) • Exchange rates should make prices equal across countries P = ER x P* ($/bourbon) = ($/£) x (£ /scotch) = ($/scotch) • If two countries have different inflation rates, exchange rates will move keep prices the same • The currency of the high inflation country will depreciate (P/P*)  ER   ($/£) 

  6. Impact of inflation rate differentials:high US inflation  $ depreciation S1 Dollars per Pound S0 B 1.70 1.50 A D1 D0

  7. Market expectations • As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates • Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining for a while

  8. Impact of expectations:expectation of $ depreciation $ depreciation S1 Dollars per Pound S0 B 1.70 1.50 A D1 D0

  9. Monetary approach Alternative approaches to exchange rates • Focus on exchange rates as the result of supply and demand for money at home and abroad • Demand depends on real income, prices, interest rates • Supply is controlled by central banks • Ms  $ depreciates • Real income   Md  $ appreciates • Interest rate   Md  $ depreciates ??!?

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