International economics by robert j carbaugh 9th edition
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International Economics By Robert J. Carbaugh 9th Edition. Chapter 13: Exchange-Rate Determination. Exchange rates. Factors influencing exchange rates. Market fundamentals Bilateral trade balances Real income Real interest rates Inflation rates

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International Economics By Robert J. Carbaugh 9th Edition

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International economics by robert j carbaugh 9th edition

International EconomicsBy Robert J. Carbaugh9th Edition

Chapter 13:

Exchange-Rate Determination


Factors influencing exchange rates

Exchange rates

Factors influencing exchange rates

  • Market fundamentals

    • Bilateral trade balances

    • Real income

    • Real interest rates

    • Inflation rates

    • Consumer preferences for domestic or foreign products

    • Productivity changes affecting production costs

    • Profitability and riskiness of investments

Carbaugh, Chap. 13


Factors influencing exchange rates1

Exchange rates

Factors influencing exchange rates

  • Market fundamentals (cont’d)

    • Product availability

    • Monetary policy and fiscal policy

    • Government trade policy

  • Market expectations

    • News about future market fundamentals

    • Speculative opinion about future exchange rates

Carbaugh, Chap. 13


When are these factors important

Exchange rates

When are these factors important?

  • Short run (days)

    • Dominated by financial transfers responding to:

      • Differences in real interest rates

      • Shifting expectations of future exchange rates

  • Medium run (months)

    • Primarily influenced by economic cycles

Carbaugh, Chap. 13


When are these factors important1

Exchange rates

When are these factors important?

  • Long run (years)

    • Dominated by movements of goods, services, investment, which are influenced by:

      • Inflation rates

      • Investment profitability

      • Consumer tastes

      • Real income

      • Productivity

      • Trade policy

  • How these factors interact to affect exchange rates depends on the relative importance of trade and financial relations between the countries

Carbaugh, Chap. 13


Exchange rate components

Exchange rates

Exchange rate components

Carbaugh, Chap. 13


Real income differentials

Factors influencing exchange rates

Real income differentials

  • A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal)

    • Imports rise faster than exports, so demand for foreign currency rises faster than its supply

  • Real income changes can also reflect other processes, which might lead to rising exports

Carbaugh, Chap. 13


Impact of real income differentials

Factors influencing exchange rates

Impact of real income differentials

Carbaugh, Chap. 13


Real interest rates

Factors influencing exchange rates

Real interest rates

  • Short term real interest rate differences influence international capital movements

    • Real interest rate is nominal minus inflation

  • Low short term rates lead to less demand for the currency and depreciation

  • High rates lead to greater demand for the currency and appreciation

Carbaugh, Chap. 13


Impact of interest rate differentials

Factors influencing exchange rates

Impact of interest rate differentials

Carbaugh, Chap. 13


Purchasing power parity

Factors influencing exchange rates

Purchasing power parity

  • Law of one price: In theory, a good should cost the same in all countries (aside from tariffs or transportation costs)

  • As a result, exchange rates should end up making prices equal across countries

  • By this theory, if two countries have different inflation rates, exchange rates will move in the opposite direction to keep prices the same

  • The theory may be more useful for predicting long-term trends than short-run fluctuations

Carbaugh, Chap. 13


Impact of inflation rate differentials

Factors influencing exchange rates

Impact of inflation rate differentials

Carbaugh, Chap. 13


Market expectations

Factors influencing exchange rates

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

Carbaugh, Chap. 13


Monetary approach

Alternative approaches to exchange rates

Monetary approach

  • 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

  • Exchange rates seen as returning domestic money supply to equilibrium after a change

Carbaugh, Chap. 13


Asset markets approach

Alternative approaches to exchange rates

Asset-markets approach

  • Investors (firms and individuals) balance their portfolios among domestic money, stocks and bonds and foreign stocks and bonds

  • Short run exchange rate changes are caused by shifts in the kind and location of financial assets investors want to hold

  • Investors shift between assets based on market expectations for expected returns

Carbaugh, Chap. 13


Short long run equilibrium overshooting

Exchange rate markets

Short, long run equilibrium: overshooting

Carbaugh, Chap. 13


Forecasting exchange rates

Exchange rate markets

Forecasting exchange rates

  • Judgmental forecasts

    • Subjective forecasts based on economic, political and other data for a country

  • Technical analysis

    • Uses historical exchange rate trends to project short-run future movements

  • Fundamental analysis

    • Includes macroeconomic and policy information in a predictive model

Carbaugh, Chap. 13


Equilibrium in asset markets approach

Alternative approaches to exchange rates

Equilibrium in asset-markets approach

Carbaugh, Chap. 13


Asset markets approach shift in demand

Alternative approaches to exchange rates

Asset-markets approach: shift in demand

Carbaugh, Chap. 13


Asset markets approach shift in supply

Alternative approaches to exchange rates

Asset-markets approach: shift in supply

Carbaugh, Chap. 13


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