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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THE DETERMINATIONOF EXCHANGE RATES
I. SETTING THE EQUILIBRIUM
A. Exchange Rates
market-clearing prices that equilibrate the quantities supplied and demanded of foreign currency.
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
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.
3. Equilibrium Exchange Rate:
occurs when the quantity supplied equals the quantity demanded of a foreign currency at a specific local
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.
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.
3. Calculating a Depreciation:
where e0 = old currency value
e1 = new currency value
Note: Resulting sign is always negative
EXAMPLE: dm Appreciation
If the dollar value of the dm goes from $0.64 (e0) to $0.68 (e1), then the dm has appreciated by
= (.68 - .64)/ .64
EXAMPLE: US$ Depreciation
We use the first formula,
(e0 - e1)/ e1
(.64 - .68)/ .68 = - 5.88%
which was the US$ depreciation.
D. FACTORS AFFECTING EXCHANGE RATES:
1. Inflation rates
2. Interest rates
3. GNP growth rates
I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION
A. Role of Exchange Rates:
THE DOMESTIC AND THE
B. THE IMPACT OF EXCHANGE RATE CHANGES
1. Currency Appreciation:
-domestic prices increase relative to foreign prices.
- Exports: less competitive
- Imports: more attractive
2. Currency Depreciation
- domestic prices fall relative to foreign prices.
- Exports: more competitive.
- Imports: less attractive
C. Foreign Exchange Market Intervention
1. Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate.
2. Goal of Intervention:
- to alter the demand for one currency by changing the supply of another.
D. The Effects of Foreign Exchange Intervention
1. Effects of Intervention:
- either ineffective or irresponsible
2. Lasting Effect:
- If permanent, change results
I. WHAT AFFECTS A CURRENCY’S VALUE? A. Current events
B. Current supply
C. Demand flows
* D. Expectation of future exchange rate
II. Role of Expectations :
A. Currency = financial asset
B. Exchange rate = simple relation of two financial assets
III. Demand for Money and Currency Values: Asset Market Model
A. Exchange rates reflect the supply of and demand for foreign-currency
B. Soundness of a Nation’s Economic Policies
- a nation’s currency tends to strengthen with sound economic policies.
IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR
- exchange rates also influenced by
expectations of central bank behavior.
A. Central Bank Reputations
B. Central Bank Independence
C. Currency Boards