Chapter 2 (a) How Exchange Rates Change. Equilibrium Exchange Rates. The two-currency model: $ vs. Really the $ vs. all other forex.

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1 Chapter 2 (a) The Determination of Floating Exchange Rates: how markets set the equilibrium exchange rates also Currency depreciation and appreciation SETTING THE EQUILIBRIUM Exchange Rates are based on the supply and demand of a foreign currency. If the exchange rate is a floating rate, then the equilibrium rate is set by market forces. The two-currency model: $ vs. Really the $ vs. all other forex. In order to purchase British goods, services, & investments, Americans must first purchase the Pound. Thus the demand for particular foreign currency is derived from the demand for that country s goods, services, and financial assets (stocks, property, bank accts., etc.) The two-currency model: the Supply of Pounds Symmetrically, in order to purchase American goods, services, & investments, the British must first purchase the dollar, using pounds. Thus the British demand for dollars is the source of the supply of pounds The American supply of pounds = British demand for dollars. The Pound s equilibrium exchange rate with the dollar is reached when the quantity of Pounds demanded by Americans equals the quantity of Pounds supplied by the British. The British only supply Pounds when they are using their currency to purchase dollars. If Americans increase their demand for British goods, services, investments, etc., they must first also increase their demand for the British currency. The value of the pound should rise and we say that the pound has appreciated. 1

2 If the exchange rate was originally pegged (fixed) by one or both of the governments, then the appreciation is often called a revaluation. When the Bretton Woods exchange rate system started to break down, the DM was initially revalued against the $. When the Bretton Woods was finally abandoned for a system of floating rates, the DM rose even more against the dollar and we said the DM appreciated. If the demand for a country s goods, etc., weakens, the currency usually depreciates. If the rate is pegged (fixed) by one or both of the governments, then the depreciation is called a devaluation. Even before the Bretton Woods exchange rate system broke down, the Italian Lira was devalued against the $ on several occasions. Calculating a Currency Appreciation or Depreciation (e 1 - e 0 )/ e 0 where e 0 = old currency value e 1 = new currency value EXAMPLE: SwF Appreciation If the dollar value of the SwF goes from $0.54 (e 0 ) up to $0.58 (e 1 ), then the SwF has appreciated by Eqn. 2.1 (e 1 - e 0 )/ e 0 = ( )/.54 = 7.41% In the same example, we can also say that the dollar has depreciated against the SwF This is the Swiss point of view: At time zero, the Swiss could buy a $ for SwF (found by inverting $0.54). Now the Swiss needs to spend only SwF for a dollar. 2

3 Note that... The $0.54 is a direct quote for an American, (also called American terms). The SwF is an indirect quote (but a direct quote for a Swiss). The SwF is also called European terms). Continuing the example, The amount of depreciation is ( )/ = - 6.9% another way to have found the change from the Swiss point of view: instead of =(1/e 1-1/e 0 )/ (1/e 0 ) use =(e 0 - e 1 )/ e 1 ( )/.58 = - 6.9% A more dramatic example: A more dramatic example: In 1998, the Brazilian Central Bank devalued the Real: it fell from R1.20/$ to as low as R2.2/$. What was the devaluation from the American perspective? Hint: this an indirect quote. 1/e 0 = 1.2/$ & 1/e 1 = 2.2/$ Converting to American direct quotes and again using =(e 1 - e 0 )/ e 0 e 0 =.833 e 1 =.455 ( )/.833 = -45% This is the Real s depreciation from the American position. From the Brazilian position: The $ has appreciated Eqn. 2.2 (e 0 - e 1 )/e 1 = ( )/.455 = +83% Remember, these equations apply when e 0 represents American terms Recent Exchange Rates USA persp. Direct ($/FX) Indirect(FX/$) American terms European terms GBP $ * JPY $ * CDN $ Can$1.50 * EUR $ * Euro SwF $ SwF1.500 * MXP $ Mex$ * 3

4 Some factors affecting exchange rates: 1. Relative inflation rates 2. Relative interest rates 3. Relative economic growth rates 4. Terms of trade 5. Changes in investor expectations 6. Central bank intervention Relative inflation rates All else being equal, countries with higher inflation rates usually find their currency depreciating. Brazil, over a period of several years, had higher inflation than its trading partners (Argentina, USA, etc.). Brazil had a peg with the dollar, so Brazilian goods and services gradually became more expensive relative to foreign substitutes. Relative inflation rates Brazil soon began to run a trade deficit as Americans found vacationing in Mexico cheaper than in Brazil. Argentines bought fewer Brazilian goods and Brazilians found that the goods and services of its trading partners were becoming cheaper than domestic products. So Brazilians demanded more dollars, but Argentineans & Americans, wanting fewer Reals, supplied fewer dollars. Relative interest rates Assuming two countries have similar levels of inflation and political risk, etc., the country with the higher (short-term) interest rates usually finds their currency appreciating. This is largely due to the currency s higher attractiveness to short-term investors. Also, higher rates tend to curb domestic inflation and may enhance the currency s reputation as a long-term store of value. More on relative interest rates A nation s interest rates are a function of: 1) inflation rates (International Fisher Effect). All else the same, if Mexico has ten percent higher inflation than the U.S., then Mexico s interest rates should be about 10% higher. (This is not the whole story, however), Relative interest rates 2) Strength of the economy. When in an economic boom, interest rates are higher than otherwise because of high loan demand (U.S. at the moment). In contrast, Japan has low growth thus very low interest rates - even after adjusting for inflation. 3) Risk of the currency: view a currency like a bond - some are junk, some are investment grade. Argentina rates are 3-4% higher than the U.S. because investors worry about a devaluation. 4

5 Relative economic growth rates Relative economic growth rates This is a tough one to call: 1) The dominant effect appears to be investment driven: countries with high growth rates (the USA) tend to have currencies that appreciate as the countries also attract foreign capital. Investors wish to buy dollars to build factories in the U.S., buy NYSE stocks, and hold dollar bank accounts. (Why?) 2) In contrast, the effect due to the current account (and merchandise trade balance) is the opposite. Americans are buying more than underemployed Europeans, so the U.S. has a large trade deficit. As we demand more Euros to buy more European vacations (and thus supply more dollars), the dollar should eventually depreciate. Terms of trade Simply put, the relative value of the products you sell vs. the products you buy. Canada's terms of trade has deteriorated sharply over the last decade: oil and other natural resource prices have fallen. Since Americans need tp supply relatively fewer USDs to buy oil, etc, the demand for the Canadian $ falls, and thus the Canadian currency depreciates. Lately, the CAN has appreciated. Why? Changes in investor expectations A major item: countries with huge trade deficits can run them for years without apparent problems: Mexico, Brazil, Thailand, the USA This is because foreign investors are willing to purchase assets in the trade deficit nation in roughly equal amounts to that which the nations are overspending on goods, services and interest. Changes in investor expectations The obvious problem arises when investors no longer expect the deficit country to be a good place to invest: Mexico, Brazil, Thailand, all suffered from a sudden reversal of capital inflows, and in each case, the currency plummeted. 5

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