Chapter 19: What Determines Exchange Rates?

Transcription

1 Chapter 19: What Determines Exchange Rates?

2 Introduction Exchange rates over time Long-term trends Medium-term trends Short-term variability Frameworks Asset market approach Purchasing power parity (PPP) Monetary approach 2016 McGraw-Hill Education. All Rights Reserved. 2

3 Selected Exchange Rates, Swiss Franc, German Mark (DM), and Japanese Yen 2016 McGraw-Hill Education. All Rights Reserved. 3

4 Selected Exchange Rates, Australian Dollar, Canadian Dollar, British Pound Sterling, and Italian Lira 2016 McGraw-Hill Education. All Rights Reserved. 4

5 Exchange Rates in the Short Run Pressures on exchange rates in the short run can be best understood in terms of the demands and supplies of assets denominated in different currencies Foreign exchange markets seems sensitive to movements in interest rates Expectations of future exchange rates can have a powerful impact on international financial positioning, and thus on the value of the current exchange rate 2016 McGraw-Hill Education. All Rights Reserved. 5

6 Asset Market Approach to Exchange Rates Emphasizes the role of portfolio repositioning by international financial investors The exchange-rate value of a foreign currency (e) is raised in the short run by the following: A rise in the foreign interest rate relative to our interest rate (i f i) A rise in the expected future spot exchange rate (e ex ) 2016 McGraw-Hill Education. All Rights Reserved. 6

7 Determinants of the Exchange Rate in the Short Run 2016 McGraw-Hill Education. All Rights Reserved. 7

8 Exchange Rates in the Long Run In the short run, floating exchange rates are often highly variable. A key economic fundamental that appears to explain long-run trends is the difference in national rates of inflation of the prices of good and services. Provides an anchor for longterm trends McGraw-Hill Education. All Rights Reserved. 8

9 The Law of One Price A product that is easily and freely traded in a perfectly competitive global market should have the same price everywhere, once the prices at different places are expressed in the same currency P = e P f Works well for heavily traded commodities, as long as government permits free trade in the commodities Gold, other metals, oil, and various agricultural products Does not hold closely for most products that are traded internationally, including nearly all manufactured products 2016 McGraw-Hill Education. All Rights Reserved. 9

10 Absolute Purchasing Power Parity (Absolute PPP) A basket of tradable products will have the same cost in different countries, if cost is stated in the same currency, The average price of these products, called the product-price level, or price level, stated in different currencies is the same when converted to a common currency Closely related to the law of one price. The equations are the same, except the price variables refer either to only one product or to a bundle of products P = e P f or e = P/P f Does not hold well, divergences can be large McGraw-Hill Education. All Rights Reserved. 10

11 National Income per Capita, McGraw-Hill Education. All Rights Reserved. 11

12 Relative Purchasing Power Parity (Relative PPP) The change in the exchange rate over time will equal the difference between changes over this time in product-price levels in the two countries P t /P 0 ( e t ) = e 0 P f,t /P f,0 where the value of the subscripts indicate the values for the initial year 0 and some later year, t, for each variable Approximately, the rate of appreciation of the foreign currency (e) will equal the difference between the country s product price inflation rate (π) and the foreign country s inflation rate (π f ) Countries with relatively low inflation rates have currencies whose values tend to appreciate in the foreign exchange market Countries with relatively high inflation rates have currencies whose values tend to depreciate in the foreign exchange market 2016 McGraw-Hill Education. All Rights Reserved. 12

13 Relative Purchasing Power Parity: Inflation Rate Differences and Exchange Rate Changes, Industrialized Countries 2016 McGraw-Hill Education. All Rights Reserved. 13

14 Relative Purchasing Power Parity: Inflation Rate Differences and Exchange Rate Changes, Developing Countries 2016 McGraw-Hill Education. All Rights Reserved. 14

15 Actual Exchange Rates and Exchange Rates Consistent with Relative PPP, Monthly, U.S. Dollars per DM 2016 McGraw-Hill Education. All Rights Reserved. 15

16 Actual Exchange Rates and Exchange Rates Consistent with Relative PPP, Monthly, U.S. Dollars per Yen 2016 McGraw-Hill Education. All Rights Reserved. 16