Exhange - Rate Determination
10 important questions on Exhange - Rate Determination
What Determines Exchange Rates?
o Market fundamentals (economic variables)
o Productivity, inflation rates, real interest rates, consumer preferences, and government trade policy
· Market expectations:
o News about future market fundamentals
o Traders’ opinions about future exchange rates.
Factors affecting exchange rates:
· Interim: cyclical factors (several months):
o Fluctuations in economic activity.
· Long term: flows of goods, services, and investment capital (0ne / two or more years):
o Inflation rates, investment profitability, consumer tastes, productivity, and government trade policy.
Determining Long-Term Exchange Rates?
· Reactions of traders in the foreign-exchange market to changes in
o Relative price levels
o Relative productivity levels
o Consumer preferences for domestic or foreign goods
Trade barriers
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Inflation Rates, Purchasing Power Parity and Long-Term Exchange Rates:
· Identical goods should be sold everywhere at the same price
o When converted to a common currency
o Assuming that it is costless to ship the good between nations, there are no barriers to trade, and markets are competitive
· Prevailing market-exchange rate is the true equilibrium rate.
The Big Mac Index:
· Can be used to determine the extent to which the market exchange rate differs from the true equilibrium exchange rate.
Inflation Rates, Purchasing Power Parity and Long-Term Exchange Rates:
Example:
Price CH0 = 100 | Price CH1 = 100
Exchange rate = S0 = $0.50/ CHF1
Determining the new exchange rate:
S1 = $0.50 [(200/100) / (100/100)] =
= $0.50 X 2 = $1.00/CHF
Thus the dollar will have to depreciate by 100%.
Determining Short-Term Exchange Rates: The Asset-Market Approach:
o Dominated by investors in assets
o Treasury securities, corporate bonds, bank accounts, stocks, and real property.
· Asset-market approach:
o Investors deciding between domestic and foreign investments
o Relative levels of interest rates
o Expected changes in the exchange rate itself over the term of the investment.
Purchasing-power-parity theory
o Determine changes in exchange rates, long term.
· A currency is expected to depreciate:
o By an amount equal to the excess of domestic inflation over foreign inflation.
· A currency is expected to appreciate:
o By an amount equal to the excess of foreign inflation over domestic inflation.
Level of the nominal (money) interest rate:
· Differences in the level of nominal interest rates between economies
· Likely to affect international investment flows
· Investors seek the highest rate of return.
If interest rates in U.S. < interest rates abroad
Dollar depreciation
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