Transcript International Finance

Unit 7 Foreign Exchange Rate
Determination
I. What determines the exchange rates?
At most basic level, exchange rates are determined
by the demand and supply of one currency relative to
the demand and supply of another. But it explains in a
superficial sense. This simple explanation doesn’t tell
us what factors underlie the demand for and supply of
a currency.
Some fundamental factors, such as inflation,
productivity, interest rates, and government policies
are quite important in explaining both short-term and
long-term fluctuations of a currency value.
II. Fundamental Factors To Forecast
Exchange Rates
a. Inflation
a) The law of one price states that in competitive markets free of
transportation costs and barriers to trade (such as tariffs), identical products
sold in different countries must be sold for the same price when their prices
are expressed in terms of the same currency, for example, if $ 1 = FFr 5,
then, a jacket sold for $ 50 in NY should be sold for FFr 250 in Paris.
If the law of one price were true for all goods and services, the PPP
exchange rate would be found from any individual set of price. So, by
comparing the prices of identical products in different currencies, it would
be possible to determine the “real” or “PPP” exchange rate. For instance, it
takes $1 to buy one dozen of apples in NY and 2.5 DM to buy the same
apples in Frankfurt, so the exchange rate between US dollars and DM is $ 1
= DM 2.5.
If prices of apples double in NY while the prices in Frankfurt remain the
same, then, the purchasing power of a dollar in NY drop 50 percent.
Consequently, the exchange rate is $ 1 = DM 1.25.
a. Inflation
b) The currency exchange rate is determined by the ratio and
change of their respective purchasing powers in each country.
This is called purchasing power parity theory. When the
inflation rate differential between 2 countries, the exchange
rate also adjust to correspond to the relative purchasing
powers of the countries.
That is,
Domestic inflation
(compared with foreign countries)
value of domestic currency
(compared with that of foreign country)
Exchange Rate of
Purchasing
Power Parity
Real Exchange
rate
Big Mac Index
b. Productivity
If one country becomes more productive than other countries,
businesses in that country can lower the prices (costs) of domestic
goods relative to foreign goods. As a result, the foreign demand for
domestic goods rises, and the domestic currency tends to
appreciate against foreign currency.
If its productivity lags behind that of other countries, its goods
become relatively more expensive and less foreign demand for
those goods, and the currency tends to depreciate.
So, in the long run, as a country becomes more productive
relative to other countries, its currency will appreciate.
c. Interest Rate
Investment capital flows in the direction of higher
yield for a given level of risk. Hence, if investors can
earn 6% interest rate per year domestically and 10 % in
country X, they will prefer to invest in country X,
provided the inflation rate and risk are the same in both
countries. It causes more demands for country X’s
currency, so the country X’s currency will appreciate
against domestic currency. The interplay between
interest rates and exchange rates is called interest rate
parity theory.
d. Government Policies
Monetary and fiscal policies also affect the currency value
in foreign exchange markets. Expansionary monetary policy
and excessive government spendings are prime causes of
inflation, and continue use of such policies eventually reduce
the value of the country’s currency.
(Supplements: Adjustments of government spendings:)
i) increase of government spending
increase of production and
income
consumers buy more (when consumers receive extra
income from increasing production)
stimulates economy
price level
inflation;
ii) spendings cutbacks
reduce production and income levels
consumption falls (as consumers’ income decline with decline in
production levels.)
price level
deflation.
e. Other Factors
a) An extended stock market rally in a country attracts
investment capital from other countries, thus creating a
huge demand by foreigners for that country’s currency.
This increase demand is expected to increase the value
of that country’s currency;
b) A significant drop in demand for a country’s principal
exports worldwide is expected to result in a
corresponding decline in the value of its currency;
c) A political turmoil in a country often drives capital
out of the country into stable countries. A mass outflow
of capital due to fear of political risk, undermines the
value of a country’s currency in the foreign exchange
markets.
Notes
Although there is a wide variety of
factors that can influence exchange
rates, all of these variables will not
influence the currency to the same
degree. Some factors may have an
overriding influence on the currency’s
value, while others have less
influences.