Dale R. DeBoer

1
An Introduction to International Economics

• Chapter 12 Exchange Rate Determination
• Dominick Salvatore
• John Wiley Sons, Inc.

2
Forces the determine exchange rates

• Relative rates of economic growth
• If the U.S. grows more rapidly than the rest of
  the world, its demand for imports will increase
  more rapidly.
• By itself, this should increase the demand for
  foreign currency and lead to depreciation of the
  dollar.

3
Forces the determine exchange rates

• Relative rates of economic growth
• Relative rates of inflation
• If U.S. inflation is greater than the rate of
  inflation in the rest of the world, the dollar
  will decrease in value.

4
Forces the determine exchange rates

• Relative rates of economic growth
• Relative rates of inflation
• Changes in interest rates
• If U.S. interest rates fall relative to interest
  rates in the rest of the world, the demand for
  U.S. interest bearing assets will fall.
• By itself, this will lead to a fall in
  international demand for the dollar and a
  depreciation of the dollar.

5
Forces the determine exchange rates

• Relative rates of economic growth
• Relative rates of inflation
• Changes in interest rates
• Expectations
• If it is expected that the dollar will fall in
  value, people will move out of dollar holdings.
• As dollar holdings fall, the dollar will
  depreciate.

6
Trade approach

• The trade approach to exchange rate determination
  focuses on the role of international trade in
  determining exchange rates.
• Also known as the elasticities approach
• Works better as a long-run model of exchange rate
  determination.

7
Trade approach

• The trade approach to exchange rate determination
  focuses on the role of international trade in
  determining exchange rates.
• In this approach, the equilibrium exchange rate
  is the rate that balances imports and exports.
• If the nation has a trade deficit, its currency
  will depreciate.
• If the nation has a trade surplus, its currency
  will appreciate.

8
Purchasing power parity theory

• The law of one price
• The idea that in the absence of barriers to trade
  the price of homogenous traded commodities will
  be identical in all markets.
• Example
• Suppose that glassware sells in the U.S. for
  1/unit.
• If the exchange rate is 100/1, the price in
  Japan should be 100/unit.
• If this does not occur, then profitable
  opportunities for arbitrage exist.

9
Purchasing power parity theory

• The law of one price
• The idea that in the absence of barriers to trade
  the price of homogenous traded commodities will
  be identical in all markets.
• In other words, P PR where R is the dollar
  price of one unit of foreign currency, P is the
  dollar price of the homogenous commodity, and P
  is the foreign currency price of the homogenous
  commodity.

10
Purchasing power parity theory

• The law of one price
• If the law of one price holds for all goods, then
  absolute purchasing power parity (PPP)will hold.
• Absolute purchasing power parity holds that
  equilibrium exchange rates are equal to the ratio
  of price levels in the two nations.
• In other words, P PR where R is the dollar
  price of one unit of foreign currency, P is the
  price level in the U.S., and P is the price
  level in the foreign nation.

11
Purchasing power parity theory

• The law of one price
• If the law of one price holds for all goods, then
  absolute purchasing power parity (PPP) will hold.
• Absolute purchasing power parity does not hold in
  absence to perfect free trade.
• Non-traded commodities
• Barriers to trade
• Transaction costs

12
Purchasing power parity theory

• The law of one price
• If the law of one price holds for all goods, then
  absolute purchasing power parity (PPP) will hold.
• Absolute purchasing power parity does not hold in
  absence to perfect free trade.
• Relative purchasing power parity postulates that
  the change in the exchange rate is equal to the
  difference in the change in the price levels
  (rates of inflation) of the two countries.

13
The monetary model of exchange rates

• The monetary model of exchange rates holds that
  the exchange rate is determined in the process of
  equilibrating the domestic demand and supply of
  currency.

14
The monetary model of exchange rates

• The monetary model of exchange rates holds that
  the exchange rate is determined in the process of
  equilibrating the domestic demand and supply of
  currency.
• An increase in the U.S. money supply (assuming no
  change in other money supplies) will depreciate
  both nominal (spot) and real exchange rates.
• The real exchange rate is the nominal exchange
  rate weighted by the consumer price index of the
  two nations.

15
The asset model of exchange rates

• The asset model of exchange rates holds that the
  exchange rate is determined in the process of
  equilibrating the domestic demand and supply of
  financial assets.
• It is also known as the portfolio model

16
The asset model of exchange rates

• The asset model of exchange rates holds that the
  exchange rate is determined in the process of
  equilibrating the domestic demand and supply of
  financial assets.
• An increase in the U.S. money supply (assuming no
  change in other money supplies) will lower
  interest rates in the U.S. and shift investors
  from domestic to foreign assets and lead to a
  depreciation of the dollar.

17
The asset model of exchange rates

• An increase in the U.S. money supply (assuming no
  change in other money supplies) will lower
  interest rates in the U.S. and shift investors
  from domestic to foreign assets and lead to a
  depreciation of the dollar.
• The depreciation in the dollar spurs U.S. exports
  and discourages imports.
• This encourages the formation of a trade surplus.

18
The asset model of exchange rates

• An increase in the U.S. money supply (assuming no
  change in other money supplies) will lower
  interest rates in the U.S. and shift investors
  from domestic to foreign assets and lead to a
  depreciation of the dollar.
• The depreciation in the dollar spurs U.S. exports
  and discourages imports.
• The movement in trade encourages an appreciation
  of the dollar that partially offsets the initial
  depreciation.

19
Exchange rate dynamics

• In adjusting to long run equilibrium values,
  exchange rates tend to overshoot the final
  equilibrium value.
• Suppose that the exchange rate is initially at
  1/1.

/
1
Time
20
Exchange rate dynamics

• Suppose that the exchange rate is initially at
  1/1.
• At time A, the money supply in the U.S. increases
  causing the exchange rate to depreciate.

/
1
Time
A
21
Exchange rate dynamics

• If the long run equilibrium exchange rate
  (determined by the PPP model) is expected to be
  1.10/ 1, in the short run the exchange rate
  will overshoot this value (perhaps to 1.16/ 1).

/
1.16
1
Time
A
22
Exchange rate dynamics

• The overshooting drives an improvement in the
  balance of trade that will lead to subsequent
  appreciation of the dollar.

/
1.16
1
Time
A
23
Exchange rate dynamics

• The overshooting drives an improvement in the
  balance of trade that will lead to subsequent
  appreciation of the dollar.
• Over time, the dollar will fall to its long run
  equilibrium value.

/
1.16
1.10
1
Time
A
24
Exchange rate forecasting

• Models of exchange rates have not been very
  successful at predicting future exchange rates.

25
Exchange rate forecasting

• Models of exchange rates have not been very
  successful at predicting future exchange rates.
• Reasons
• Exchange rates are highly influenced by new
  information.

26
Exchange rate forecasting

• Models of exchange rates have not been very
  successful at predicting future exchange rates.
• Reasons
• Exchange rates are highly influenced by new
  information.
• Expectations in exchange rate markets tend to be
  self-fulfilling (at least in the short-run).
• This may generate movements in the market
  contrary to what is expected by theory.