Chapter 4 Exchange Rate Determination. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a...

Chapter 4

Exchange Rate Determination

Slides prepared by Afaf Moosa

Objectives

• To identify the factors causing changes in the exchange rate.

• To describe purchasing power parity and the monetary model of exchange rates.

• To explain how the bid-offer spread and the forward spread are determined.

• To examine the factors affecting the AUD exchange rate.

Some stylised facts

• The exchange rate follows approximately a random walk with little or no drift.

• The spot and forward rates tend to move in the same direction and by approximately the same amount.

• There is no correspondence between exchange rates and prices.

(cont.)

Some stylised facts (cont.)

• The relation between the exchange rate and the current account is not strong .

• Rapid monetary expansion leads to rapid currency depreciation.

(cont.)

Some stylised facts (cont.)

• The behaviour of exchange rates is often described as “bubbles followed by crashes”.

• Volatility clustering. Periods of calm are followed by periods of calm, and periods of turbulence are followed by periods of turbulence.

• Exchange rates move in cycles with significant random variation.

The equilibrium exchange rate

S(d/f)

Factors affecting the supply of and demand for FX

• Relative inflation rates: A country that has a higher inflation rate than its trading partners will experience a depreciating currency.

(cont.)

The effect of a higher domestic inflation rate

S(d/f)

Factors affecting the supply of and demand for FX (cont.)

• Relative interest rates: Higher interest rates lead to currency appreciation.

• Distinction must be made between nominal and real exchange rates.

The effect of a higher domestic interest rate S(d/f)

• Relative growth rates: The effect of growth is ambiguous since it affects the current account and financial account in different directions.

(cont.)

• The role of the government: The government affects exchange rates by determining the exchange rate regime, through central bank intervention, by imposing and removing trade barriers, and by affecting the variables that determine exchange rates.

(cont.)

• The role of expectations: Speculators buy and sell currencies on the basis of expectations.

Speculation

• Speculators participate in the foreign exchange market, buying and selling currencies by anticipating future movements of exchange rates.

• By their actions, speculators affect the supply of and demand for currencies and therefore exchange rates.

(cont.)

Speculation (cont.)

• Destabilising speculation, which drives the exchange rate away from its equilibrium value, occurs when speculators buy a currency when it is high and sell it when it is low.

• This kind of behaviour arises, for example, when speculators believe that there is a bubble in the market .

(cont.)

Speculation (cont.)

• Stabilising speculation occurs when speculators buy a depreciating currency and sell an appreciating currency.

Purchasing power parity

• The theory of purchasing power parity (PPP) describes the relation between prices and exchange rates.

• PPP is important for international business firms because the validity of this theory precludes the possibility of real currency appreciation and depreciation and hence the presence of exposure to economic risk.

Deriving PPP

*SPP 00 *SPP 11

(cont.)

Deriving PPP (cont.)

)1)(1()1(

Deriving PPP from the S-D model

(cont.)

Deriving PPP from the S-D model (cont.)

The PPP exchange rate

Derivation from PPP

PPP and the real exchange rate

(cont.)

PPP and the real exchange rate (cont.)

(cont.)

PPP and the real exchange rate (cont.)

00 )1(

)1()1(

The empirical validity of PPP

• There is little empirical evidence to support the validity of PPP, particularly in the short run.

• There is some evidence for PPP under hyperinflation and over long periods of time.

Actual and PPP exchange rates (USD/AUD)

Percentage deviation of the actual rate from the PPP rate (USD/AUD)

Nominal and real exchange rates (USD/AUD)

PPP as a trading rule

),,,( 21 nXXXSFS

Buy when and sell when SS SS

The monetary model of exchange rates

kPYM d

Predictions of the monetary model

• A monetary expansion leads to depreciation of the domestic currency.

• A rise in income leads to appreciation of the domestic currency.

• A rise in foreign prices leads to appreciation of the domestic currency.

Determination of the bid-offer spread

• Since the bid rate is the rate at which the dealer buys and the customer sells, it is determined by the intersection of the dealer’s demand curve and the customer’s supply curve.

• Conversely, the offer rate is determined by the intersection of the customer’s demand curve and the dealer’s supply curve.

Determination of the forward spread

• The naïve model is based on the assumption that there are independent demand and supply forces in the spot and forward markets.

• It also assumes that there is a separate market with independent supply and demand forces for forward contracts with different maturities.

(cont.)

Determination of the forward spread (cont.)

• The equilibrium spot exchange rate is determined in the spot market, whereas the equilibrium forward rate (for a particular maturity) is determined in the forward market.

• The forward spread is the difference between the forward and spot rates.

Factors affecting the AUD exchange rates

• Interest rates• Commodity prices and the terms of trade• Inflation• The external account • The role of the RBA

Australian dollar exchange rates(December 1983 = 100)

Australian and US short-term interest rates

Commodity prices (December 1983 = 100)

Consumer prices (December 1983 = 100)

The role of the RBA

• The RBA intervenes in the foreign exchange market for three reasons:

(i) to calm the market when it tends to become disorderly;

(ii) to help reverse exchange rate overshooting;

(iii) to give monetary policy greater room to manoeuvre.

(cont.)

The role of the RBA (cont.)

• Direct intervention by the RBA takes the form of smoothing and testing transactions.

• ‘Smoothing’ transactions aims to ease the volatility of the currency’s path in reaction to news to prevent exchange rate overshooting.

• By ‘testing’, the RBA tries to discern market volatility from trends.

Chapter 4 Exchange Rate Determination. Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a...

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