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Topic 5 Determination of ExchangeRate (Shapiro, Chapter 2)
Balance of Payments (BOP)
Balance of payments refers to the net value of alleconomic transactions including trade in goodsand services, transfer payments, loans, andinvestments between residents of the samecountry and those of all other countries.
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Balance of Payments (BOP) categories:1. Current account: records imports and
exports of goods, services, income, andcurrent unilateral transfers.
2. Capital account: includes debt
forgiveness, transfers of goods andfinancial assets by migrants as they enteror leave the country.
3. Financial account: shows public andprivate investment and lending activities.It records inflows and outflows of capital.
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A countrys balance of payments (BOP) canhave significant impact on its exchange rateand vice versa, depending on that countrysexchange rate regime.
BOP is equal to the sum total of currentaccount balance (X M), capital accountbalance (CI CO), financial account balance(FI FO) and reserve balance (FXB)
BOP = (X M)+(CI CO)+(FI FO)+(FXB)
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The balance of payments approach is thesecond most utilized theoretical approach in
exchange rate determination: The basic approach argues that the equilibriumexchange rate is found currency flows match upvis a vis current and financial account activities.
This framework has wide appeal as BOPtransaction data is readily available and widelyreported.
Critics may argue that this theory does not takeinto account stocks of money or financial assets.
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Supply and Demand analysis in thedetermination of exchange rates
(A) Foreign Currency Demand:- derived from the demand for foreigncountrys goods, services, and financial
assets. e.g. Americans demand Australian goods such as minerals.
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The Demand for AUD in the U.S.
Qty
USD0.96
USD/AUDD
At higher exchange rates, Americans
demand less AUD and vice versa.
USD0.97
USD0.95
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(B) Foreign Currency Supply:- derived from the foreign countrys
demand for local goods.- Foreign buyers must convert theircurrency in order to purchase.e.g. Australians demand for USgoods, such as Dell computers means
Australians must convert AUD toUSD in order to buy .
Therefore, foreign currency supply anddemand are derived supply and demand
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The Supply of AUD in the U.S.
USD/AUD
Qty
USD0.96
SUSD0.97
USD0.95
At higher exchange rates, Australians
supply more AUD and vice versa.
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(D) How Exchange Rates Change
1. Increased demandas more foreign goods are demanded, moreof the foreign currency is demand at each
possible exchange rate
2. The price of the foreign currency in localcurrency increases.3 . Home Currency Depreciation
a. Foreign currency more valuable thanthe home currency.
b. Conversely, the foreign currencysvalue has appreciated against thehome currency.
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The USD Depreciates
QtyUSD0.95
S
USD/AUD
D
D
USD0.96
Q1 Q2
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Exchange rate determination is complex. The following exhibit provides an overview
of the many determinants of exchangerates. This road map is first organized by the
three major schools of thought (parityconditions, balance of paymentsapproach, asset market approach), andsecondly by the individual drivers withinthose approaches.
These are not competing theories butrather complementary theories.
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Without the depth and breadth of the variousapproaches combined, our ability to capture thecomplexity of the global market for currencies islost.In addition to gaining an understanding of thebasic theories, it is equally important to gain a
working knowledge of: the complexities of internationalpolitical economy;
societal and economic infrastructures;and,
random political, economic, or socialevents affect the exchange rate markets.
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Parity Conditions1. Relative inflation rates
2. Relative interest rates3. Forward exchange rates4. Interest rate parity
Balance of Payments1. Current account balances2. Portfolio investment3. Foreign direct investment4. Exchange rate regimes
5. Official monetary reserves
Asset Approach1. Relative real interest rates2. Prospects for economic growth3. Supply & demand for assets4. Outlook for political stability5. Speculation & liquidity6. Political risks & controls
SpotExchange
Rate
I s there a well-developed
and li quid money and capitalmarket in that currency?
I s there a sound and secur e
banking system i n-place tosupport currency tradingactivities?
Exhibit: Determinants of Exchange Rates
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The previous exhibit, with its tripartitecategorization of exchange rate theory is a
good start but in our humble opinion isnot robust enough to capture the multitude oftheories and approaches.
Therefore, in the following slides, we willintroduce several additional streams of
thought.
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The Monetary Approach
PPP can be reformulated into the Monetaryapproach (Shapiro pp140-42) based on thequantity theory of money:
M/P = y/v
where M is the national money supply, P is
the general price level, y is real GNP, and vis the velocity of money.
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After rewriting, in terms of growth rates togive the determinants of domestic inflation:
ih = h - g yh + g vhwhere i
his the domestic inflation rate,
h is
the rate of domestic money supply expansion,gyh is growth in real domestic GNP, and g vhthe change in the velocity of the domesticmoney supply.
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For example, U.S. money supply growth isforecast at 5%, real GNP is expected to to
grow at 2%, the velocity of money is expectedto fall by 0.5%, U.S. inflation will be
ih = h - g yh + g vh= 5% - 2% + (-0.5%) = 2.5%
Foreign inflation rate can be obtained in thesame way. Combining these two equationsalong with PPP leads to the following predictedexchange rate change:
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Where h and f refers to the correspondingrates for the home and foreign country.
The monetary approach in its simplest formstates that the exchange rate is determined
by the supply and demand for nationalmonetary stocks, as well as the expectedfuture levels and rates of growth of monetary
stocks.
)()()(0
01vf vh yf yh f h f he
ee g g g g ii
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Other financial assets, such as bonds are notconsidered relevant for exchange rate determination,as both domestic and foreign bonds are viewed asperfect substitutes.
Expectations and Asset Market ModelCurrency values: affected by current events andcurrency supply and demand flows in FX market, alsodepend on expectations.
Asset Market Model: the exchange rate between twocurrencies represents the price that just balances therelative supplies of, and demands for, assetsdenominated in those currencies. Shifts inpreferences can lead to massive shifts in currency
values.
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The asset market approach assumes thatwhether foreigners are willing to hold claims inmonetary form depends on an extensive set ofinvestment considerations or drivers (amongothers): Relative real interest rates are a majorconsideration for investors in foreign bonds andSTMM instruments Prospects for economic growth and profitability
are an important determinant of cross-borderequity investment in both securities and foreigndirect investment (FDI)
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Contagion: the spread of a crisis in one country toits neighbouring countries and other countries thathave similar characteristics. Speculation can both cause a FX crisis or makean existing crisis worse.
The asset market approach argues that exchangerates are determined by the supply and demand fora wide variety of financial assets:
Shifts in the supply and demand for financialassets alter exchange rates.
Changes in monetary and fiscal policy alterexpected returns and perceived relative risks offinancial assets, which in turn alter exchangerates.
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Foreign investors are willing to hold securities andundertake foreign direct investment in highlydeveloped countries based primarily on relative realinterest rates and the outlook for economic growthand profitability.The asset market approach is also applicable toemerging markets, however in these cases there is anumber of additional variables contribute toexchange rate determination.
Although different schools of thought on exchange
rate determination (parity conditions, monetaryapproach, balance of payments approach, assetapproach) make understanding exchange ratesappear to be straightforward, that it rarely the case.
26
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The large and liquid capital and currency marketsfollow many of the principles outlined so farrelatively well in the medium to long term.
The smaller and less liquid markets, however,frequently demonstrate behaviors that seeminglycontradict the theory.
The problem lies not in the theory, but in therelevance of the assumptions underlying thetheory.