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EXCHANGE RATE DETERMINATION

Introduction

What are the factors that cause supply and demand for exchange to change?

There are

several theories on this topic.

Some theories attempt to explain short run movements in exchange rates

while others

study long run movements. The determinants of equilibrium exchange rates

in the short run

and in the long run tend to be different.

1. Balance of Payments Approach to Exchange Rate Determination

This approach emphasizes the flows of goods, services, and investment

capital that

respond gradually to real economic factors such as GDP. It predicts that

exchange rate

depreciation for countries with deficits in their current accounts and

appreciation for

countries with surplus.


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Recall D for FX involves all debit transactions in the BPs. S involves all credit

transactions.

D is downward sloping and S is upward sloping.

S and D for FX reflect changes in the domestic D for foreign goods and

services and in the

foreign D for domestic goods and services. These, in turn, are determined by

macroeconomic conditions at home and abroad.

relative prices of domestic and foreign goods

(e.g.) If U.S. inflation rate is higher than U.K.? D for British goods goes up; D

for

American goods down; D for FX up, S down; $ depreciation.

(Figure 1)

the level of real income within countries

(e.g.) If U.S. income grows faster than U.K.? American D for British goods

goes up

(why?); D for FX goes up; S goes down; $ depreciates.


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technological change

consumer tastes

others including resource accumulation, harvest conditions, strikes, market

structure, and commercial policy.

International capital movement also affects exchange rates in the short run.In general,

easy credit and relatively low short-term interest rates lead to exchange rate

depreciation

for a country. (Short term interest differential is a key determinant of

international capital

movements.)

(e.g.) The case where U.S. interest rate is relatively lower than U.K. due to

the feds

easy monetary policy. American investors will want to invest in London; D forpound

increase; British investors will want to avoid $ denominated assets for

investment; S


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of pound goes down; the result? $ depreciates.

The balance of payments approach is no longer popular. It cant explain short

run volatility

of exchange rates, as it emphasizes flows of funds that adjust gradually over

a period of

time. It is also difficult to decide which BP account to use to predict exchange

rate

movements.

2. The Monetary Approach to Exchange Rate Determination

This approach views the money supply and money demand at home and

abroad as major

determinants in exchange rate movements. It suggests that an increase in

the domestic

money supply causes the home currency to depreciate, while an increase in

domestic

money demand causes it to appreciate.

The aggregate money supply is controlled by central banks.

The aggregate money demand is a function of real income, prices, and


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interest rates.

How an increase in money supply leads to depreciation of home currency: As

money supply

goes up, domestic spending and income rise; imports increase; D for FX goes

up. Also, as

money expands, interest rate goes down; Americans invest abroad; D for FX

increases.

The result: $ depreciates.

(Figure 2)

Show how an increase in money demand will lead to an appreciation of home

currency.

The monetary approach suggests that if we can forecast money demands

and money

supplies, we can forecast long run movements in exchange rates.

The monetary approach is criticized for paying too much emphasis on money

while ignoring

other important variables. In addition, empirical support of the theory has

been mixed.


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3. Expectations and Exchange Rates

Day-to-day movements in exchange rates are closely related to peoples

expectations.

The following are examples of expectations that will lead to appreciation in

the yen and a

depreciation in the dollar:

economy will grow faster than the Japanese economy

interest will be lower than Japans

inflation rate will be higher than Japans

Money supply will grow faster in U.S. than in Japan

All these will, if true, cause $ to depreciate and yen to appreciate.

A graphical illustration of how expectations of future inflation can affect

exchange rates:

Start at initial equilibrium. Suppose people expect a depreciation of $ for

some

reason (e.g., unanticipated growth in money supply in the U.S.); Americans

who


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intend to buy goods from Germany will purchase DM before $ depreciates. D

for DM

increases (D curves shifts up).

The Germans, having the same expectations, will be less willing to obtain $

whose

value is expected to decline. The supply of DM declines (S curve shifts up).

Both cause the ($/DM) rate to increase now; $ depreciates, DM appreciates.

The

expectations are self-fulfilling.

(Figure 3)

4. The Asset-Markets (Portfolio-Balance) Approach

a. Introduction

This approach extends the monetary approach in that it includes domestic

currencies to be

one among many financial assets that a nations citizens desire to hold (e.g.,

domestic


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currency, domestic securities, foreign securities denominated in a foreign

currency, foreign

currency, ).

This approach suggests that stock adjustments among financial assets

(reallocating stock

of wealth among assets in various countries) are a key determinant of short

term

movements in exchange rates. It maintains that it is mainly through the

medium of market

expectations of future returns that exchange rates are affected in the short

run. Other

variables such as the CA balance or money supply growth affect exchange

rates to the

extent that they influence market expectations.

This theory explains the movements in exchange rates in terms of the D and

S of assets

denominated in different currencies.

b. The theory


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1) Exchange rates and a nations money supply (Ms)

If Ms, value of $ will decline. (e.g. During 1922-23, Germanys Ms by trillion

times

(hyperinflation); value of FX in Germany by trillion times.

Ms is controlled by central banks. (e.g. the Fed)

2) Transaction D for money (Md)

Why would people want to hold money? To buy goods and services. (cf. Other

motives for

Md: as an asset, speculation) Why would people demand FX? To buy foreign

goods and

services.

Md is a function of interest rate (r), price level (p) and real income (y). (e.g.

When r goes

up, opportunity cost of holding money increases; Md goes down. When p

goes up, more

money is needed to buy the same basket of goods; Md goes up. When y goes

up, people

demand more goods, and thus demand more money.


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Md curve is downsloping. Why? Given the y level, real Md and r are inversely

related.

(Figure 4)

What happens to the Md curve when y increases? (Shift to right!)

3) Money market equilibrium

Equilibrium in the money market requires Ms=Md or (Ms/p)=(Md/p). But

Md=p*L(r, y) and

(Md/p)=L(r, y) since Md is directly proportional to p. (Why? A 10% increase in

p means you

need 10% more money to buy the same basket of goods). Thus, equilibrium

requires:

(Ms/p) = L(r, y)

(Figure 5)

4) Effects of changes in Ms and y on the equilibrium r

(e.g.) Ms goes up, [(Ms/p) > (Md/p) at r]; people find that they are holding

more money


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their desired level; r declines as unwilling money holders try to lend out some

money. A

nations Ms and r are inversely related.

(Figure 6)

(e.g.) y (GDP) from y1 to y2; Md curve shift up to right as people want to hold

more

money for transaction D; r goes up.

(Figure 7)

5) Effects of changes in Ms and y on the exchange rates

Consider world money market equilibrium: S of money = (M*/M), therelative supply of DM

(the FX in question) to $. (Recall Ms in the U.S. and Germany are fixed at any

given time.

Thus, the ratio is also fixed.) D for money = (L*/L), the relative D for DM to $.

This Money

demand ratio is a function of (y*/y), (r*/r), expectations, etc.

(e.g.) As the Bundesbank increases the German Ms, (M*/M) goes up, the

world Ms curve


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shifts to right; e (exchange rate measure in $/DM rate) would go down. DM

depreciation

($ appreciation)

(Figure 8)

(e.g.) As German real income (y*) increases relative to y in the U.S.; (y*/y)

will increase,

and D for DM will go up. [(L*/L) increases as people need to hold more DM for

transaction

purpose.]; (L*/L) curve shifts up and e goes up (DM appreciation or $

depreciation)

If y* is a result of governments expansionary policy, its main effect may bean increase in

imports so that (L*/L) declines as Germans would want to have more $ to buy

more from

America.

(Figure 9)

6) Other determinants of exchange rate


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Factors that can shift (L*/L), besides (y*/y), include: (r*-r), expectations, BT

(e.g.) If (r*-r)>0 (i.e., r*>r), more DM will be demanded (why?); (L*/L) will

increase and e

goes up (DM appreciation)

(e.g.) If (M*/M) decline is expected, $ depreciation is expected and people

would sell $ for

DM before its too late. e increases ($ depreciates) today

(e.g.) Government policies toward private assets such as freezing assets,

possible

taxation, . can affect investors expectations.

(e.g.) If deficit goes up in the American BT (or CA) balance, FX market would

react to

bring down $ value. (why?)

5. Purchasing Power Parity (PPP) Approach

Introduction

If the value of a countrys currency rises above the level warranted by its

economic


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conditions, the exporting industries of the country will become less

competitive in

international markets and a trade deficit will be likely to follow. It is

important, therefore,

for policy makers to have forecasting ability about the equilibrium value of

exchange rate if

an effective exchange rate management is desired. In fact, discussion of

overvalued or

undervalued currency assumes that there exists a stable equilibrium

exchange rate to

which the value of a currency can be referenced. The purchasing-power

parity (PPP)

theory states that the equilibrium value of an exchange rate is determined by

the changes

in the relative national price levels. For example, if the U.S. price level rises

by 10 percent

over a year while Japans price level rises by only 6 percent, then relative PPP

predicts

that the dollar will depreciate against the yen by 4 percent. The dollars 4

percent


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confirm the validity of longrun PPP while Frankel (1985), Kim (1990) and

Abuaf and Jorion

(1990) were able to support it. These and other studies for the test of PPP

employed

various statistical methods using different sample periods and frequencies of

data.

The Law of One Price and PPP

The law states that in competitive markets free of transportation costs and

barriers to

trade, identical goods sold in different countries must sell for the same price

when their

prices are expressed in terms of the same currency.

(e.g.) Let e = $2/ , P of a sweater = 20 in London, $50 (or 25) in New York,

then the

price in NY is higher; arbitrage would bring NY price down and London price

up until the

prices are equal.

Expressing the law in general terms, for any good,


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PUS = (e$/ ) x PUK.

Carrying the law to all goods, the equation also states PPP.

The Model

The relative version of PPP states that the percentage changes in the

exchange rate

between two currencies over a period of time reflect the differences in the

inflation rates

of the two countries over the same time period. It asserts that exchange

rates and

national prices will adjust in such a way that the ratio of the purchasing

powers of two

currencies remains steady. Relative PPP can be represented by the equation

(Equation 1)

where r is the nominal exchange rate between home and partner country

defined as units of

partner countrys currency per unit of home currency, p* denotes the price

level of the partner

country, p is that of the home country and k is a constant. Relative PPP


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indicates that k is

stable in the long run. Testing the validity of PPP statistically entails some

modifications of the

equation. First, a random disturbance term needs to be included as the

relation in (1) is not

expected to hold exactly. In addition, the coefficient on the price ratio is

treated as an unknown

parameter rather than a known constant. (Whitt 1988) Finally an intercept

term is usually

included in a linear specification of the PPP equation. The resulting equation

is as follows:

(Equation 2)

where the subscript t denotes the time period t, u is a random error term, a

an intercept term

and b the coefficient of the price indexes to be estimated. Both variables, the

exchange rate

and the ratio of price indexes, are measured in logarithms. In empirical

testing if the coefficient b

is not significantly different from unity, the PPP principle would be confirmed.


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There are several practical issues to be resolved in testing the PPP

relationship. First, it is

argued that low frequency data are more appropriate for long run PPP. In the

absence of

annual data for a substantially long period, this study will use both monthly

and quarterly

observations. Second, there are at least three alternative price indexes that

can be used

as proxies for the price level: the GNP deflator, the Consumer Price Index

(CPI) and the

Wholesale Price Index (WPI). The GNP deflator is regarded as a poor choice

since it does

not properly reflect the changes in the average price level while the WPI is

biased toward

the PPP hypothesis. The CPI is the primary choice for this study as it is

considered to be a

reasonable choice (Layton and Stark 1990) and is more readily available. For

a comparison

purpose, WPI series will be also used for the countries for which data are

available. Finally,


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this study will employ the concept of cointegration to test the PPP hypothesis

since the

newly developed method is, as discussed in the following section, considered

to be

particularly suitable in examining longrun equilibrium relationships.

The PPP theory has several limitations: The theory overlooks the fact that

exchange rate

movement may be affected by capital flows. There is a problem of choosing

the

appropriate price index (CPI, PPI, ) and the base year. Government

commercial policy

can interfere with the operation of the theory (trade restrictions).

Empirical evidence on PPP is also mixed. For the countries with high inflation

rates (e.g.,

Latin America), the theory appears to perform well. However, when inflation

differential is

small, factor other than price comparisons can become more important in the

determination


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