PPT (Determination of Exchange Rates).pdf

8/19/2019 PPT (Determination of Exchange Rates).pdf

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International Finance

Determination of Exchange Rates,Exchange Rate Dynamics and

Intervention

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Foreign Exchange Market

Definition

A network of markets and institutions that

handle foreign currency

Types

Spot Market Forward Market

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Source of Demand for Forex

Source of Supply for Forex

Foreign Exchange Market

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Factors Affecting Demand and Supply

(Shapiro & Sarin, 2009)

Relative Inflation Rates

Relative Interest RatesRelative Economic Growth

Political and Economic Risks

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Bank and Non-Bank Forex Dealers

Individuals and Firms

Speculators and Arbitrageurs

Central Banks and Treasuries

Forex Brokers

Participants in Forex Market

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Calculating Exchange Rate Changes

Percentage increase or decrease in value ofthe domestic currency in terms of another

currency

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First Sample Problem

In 2002, the yen went from$0.0074074 to $0.0084746.

By how much did the yen appreciateagainst the dollar?

By how much did the dollar depreciate

against the yen?

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Second Sample Problem

On April 1, 1998, the government ofYugoslavia devalued the Yugoslav dinar,

setting its new rate at 10.92 dinar to the dollar,from 6 dinar previously.

By how much has the dinar devalued against thedollar?

By how much has the dollar appreciated againstthe dinar?

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Exchange rates treated as the relativeprices of two financial assets traded in an

efficient market Value of a currency determined largely by

expectations and how strongly peoplewould want to hold on to assets

denominated in the currency

Exchange Rate Dynamics: Asset Market

Model (Appleyard & Field, 1998)

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Integrated financial markets

Domestic residents can hold to both domesticand foreign financial assets

Financial assets regarded as imperfectsubstitutes

Asset holders readily switch out of one type ofasset to another whenever events alter returns

Investors are forward looking (i.e. maximizeutility and try acquiring as much informationand knowledge about markets to formforecasts)


Model – Important Assumptions

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Domestic Money

Domestic BondsForeign Bonds


Model - Types of Financial Assets

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Return rate on domestic bond yield (r D)

Return rate on foreign bond yield (r F)

Expected change in the value of the local

currency (%Δe) (+) expected appreciation

(-) expected depreciation

Domestic real income (YD)

Domestic price level (PD) Domestic wealth (WD)


Model – Demand Factors of FAs

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Domestic Money

(-) (-) (-) (+) (+) (+)

MD = f( r D , r F , %Δe , YD , PD , WD )

Domestic Bonds(+) (-) (+) (+) (-,+) (+)

BD = f( r D , r F , %Δe , YD , PD , WD )

Foreign Bonds

(-) (+) (-) (+) (-,+) (+)BF = f( r D , r F , %Δe , YD , PD , WD )


Model – Functional Forms

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Pegged Exchange Rate Regime

Managed Float Exchange Rate Regime

Clean Float Exchange Rate Regime

Exchange Rate Regimes

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What is Money?

Bills and coins

Deposits in bank accounts

Access to credit

Store of value and liquidity

Exchange Rate Intervention :Money Defined

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What is a Central Bank?

A central bank, or reserve bank, by

definition is the monetary authoritywithin a country or coalition ofcountries that regulates moneysupply.

Exchange Rate Intervention:Central Bank Defined

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Printing and distribution of thedomestic currency

Implementation of monetary policyRegulating the banking industry

Setting official interest rates

Lender of last resort

Exchange Rate Intervention:Responsibilities of a Central Bank

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Price stability

Low interest ratesStabilize currency value

Exchange Rate Intervention:Objectives of Central Bank

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Independence from executive branch ofgovernment

Resists pressure to make short-term policydecisions inconsistent with long term growthobjectives

Political influence over a CB leads toperception of inflation risk

Exchange Rate Intervention:CB Reputation

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Buy and sell forex to protect value ofcurrency

Minimize opportunity cost of holding toexcess forex

Exchange Rate Intervention:Role of CB

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Internal Balance

External Balance

Exchange Rate Intervention :Gov’t Goals in an Open Economy

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Analysis begins with definition of money supply

MS = CP + DD

Where MS = money supply

CP = currency in circulation

DD = demand deposits

Exchange Rate Intervention:Fundamentals

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CB affects domestic money supply by influencing themonetary base (high powered money)

H = CP + RE

where H = monetary base

RE = reserves held by KBs


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Assets and liabilities side of high poweredmoney (H)

IR + CBC = CP + RE = H

ΔH = ΔIR + ΔCBC

CB has no control over IR but can influenceCBC

To sterilize the effects any form of

intervention of CB in the market, it would getto engage in open market operations


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Documents

PPT (Determination of Exchange Rates).pdf