Macro exchange rate

University of Management and Technology (Pakistan)
May. 7, 2012
1 of 16

Macro exchange rate

• 2. Chapter Objectives • To explain how exchange rate movements are measured; • To explain how the equilibrium exchange rate is determined; and • To examine the factors that affect the equilibrium exchange rate. C4 - 2
• 3. Measuring Exchange Rate Movements • An exchange rate measures the value of one currency in units of another currency. • When a currency declines in value, it is said to depreciate. When it increases in value, it is said to appreciate. • On the days when some currencies appreciate while others depreciate against the dollar, the dollar is said to be “mixed in trading.” C4 - 3
• 4. Measuring Exchange Rate Movements • The percentage change (% ∆) in the value of a foreign currency is computed as St – St-1 St-1 where St denotes the spot rate at time t. • A positive % ∆ represents appreciation of the foreign currency, while a negative % ∆ represents depreciation. C4 - 4
• 5. Exchange Rate Equilibrium • An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency. Value of £ S: Supply of £ \$1.60 \$1.55 equilibrium exchange rate \$1.50 D: Demand for £ Quantity of £ C4 - 5
• 6. Factors that Influence Exchange Rates Relative Inflation Rates \$/£ U.S. inflation ↑ S1 ⇒ ↑ U.S. demand for S0 r1 British goods, and r0 hence £. D1 ⇒ ↓ British desire for U.S. D0 goods, and hence the Quantity of £ supply of £. C4 - 6
• 7. Factors that Influence Exchange Rates Relative Interest Rates \$/£ U.S. interest rates ↑ S0 ⇒ ↓ U.S. demand for S1 r0 British bank deposits, r1 and hence £. D0 ⇒ ↑ British desire for U.S. D1 bank deposits, and Quantity of £ hence the supply of £. C4 - 7
• 8. Factors that Influence Exchange Rates Relative Interest Rates • A relatively high interest rate may actually reflect expectations of relatively high inflation, which discourages foreign investment. • It is thus useful to consider real interest rates, which adjust the nominal interest rates for inflation. C4 - 8
• 9. Factors that Influence Exchange Rates Relative Interest Rates • real nominal interest ≈ interest – inflation rate rate rate • This relationship is sometimes called the Fisher effect. C4 - 9
• 10. Factors that Influence Exchange Rates Relative Income Levels \$/£ U.S. income level ↑ ⇒ ↑ U.S. demand for S0 ,S1 British goods, and r1 r0 hence £. D1 ⇒ No expected change for D0 the supply of £. Quantity of £ C4 - 10
• 11. Factors that Influence Exchange Rates Government Controls • Governments may influence the equilibrium exchange rate by: ¤ imposing foreign exchange barriers, ¤ imposing foreign trade barriers, ¤ intervening in the foreign exchange market, and ¤ affecting macro variables such as inflation, interest rates, and income levels. C4 - 11
• 12. Factors that Influence Exchange Rates Expectations • Foreign exchange markets react to any news that may have a future effect. • Institutional investors often take currency positions based on anticipated interest rate movements in various countries. • Because of speculative transactions, foreign exchange rates can be very volatile. C4 - 12
• 13. Factors that Influence Exchange Rates Expectations Signal Impact on \$ Poor U.S. economic indicators Weakened Fed chairman suggests Fed is Strengthened unlikely to cut U.S. interest rates A possible decline in German Strengthened interest rates Central banks expected to Weakened intervene to boost the euro C4 - 13
• 14. Factors that Influence Exchange Rates Interaction of Factors • Trade-related factors and financial factors sometimes interact. Exchange rate movements may be simultaneously affected by these factors. • For example, an increase in the level of income sometimes causes expectations of higher interest rates. C4 - 14
• 15. Factors that Influence Exchange Rates Interaction of Factors • Over a particular period, different factors may place opposing pressures on the value of a foreign currency. • The sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries. C4 - 15
• 16. How Factors Can Affect Exchange Rates Trade-Related Factors U.S. demand for foreign 1. Inflation goods, i.e. demand for Differential foreign currency 2. Income Differential Foreign demand for U.S. 3. Gov’t Trade goods, i.e. supply of Exchange Restrictions foreign currency rate between foreign Financial U.S. demand for foreign currency Factors securities, i.e. demand for and the 1. Interest Rate foreign currency dollar Differential Foreign demand for U.S. 2. Capital Flow securities, i.e. supply of Restrictions foreign currency C4 - 16