INTERNATIONAL ECONOMICS

D.  Exchange-Rate Determination

1.  Exchange-rate market

a.  Factors

(1)  Market fundamentals

• Economic variables - productivity, inflation rates, real interest rates, consumer preferences, trade policy

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(2)  Market expectations

• News about future market fundamentals, opinions about future exchange rates

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b.  Time frames

(1)  Short-run

• Transfers of financial assets in response to differences in real interest rates and expectations of future exchange rates

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(2)  Medium-run

• Cyclical fluctuations in economic activity

• GDP, income affected, which in turn affects imports

- Expansion => increase in GDP, income => increase in imports => increase in supply of domestic currency

- Recession => decrease in GDP, income => decrease in imports => decrease in supply of domestic currency

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(3)  Long-run

• Flows of goods, services, and investment capital in response to inflation rates, investment profitability, consumer tastes, productivity, and trade policy

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2.  Long-run exchange rate determination

a.  Relative price levels

• .Buy more of lower priced goods, less of higher priced goods

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b.  Relative productivity levels

• Productivity growth = increase in output for a given level of input

• More rapid productivity growth => lower cost of production, lower prices

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c.  Preferences for domestic or foreign goods

• Affects exports and imports

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d.  Trade barriers

• Tariffs, quotas reduce imports

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3.  Impact of prices and inflation

a.  Law of One Price

• An identical good should cost the same in all countries after exchange rate is taken into account

• Assuming that it is costless to ship the good between nations, no barriers to trade, and markets are competitive

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• Big Mac Index - use McDonald's Big Mac as the common good

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b.  Purchasing power parity

• Apply Law of One Price to national price levels

• Exchange rates adjust to make goods and services cost the same everywhere

• Trade flows are the mechanism that makes currency appreciate or depreciate

• Changes in relative national price levels determines changes in exchange rates over the long term

- Currency expected to depreciate by amount of excess domestic inflation over foreign inflation

- Currency expected to appreciate by amount of excess foreign inflation over domestic inflation

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• Problems

(1)  Exchange rates may be influenced by investment flows

(2)  Difficult to choose appropriate price index to use

(3)  Which equilibrium period to use as base?

(4)  Government policy may interfere

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• Good in long term, poor short-term forecaster

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4.  Short-run exchange rate determination

a.  Asset-market approach

• Most exchange rate transactions are by investors in financial assets

- Treasury securities, corporate bonds, bank accounts, stocks, real property

(1)  Relative levels of interest rates

(a) Nominal interest rate

• Quoted or money interest rate

• High nominal interest rates => demand for securities and financial instruments increases, demand for currency increases

• Low nominal interest rates => demand for securities and financial instruments decreases, demand for currency decreases

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(b)  Real interest rate

• Real interest rate = nominal rate - inflation rate

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• Inflation may offset high nominal interest rate

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(2)  Expected change in exchange rates

• Future changes in exchange rates can affect rate of return

• Depreciation => lower return, appreciation => higher return

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b.  Diversification and safe havens

• Desire to diversify may lead investors away from a country, even if interest rates are high

• During times of turmoil, investors may invest in a safe country, e.g., U.S., even if returns are higher elsewhere

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5.  Exchange-rate overshooting

• Short-run response greater than long-run response

• Exchange rate more flexible than other prices

• Elasticities smaller in the short run than in the long run

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6.  Forecasting exchange rates

• Necessary for exporters, importers, investors, bankers, foreign exchange dealers

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a.  Judgmental forecasts

• Subjective or common sense models, based on economic and/or political data

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b.  Technical forecasts

• Use historic exchange rate data to forecast future ones

• Look for patterns

• Primary method of analyzing short-term movements

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c.  Fundamental analysis

• Use economic variables and econometrics

- Interest rates, balance of trade. productivity, inflation rates