Determination of exchange rates
DEFINITION: Exchange rate is the price of one country’s currency in terms of another.
- For example, the Dollar/Euro exchange rate is the number of Dollars one Euro will buy. Thus, $1.5/€ means €1 will buy $1.5.
- Alternatively, the Euro/Dollar exchange rate is the number of Euros one Dollar will buy. Thus, €0 .67/$ means $1 will buy €0.67.
Equilibrium Spot Exchange Rates
- Determined by supply and demand
- Factors that affect equilibrium exchange rate include relative inflation rates, interest rates, economic growth rates, and political and economic risk.
Two forces determine the price of a foreign currency: Supply and Demand (of the foreign currency).
- Demand for the foreign currency is derived from demand for the foreign country’s goods, services, financial assets.
- Supply for the foreign currency is derived from foreign country’s demand for local goods, services, financial assets.
Quoting exchange rate:
- Direct: the domestic currency price of the foreign currency.
- “How much domestic currency does it take to buy 1 unit of foreign currency?”
- Direct Quote: (d/f)
Alternative exchange rate systems
Free float
Definition: Market forces of supply and demand determine exchange rates. Forces are influenced by price levels, interest rates and economic growth.
Costs:
i. Volatile export industries (if currency appreciates) ii. Volatile price level
iii. Exchange rate uncertainty acts as a tax on trade and foreign investment.
1. Managed float
Definition: Most countries that adopt floating rates attempt to smooth out exchange rate fluctuations through central bank intervention.
2. Target-zone arrangement
Definition: Market forces constrained to upper and lower range of rates. Members to the arrangement adjust their national economic policies to maintain target.
Costs:
iv. Volatile export industries (if currency appreciates)
v. Volatile price level
vi. Exchange rate uncertainty acts as a tax on trade and foreign investment.
3. Fixed-rate system
Definition: Government maintains target rates. If rates threatened, central banks buy/sell currency.
Costs:
vii. Volatile prices
The trilemma and exchange rate regimes
Policymakers aim to achieve these 3 goals: a stable exchange rate, an independent monetary policy and capital market integration. The trilemma is that in pursuing any 2 goals, the 3rd must be forgone.
i) A stable exchange rate:promotes trade as less risk for business and individuals to buy/sell and invest overseas. Volatile exchange rates make planning difficult.
ii) Independent monetary policy: during economic slump, central bank can expand money supply and cut interest rates. An overheating economy: reduce money supply and raise interest rates to curb inflation.
iii) Capital market integration: facilitates FDI and cross-border co-operation. Open economy to international flow reduces cost of capital and improves portfolio diversification.
International Parity Conditions
Forward premium/discount
- Calculating the premium/discount per annum for the foreign currency, using a direct exchange rate.
- If forward price > spot price, it is trading at forward premium; if spot price > forward price, it is trading at forward discount.
International Parity conditions
1. Purchasing Power Parity (PPP) Definition:
- The relationship between the prices of goods/services (inflation rates) and exchange rates. - Says that exchange rates would adjust to offset the difference in inflation rates between
countries.
Absolute PPP vs Relative PPP:
- Absolute Purchasing Power Parity says that exchange rates would adjust to offset the difference in price levelsbetween countries. Meaning one unit of currency has the same purchasing power globally – Law Of One Price (LOOP).
- Relative Purchasing Power Parity says exchange rates would adjust to reflect changes in price levels (inflation rates) between countries.
Problems:
- Difficult to test as baskets of goods may vary between countries and not all goods are traded internationally. Thus, prices may not conform to PPP.
- Ignores differences in trade restrictions (tariffs/import quotas, transportation costs, restrictions on movement of certain types of goods).
- In mathematical terms:
Implications:
- If inflation in home country > inflation in foreign country, the home currency will depreciate relative to foreign currency.
- Real exchange rates: nominal exchange rate adjusted for inflation. Formula:
-
2. The Fisher Effect (FE) Definition:
- The relationship between interest rate, inflation rate and exchange rate.
- Declared interest rate is always nominal rate which reflects inflation rate.
- The nominal interest rate differential should reflect the inflation rate differential.
- Fisher effect states that nominal interest rates (r) is made up of a real required rate of return or real interest rate (a) and an inflation premium equal to the expected inflation (i).
The Fisher equation
Fisher effect asserts that if expected real returns are higher in one country than another,
capital would flow from the second to the first country currency. Done through arbitrage. So nominal interest rate differential = anticipated inflations between 2 currencies.
Implication:
- Countries with higher expected inflation rates should have higher nominal interest rates.
