Carbaugh, International Economics 9e, Chapter 13
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Transcript Carbaugh, International Economics 9e, Chapter 13
International Economics
By Robert J. Carbaugh
9th Edition
Chapter 13:
Exchange-Rate Determination
Copyright ©2004, South-Western College Publishing
Exchange rates
Factors influencing exchange rates
Market fundamentals
Bilateral trade balances
Real income
Real interest rates
Inflation rates
Consumer preferences for domestic or foreign
products
Productivity changes affecting production costs
Profitability and riskiness of investments
Carbaugh, Chap. 13
2
Exchange rates
Factors influencing exchange rates
Market fundamentals (cont’d)
Product availability
Monetary policy and fiscal policy
Government trade policy
Market expectations
News about future market fundamentals
Speculative opinion about future exchange
rates
Carbaugh, Chap. 13
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Exchange rates
When are these factors important?
Short run (days)
Dominated by financial transfers responding to:
Differences in real interest rates
Shifting expectations of future exchange rates
Medium run (months)
Primarily influenced by economic cycles
Carbaugh, Chap. 13
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Exchange rates
When are these factors important?
Long run (years)
Dominated by movements of goods, services,
investment, which are influenced by:
Inflation rates
Investment profitability
Consumer tastes
Real income
Productivity
Trade policy
How these factors interact to affect exchange
rates depends on the relative importance of trade
and financial relations between the countries
Carbaugh, Chap. 13
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Exchange rates
Exchange rate components
Carbaugh, Chap. 13
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Factors influencing exchange rates
Real income differentials
A country with faster economic growth than
the rest of the world will have a depreciating
currency (other things being equal)
Imports rise faster than exports, so demand for
foreign currency rises faster than its supply
Real income changes can also reflect other
processes, which might lead to rising
exports
Carbaugh, Chap. 13
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Factors influencing exchange rates
Impact of real income differentials
Carbaugh, Chap. 13
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Factors influencing exchange rates
Real interest rates
Short term real interest rate differences
influence international capital movements
Real interest rate is nominal minus inflation
Low short term rates lead to less demand
for the currency and depreciation
High rates lead to greater demand for the
currency and appreciation
Carbaugh, Chap. 13
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Factors influencing exchange rates
Impact of interest rate differentials
Carbaugh, Chap. 13
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Factors influencing exchange rates
Purchasing power parity
Law of one price: In theory, a good should cost
the same in all countries (aside from tariffs or
transportation costs)
As a result, exchange rates should end up
making prices equal across countries
By this theory, if two countries have different
inflation rates, exchange rates will move in the
opposite direction to keep prices the same
The theory may be more useful for predicting
long-term trends than short-run fluctuations
Carbaugh, Chap. 13
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Factors influencing exchange rates
Impact of inflation rate differentials
Carbaugh, Chap. 13
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Factors influencing exchange rates
Market expectations
As with stock markets, foreign exchange
markets react quickly to news or even
rumors that point to future changes
affecting rates
Future expectations can be self-fulfilling;
speculative bubbles can start without any
real information but can become self
sustaining - for a while
Carbaugh, Chap. 13
13
Alternative approaches to exchange rates
Monetary approach
Focus on exchange rates as the result of
supply and demand for money at home and
abroad
Demand depends on real income, prices,
interest rates
Supply is controlled by central banks
Exchange rates seen as returning domestic
money supply to equilibrium after a change
Carbaugh, Chap. 13
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Alternative approaches to exchange rates
Asset-markets approach
Investors (firms and individuals) balance
their portfolios among domestic money,
stocks and bonds and foreign stocks and
bonds
Short run exchange rate changes are
caused by shifts in the kind and location of
financial assets investors want to hold
Investors shift between assets based on
market expectations for expected returns
Carbaugh, Chap. 13
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Exchange rate markets
Short, long run equilibrium: overshooting
Carbaugh, Chap. 13
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Exchange rate markets
Forecasting exchange rates
Judgmental forecasts
Subjective forecasts based on economic,
political and other data for a country
Technical analysis
Uses historical exchange rate trends to project
short-run future movements
Fundamental analysis
Includes macroeconomic and policy
information in a predictive model
Carbaugh, Chap. 13
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Alternative approaches to exchange rates
Equilibrium in asset-markets approach
Carbaugh, Chap. 13
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Alternative approaches to exchange rates
Asset-markets approach: shift in demand
Carbaugh, Chap. 13
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Alternative approaches to exchange rates
Asset-markets approach: shift in supply
Carbaugh, Chap. 13
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