Chapter 16 Determinants of the Foreign Exchange Value of a Currency Copyright Copyright  2003  2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher.

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Transcript Chapter 16 Determinants of the Foreign Exchange Value of a Currency Copyright Copyright  2003  2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher.

Chapter 16
Determinants of the
Foreign Exchange Value
of a Currency
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Learning Objectives
• Explain how exchange rates are determined
• Describe the factors responsible for
movements in the exchange rate
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Chapter Organisation
16.1 Introduction
16.2 FX Market and the Equilibrium
Exchange Rate
16.3 Factors Influencing Exchange
Rate Movements
16.4 Sensitivity of the Exchange Rate
to Changes in Economic Variables
16.5 Purchasing Power Parity
16.6 Summary
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16.1 Introduction
• The structure and operations of the FX
markets are considered in Chapter 15
• Attention is now focused on the factors that
influence the value of a currency (in a
floating exchange rate regime) in order to
attempt to forecast future exchange rates
with some reliability and accuracy
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16.1 Introduction (cont.)
• A floating exchange rate regime is one in
which the value of the currency is
determined by demand and supply
conditions
• A pegged exchange rate regime is where a
domestic currency is locked into a multiple
of another currency such as the USD e.g.
Hong Kong dollar
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Chapter Organisation
16.1 Introduction
16.2 FX Market and the Equilibrium
Exchange Rate
16.3 Factors Influencing Exchange
Rate Movements
16.4 Sensitivity of the Exchange Rate
to Changes in Economic Variables
16.5 Purchasing Power Parity
16.6 Summary
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16.2 FX Market and the
Equilibrium Exchange Rate
• Demand for a currency
To purchase Australian goods and services,
foreigners must buy AUD
– Downward sloping demand curve occurs as the
devaluation of AUD results in a greater demand by
foreigners
– For foreigners, a fall in the price of the AUD is
equivalent to a reduction in the price of everything
in Australia
–
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16.2 FX Market and the
Equilibrium Exchange Rate
(cont.)
• Supply of a currency
Upward sloping supply curve occurs as the quantity
of AUDs supplied to the FX market increases as the
price of the AUD increases
– As the AUD appreciates, the price of foreign
currency falls, making foreign goods cheaper for
Australian residents
– The demand for foreign currency increases and,
therefore, the supply of AUD
–
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16.2 FX Market and the
Equilibrium Exchange Rate
(cont.)
• Equilibrium exchange rate
The equilibrium exchange rate is the rate at which
the quantity of AUD supplied to the market is equal
to the demand for AUD
– It shows the unique rate at which both the
demanders and suppliers of AUD will be satisfied
–
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16.2 FX Market and the
Equilibrium Exchange Rate
(cont.)
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Chapter Organisation
16.1 Introduction
16.2 FX Market and the Equilibrium
Exchange Rate
16.3 Factors Influencing Exchange
Rate Movements
16.4 Sensitivity of the Exchange Rate
to Changes in Economic Variables
16.5 Purchasing Power Parity
16.6 Summary
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16.3 Factors Influencing
Exchange Rate Movements
• Relative inflation rates
• Relative national income growth rates
• Relative interest rates
• Exchange rate expectations
• Government or central bank intervention
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Relative inflation rates
• Relative inflation rates influence the price and,
therefore, the demand for foreign goods by
residents
• The change in demand for imported goods, in
turn, affects the demand for foreign currency
used to buy these goods
–
This view of the determination of the value of a
currency is called purchasing power parity (PPP) and
is discussed in detail later
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Relative inflation rates (cont.)
• Example: increase in US rate of inflation
relative to Australia
–
Effect for Australian residents

–
Effect for foreign residents

–
US imports more expensive, decreasing demand for
these goods; therefore, reducing the supply of AUD
Some US demand for goods and services, and assets
will switch to Australian items, increasing demand for
AUD to pay for these items
Net effect is an appreciation of the AUD
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Relative inflation rates (cont.)
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Relative national income growth
rates
• Example: Australian income growth rates
rise relative to the USA
Australian demand for imports increases, increasing
the supply of AUD, causing the AUD to depreciate
– A secondary effect could be an increase in foreign
investment in Australia, increasing the demand for
AUD, causing the AUD to recover some value
–
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Relative national income growth
rates (cont.)
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Relative interest rates
• Example: if Australian interest rates rise,
relative to the USA
–
Effect for US residents

US residents and companies may redirect some of
their cash into Australian interest bearing instruments,
increasing the demand for the AUD
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Relative interest rates (cont.)
–
Effect for Australian residents

–
Australian investors and businesses are more likely to
keep their surplus funds invested in Australia, causing
a decrease in the supply of the AUD
Net effect

AUD will appreciate
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Relative interest rates (cont.)
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Relative interest rates (cont.)
• The role of interest rates on the exchange
rate ignores expectations about the value of
the currency during the investment period
• Table 16.1 illustrates the interaction of
interest rate differentials and expected
changes in the exchange rate over the
investment period on currency value
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Relative interest rates (cont.)
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Relative interest rates (cont.)
• From Table 16.1 the following impact on the
value of the AUD would be evident
Scenario
– Scenario
– Scenario
– Scenario
–
1:
2:
3:
4:
AUD
AUD
AUD
AUD
would
would
would
would
depreciate
appreciate
not change
appreciate
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Relative interest rates (cont.)
• The analysis has ignored whether a change
in nominal interest rates is due to a change
in the real rate of return or a change in the
inflation expectations premium
inom  r  pe
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Relative interest rates (cont.)
• Example: if nominal interest rates rise due
to an increase in the inflation expectations
premium
–
The currency may not appreciate, and could
depreciate due to


The effect of inflationary expectations (PPP theory)
Businesses and individuals seeking to invest cash
holdings in overseas’ securities to avoid a loss of value
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Relative interest rates (cont.)
• Example: if nominal interest rates rise due
to an increase in the real rate of return
–
The currency may appreciate

Due to an inflow of funds from the rest of the world
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Exchange rate expectations
• Relatively little of the turnover in the FX
market is associated with payments for
imports and exports of goods and services
• Most turnover is motivated by changes in
exchange rate expectations
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Exchange rate expectations
(cont.)
• Exchange rate expectations are based on
expectations about future changes in
Relative inflation
– Relative income growth
– Relative interest rates
–
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Exchange rate expectations
(cont.)
• Example: AUD expected to depreciate
–
Effect for Australian residents


–
Effect for foreign residents


–
Seek to buy foreign currency before AUD falls
Increasing supply of AUD on FX markets
Defer purchases of AUD denominated items
Reduces demand for AUD
Net effect

AUD depreciates as expected
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Exchange rate expectations
(cont.)
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Government or central bank
intervention
• Policies by foreign and/or domestic
governments may affect the relative rate of
inflation, income growth or interest rates
between countries
• Also, the market participants’ expectations
that the government will alter it’s policy
affecting these variables in the future
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Government or central bank
intervention (cont.)
• A central bank may also influence the
currency by
Intervening in international trade flows
– Intervening in foreign investment flows
– Directly intervening in the FX market
–
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Government or central bank
intervention (cont.)
• International trade flows
– Intervention aimed at increasing exports and/or
reducing imports by the use of

Subsidies to exporters, making exports more
competitive
•

Thereby, increasing demand for Australian exports and
increasing demand for AUD
Tariffs, quotas and embargoes on imports
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Government or central bank
intervention (cont.)
• Foreign investment flows
– Governments alter the exchange rate by altering
the flow of investment funds between countries
by


Prohibitions on the outflow of funds from a country
Imposing penalty taxes to residents who earn income
offshore
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Government or central bank
intervention (cont.)
• Direct FX market intervention
– Involves purchases or sales of currency
– Two motivations for doing this

Smoothing
•

RBA tries to remove volatility in the currency caused by
speculators
Exchange rate targeting
•
RBA tries to push the equilibrium exchange rate to
some level
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Government or central bank
intervention (cont.)
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Chapter Organisation
16.1 Introduction
16.2 FX Market and the Equilibrium
Exchange Rate
16.3 Factors Influencing Exchange Rate
Movements
16.4 Sensitivity of the Exchange Rate to
Changes in Economic Variables
16.5 Purchasing Power Parity
16.6 Summary
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16.4 Sensitivity of the
Exchange Rate to Changes in
Economic Variables
• Regression analysis can be used to assess
how changes in economic variables affect
the exchange rate
–
It is a statistical technique that determines the
relationship between a dependent variable (the
exchange rate) and independent variables
(relative growth, inflation and interest rates
etc.)
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Chapter Organisation
16.1 Introduction
16.2 FX Market and the Equilibrium
Exchange Rate
16.3 Factors Influencing Exchange
Rate Movements
16.4 Sensitivity of the Exchange Rate
to Changes in Economic Variables
16.5 Purchasing Power Parity
16.6 Summary
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16.5 Purchasing Power Parity
(PPP)
• Purchasing power parity (PPP) suggest that
exchange rates will adjust to ensure prices
on the same goods are equal between
countries
–
i.e. a currency should have equal purchasing
power at home or in any foreign country once
the currency is exchanged into foreign currency
at the current rate
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16.5 Purchasing Power Parity
(PPP) (cont.)
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16.5 Purchasing Power Parity
(PPP) (cont.)
• PPP provides reasonably accurate results over
the long run
–
Poor short-term performance is attributed to factors
affecting the mechanism for adjustments in the demand
for goods and services between countries with different
rates of inflation, including



Existence of substitutes
Unknown quality and reliability of new supply
Delivery time from overseas
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16.5 Purchasing Power Parity
(PPP) (cont.)
S% 
(1  I )
f
1 I )
1
h
(16.1)
Where :
S  percentage change in the exchange rate that should
offset the change in the inflation differential between
two countries
I  home country inflation rate
h
I
f
 foreign country inflation rate
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16.5 Purchasing Power Parity
(PPP) (cont.)
• Assume that the home country experiences
inflation of 10 per cent per annum, while the
foreign country has inflation of 4 per cent per
annum. If PPP is maintained, then:
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16.5 Purchasing Power Parity
(PPP) (cont.)
S% 
(1  I )
f
1 I )
1
h
(1  4.00%)

1
1  10.00%)
1.04

1
1.10
 5.4545%
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16.5 Purchasing Power Parity
(PPP) (cont.)
• That is, the home currency should depreciate by
5.46 per cent in response to the higher rate of
inflation in the home country.
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Chapter Organisation
16.1 Introduction
16.2 FX Market and the Equilibrium
Exchange Rate
16.3 Factors Influencing Exchange Rate
Movements
16.4 Sensitivity of the Exchange Rate
to Changes in Economic Variables
16.5 Purchasing Power Parity
16.6 Summary
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16.6 Summary
• Demand and supply determine the value of a
currency in a floating exchange rate regime
• Factors that influence the demand and/or supply of
a currency are
–
–
–
–
–
Relative inflation rates (PPP)
Relative national income growth rates
Relative interest rates
Exchange rate expectations
Central bank or government intervention
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