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.
Download ReportTranscript 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 1 Learning Objectives • Explain how exchange rates are determined • Describe the factors responsible for movements in the exchange rate 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 2 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 3 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 4 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 5 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 6 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 – 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 7 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 – 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 8 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 – 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 9 16.2 FX Market and the Equilibrium Exchange Rate (cont.) 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 10 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 11 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 12 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 13 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 14 Relative inflation rates (cont.) 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 15 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 – 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 16 Relative national income growth rates (cont.) 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 17 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 18 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 19 Relative interest rates (cont.) 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 20 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 21 Relative interest rates (cont.) 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 22 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 23 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 24 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 25 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 26 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 27 Exchange rate expectations (cont.) • Exchange rate expectations are based on expectations about future changes in Relative inflation – Relative income growth – Relative interest rates – 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 28 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 29 Exchange rate expectations (cont.) 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 30 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 31 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 – 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 32 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 33 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 34 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 35 Government or central bank intervention (cont.) 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 36 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 37 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.) 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 38 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 39 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 40 16.5 Purchasing Power Parity (PPP) (cont.) 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 41 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 42 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 43 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: 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 44 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% 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 45 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. 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 46 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 47 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 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 Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 48