International Economics
By Robert J. Carbaugh
9th Edition
Chapter 13:
Exchange-Rate Determination
Carbaugh, Chap. 13
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
Exchange rates
Carbaugh, Chap. 13
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
Exchange rates
Carbaugh, Chap. 13
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
Exchange rates
Carbaugh, Chap. 13
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
Exchange rates
Carbaugh, Chap. 13
Exchange rate components
Exchange rates
Carbaugh, Chap. 13
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
Factors influencing exchange rates
Carbaugh, Chap. 13
Impact of real income differentials
Factors influencing exchange rates
Carbaugh, Chap. 13
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
Factors influencing exchange rates
Carbaugh, Chap. 13
Impact of interest rate differentials
Factors influencing exchange rates
Carbaugh, Chap. 13
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
Factors influencing exchange rates
Carbaugh, Chap. 13
Impact of inflation rate differentials
Factors influencing exchange rates
Carbaugh, Chap. 13
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
Factors influencing exchange rates
Carbaugh, Chap. 13
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
Alternative approaches to exchange rates
Carbaugh, Chap. 13
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
Alternative approaches to exchange rates
Carbaugh, Chap. 13
Short, long run equilibrium: overshooting
Exchange rate markets
Carbaugh, Chap. 13
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
Exchange rate markets
Carbaugh, Chap. 13
Equilibrium in asset-markets approach
Alternative approaches to exchange rates
Carbaugh, Chap. 13
Asset-markets approach: shift in demand
Alternative approaches to exchange rates
Carbaugh, Chap. 13
Asset-markets approach: shift in supply
Alternative approaches to exchange rates
Carbaugh, Chap. 13
