Exchange Rate 2 Essay Research Paper International

Exchange Rate 2 Essay, Research Paper

International Economics at Shippensburg University

EXCHANGE RATE DETERMINATION

Introduction

What are the factors that cause supply and demand for exchange to change. There are

several theories on this topic.

Some theories attempt to explain short run movements in exchange rates while others

study long run movements. The determinants of equilibrium exchange rates in the short run

and in the long run tend to be different.

1. Balance of Payments Approach to Exchange Rate Determination

This approach emphasizes the flows of goods, services, and investment capital that

respond gradually to real economic factors such as GDP. It predicts that exchange rate

depreciation for countries with deficits in their current accounts and appreciation for

countries with surplus.

Recall D for FX involves all debit transactions in the BPs. S involves all credit transactions.

D is downward sloping and S is upward sloping.

S and D for FX reflect changes in the domestic D for foreign goods and services and in the

foreign D for domestic goods and services. These, in turn, are determined by

macroeconomic conditions at home and abroad.

relative prices of domestic and foreign goods

(e.g.) If U.S. inflation rate is higher than U.K.. D for British goods goes up; D for

American goods down; D for FX up, S down; $ depreciation.

(Figure 1)

the level of real income within countries

(e.g.) If U.S. income grows faster than U.K.. American D for British goods goes up

(why.); D for FX goes up; S goes down; $ depreciates.

technological change

consumer tastes

others including resource accumulation, harvest conditions, strikes, market

structure, and commercial policy.

International capital movement also affects exchange rates in the short run. In general,

easy credit and relatively low short-term interest rates lead to exchange rate depreciation

for a country. (Short term interest differential is a key determinant of international capital

movements.)

(e.g.) The case where U.S. interest rate is relatively lower than U.K. due to the fed’s

easy monetary policy. American investors will want to invest in London; D for pound

increase; British investors will want to avoid $ denominated assets for investment; S

of pound goes down; the result. $ depreciates.

The balance of payments approach is no longer popular. It can’t explain short run volatility

of exchange rates, as it emphasizes flows of funds that adjust gradually over a period of

time. It is also difficult to decide which BP account to use to predict exchange rate

movements.

2. The Monetary Approach to Exchange Rate Determination

This approach views the money supply and money demand at home and abroad as major

determinants in exchange rate movements. It suggests that an increase in the domestic

money supply causes the home currency to depreciate, while an increase in domestic

money demand causes it to appreciate.

The aggregate money supply is controlled by central banks.

The aggregate money demand is a function of real income, prices, and interest rates.

How an increase in money supply leads to depreciation of home currency: As money supply

goes up, domestic spending and income rise; imports increase; D for FX goes up. Also, as

money expands, interest rate goes down; Americans invest abroad; D for FX increases.

The result: $ depreciates.

(Figure 2)

Show how an increase in money demand will lead to an appreciation of home currency.

The monetary approach suggests that if we can forecast money demands and money

supplies, we can forecast long run movements in exchange rates.

The monetary approach is criticized for paying too much emphasis on money while ignoring

other important variables. In addition, empirical support of the theory has been mixed.

3. Expectations and Exchange Rates

Day-to-day movements in exchange rates are closely related to people’s expectations.

The following are examples of expectations that will lead to appreciation in the yen and a

depreciation in the dollar:

economy will grow faster than the Japanese economy

interest will be lower than Japan’s

inflation rate will be higher than Japan’s

Money supply will grow faster in U.S. than in Japan

All these will, if true, cause $ to depreciate and yen to appreciate.

A graphical illustration of how expectations of future inflation can affect exchange rates:

Start at initial equilibrium. Suppose people expect a depreciation of $ for some

reason (e.g., unanticipated growth in money supply in the U.S.); Americans who

intend to buy goods from Germany will purchase DM before $ depreciates. D for DM

increases (D curves shifts up).

The Germans, having the same expectations, will be less willing to obtain $ whose

value is expected to decline. The supply of DM declines (S curv

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