Short Run Movements In Exchange Rates example essay topic

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 curve shifts up). Both cause the ($/DM) rate to increase now; $ depreciates, DM appreciates. The expectations are self-fulfilling.

(Figure 3) 4. The Asset-Markets (Portfolio-Balance) Approach a. Introduction This approach extends the monetary approach in that it includes domestic currencies to be one among many financial assets that a nation's citizens desire to hold (e. g., domestic currency, domestic securities, foreign securities denominated in a foreign currency, foreign currency, ... ). This approach suggests that stock adjustments among financial assets (reallocating stock of wealth among assets in various countries) are a key determinant of short term movements in exchange rates. It maintains that it is mainly through the medium of market expectations of future returns that exchange rates are affected in the short run.

Other variables such as the CA balance or money supply growth affect exchange rates to the extent that they influence market expectations. This theory explains the movements in exchange rates in terms of the D and S of assets denominated in different currencies. b. The theory 1) Exchange rates and a nation's money supply (Ms) If Ms, value of $ will decline. (e.g. During 1922-23, Germany's Ms by trillion times (hyperinflation); value of FX in Germany by trillion times. Ms is controlled by central banks. (e.g. the Fed) 2) Transaction D for money (Md) Why would people want to hold money To buy goods and services. (cf. Other motives for Md: as an asset, speculation...

) Why would people demand FX To buy foreign goods and services. Md is a function of interest rate (r), price level (p) and real income (y). (e.g. When r goes up, opportunity cost of holding money increases; Md goes down. When p goes up, more money is needed to buy the same basket of goods; Md goes up. When y goes up, people demand more goods, and thus demand more money. Md curve is down sloping.

Why "Given the y level, real Md and r are inversely related". (Figure 4) What happens to the Md curve when y increases (Shift to right!) 3) Money market equilibrium Equilibrium in the money market requires Ms = Md or (Ms / p ) = (Md / p ). But Md = p L (r, y) and (Md / p ) = L (r, y) since Md is directly proportional to p. (Why A 10% increase in p means you need 10% more money to buy the same basket of goods). Thus, equilibrium requires: (Ms / p ) = L (r, y) (Figure 5) 4) Effects of changes in Ms and y on the equilibrium r (e. g.) Ms goes up, [ (Ms / p ) (Md / p ) at r]; people find that they are holding more money their desired level; r declines as unwilling money holders try to lend out some money. "A nation's Ms and r are inversely related".

(Figure 6) (e. g.) y (GDP) from y 1 to y 2; Md curve shift up to right as people want to hold more money for transaction D; r goes up. (Figure 7) 5) Effects of changes in Ms and y on the exchange rates Consider "world money market" equilibrium: S of money = (M / M), the relative supply of DM (the FX in question) to $. (Recall Ms in the U.S. and Germany are fixed at any given time. Thus, the ratio is also fixed.) D for money = (L / L), the relative D for DM to $. This Money demand ratio is a function of (y / y), (r / r), expectations, etc. (e. g.) As the Bundesbank increases the German Ms, (M / M) goes up, the world Ms curve shifts to right; e (exchange rate measure in $/DM rate) would go down. "DM depreciation" ($ appreciation) (Figure 8) (e. g.) As German real income (y ) increases relative to y in the U.S. ; (y / y) will increase, and D for DM will go up.

[ (L / L) increases as people need to hold more DM for transaction purpose. ]; (L / L) curve shifts up and e goes up ("DM appreciation" or "$ depreciation") If y is a result of government's expansionary policy, its main effect may be an increase in imports so that (L / L) declines as Germans would want to have more $ to buy more from America. (Figure 9) 6) Other determinants of exchange rate Factors that can shift (L / L), besides (y / y), include: (r -r), expectations, BT (e. g.) If (r -r) 0 (i. e., r r), more DM will be demanded (why); (L / L) will increase and e goes up (DM appreciation) (e. g.) If (M / M) decline is expected, $ depreciation is expected and people would sell $ for DM before it's too late. e increases ($ depreciates) today (e. g.) Government policies toward private assets such as freezing assets, possible taxation, ... can affect investors' expectations. (e. g.) If deficit goes up in the American BT (or CA) balance, FX market would react to bring down $ value. (why) 5. Purchasing Power Parity ( ) Approach Introduction If the value of a country's currency rises above the level warranted by its economic conditions, the exporting industries of the country will become less competitive in international markets and a trade deficit will be likely to follow. It is important, therefore, for policy makers to have forecasting ability about the equilibrium value of exchange rate if an effective exchange rate management is desired. In fact, discussion of "overvalued" or "undervalued" currency assumes that there exists a stable equilibrium exchange rate to which the value of a currency can be referenced.

The purchasing-power parity ( ) theory states that the equilibrium value of an exchange rate is determined by the changes in the relative national price levels. For example, if the U.S. price level rises by 10 percent over a year while Japan's price level rises by only 6 percent, then relative predicts that the dollar will depreciate against the yen by 4 percent. The dollar's 4 percent depreciation against the yen just cancels the differential in the inflation rates, leaving the relative domestic and foreign purchasing powers of both currencies unchanged. The theory recognizes national price levels and its interaction with exchange rates as a key factor in understanding why exchange rates can change dramatically over periods of several years. If valid, the theory can be used to forecast approximate levels to which current levels should be, given the projection of relative price levels. The theory has been empirically tested for several countries.

Prior studies have shown that in general the hypothesis is not likely to hold in the short and intermediate runs. There remains, however, considerable disagreement among researchers concerning in the long run. For example, Roll (1979) and Adler and Lehmann (1983) were unable to confirm the validity of longrun while Frankel (1985), Kim (1990) and Ab uaf and J orion (1990) were able to support it. These and other studies for the test of employed various statistical methods using different sample periods and frequencies of data. The Law of One Price and The law states that in competitive markets free of transportation costs and barriers to trade, identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency. (e. g.) Let e = $2/, P of a sweater = 20 in London, $50 (or 25) in New York, then the price in NY is higher; arbitrage would bring NY price down and London price up until the prices are equal. Expressing the law in general terms, for any good, PUS = (e$/) x PUK.

Carrying the law to all goods, the equation also states. The Model The relative version of states that the percentage changes in the exchange rate between two currencies over a period of time reflect the differences in the inflation rates of the two countries over the same time period. It asserts that exchange rates and national prices will adjust in such a way that the ratio of the purchasing powers of two currencies remains steady. Relative can be represented by the equation (Equation 1) where r is the nominal exchange rate between home and partner country defined as units of partner country's currency per unit of home currency, p denotes the price level of the partner country, p is that of the home country and k is a constant.

Relative indicates that k is stable in the long run. Testing the validity of statistically entails some modifications of the equation. First, a random disturbance term needs to be included as the relation in (1) is not expected to hold exactly. In addition, the coefficient on the price ratio is treated as an unknown parameter rather than a known constant.

(Whitt 1988) Finally an intercept term is usually included in a linear specification of the equation. The resulting equation is as follows: (Equation 2) where the subscript t denotes the time period t, u is a random error term, a an intercept term and b the coefficient of the price indexes to be estimated. Both variables, the exchange rate and the ratio of price indexes, are measured in logarithms. In empirical testing if the coefficient b is not significantly different from unity, the principle would be confirmed. There are several practical issues to be resolved in testing the relationship. First, it is argued that low frequency data are more appropriate for long run.

In the absence of annual data for a substantially long period, this study will use both monthly and quarterly observations. Second, there are at least three alternative price indexes that can be used as proxies for the price level: the GNP deflator, the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). The GNP deflator is regarded as a poor choice since it does not properly reflect the changes in the average price level while the WPI is biased toward the hypothesis. The CPI is the primary choice for this study as it is considered to be a reasonable choice (Layton and Stark 1990) and is more readily available. For a comparison purpose, WPI series will be also used for the countries for which data are available. Finally, this study will employ the concept of cointegration to test the hypothesis since the newly developed method is, as discussed in the following section, considered to be particularly suitable in examining longrun equilibrium relationships.

The theory has several limitations: The theory overlooks the fact that exchange rate movement may be affected by capital flows. There is a problem of choosing the appropriate price index (CPI, PPI, ... ) and the base year. Government commercial policy can interfere with the operation of the theory (trade restrictions). Empirical evidence on is also mixed.

For the countries with high inflation rates (e. g., Latin America), the theory appears to perform well. However, when inflation differential is small, factor other than price comparisons can become more important in the determination of exchange rates. In addition, tends to hold in the long run better than in the short run, perhaps because time lags in the BP adjustment process and government interference, etc.