Determination of exchange rates
Determination of Exchange Rates
Supply and Demand in Currency Markets
The exchange rate is the rate at which one country’s
currency can be traded for another’s
People exchange currencies to buy goods or assets in
other countries
To demand one currency, you must supply another
The supply curve of dollars is upward-sloping
The demand curve for dollars is downward-sloping
The market for dollars is in equilibrium when quantity
supplied equals quantity demanded
Supply and demand model
• Indian exports of goods and services create a supply of foreign currency ($)
and demand for the Indian Re
• Imports of goods and services creates a demand for foreign currency ($) and
a supply of Indian Re
• Similar reasoning applies for transactions in financial assets – Capital flows
create demand for US $ (foreign currency) and supply of Indian Rupee
• Capital inflows create demand for Re and supply of foreign currency ( US$)
• Thus all transactions create demand and supply for foreign exchange
• Demand and supply determine exchange rate
Supply and demand for foreign exchange
• Demand for foreign currency in the Rs/
$
foreign exchange markets is driven
by transactions requiring foreign
currency.
• Imports
• Asset flows abroad
D$
Demand curve is downward sloping.
Quantity of $
Supply and demand model
• Supply for foreign currency in the foreign Rs/
exchange markets is driven
S by
$
transactions requiring dollars. $
• Exports
• Asset flows to the country
D$
Supply curve is upward sloping
Quantity of $
Supply and demand model
• The equilibrium exchange rate occurs at the
Rs/
intersection of theS$
supply and
demand curves. $
Equilibrium
D$
Quantity of dollars
Floating exchange rates system
• No intervention by the government and central bank
• Spot price of foreign currency is market driven, determined by the
interaction of private demand and supply for that currency
• Market clears itself through price mechanism
Determination of Exchange Rates and Trade
Supply and Demand in Currency Markets
If forces shift the supply and demand for a currency, the
exchange-rate price will change
A currency depreciation is a change in the exchange
rate so that one currency buys fewer units of a foreign
currency
A currency appreciation is a change in the exchange
rate so that one currency buys more units of a foreign
currency
Appreciation and depreciation of currency
• Appreciation – when the demand for domestic currency increases
(and supply of dollars increases) through exports and capital inflows
• Depreciation – when the demand for foreign currency increases
(supply of domestic currency increases) through imports and capital
outflows
Forces that determine exchange rates in short run
1. Economic growth or incomes
2. Asset approach: Assets include all financial assets
• A rise in the foreign interest rate relative to our interest rate (if – i)
3. A rise in the expected future spot exchange rate
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The long run: PPP
• Purchasing Power Parity
• The law of one price
• The idea that in the absence of barriers to trade the price of homogenous
traded commodities will be identical in all markets.
• Example
• Suppose that glassware sells in the U.S. for $1/unit.
• If the exchange rate is ¥100/$1, the price in Japan should be ¥100/unit.
• If this does not occur, then profitable opportunities for arbitrage exist.
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Absolute PPP
• Posits that a basket of products will have the same cost in different
countries if the cost is stated in the same currency.
• Or the price of the product stated in different currencies is the same
when converted to a common currency
• At a point in time (absolute PPP)
P = Pfe --or-- e = P/Pf
• Limitations of the theory
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Relative PPP
• Difference between changes over time in product-price levels in two
countries will be offset by the change in the exchange rate over time.
• Relative purchasing power parity postulates that the change in the
exchange rate is equal to the difference in the change in the price
levels (rates of inflation) of the two countries.
• e1/eo = (Pt/Po)/(Pf,t/Pf,o)
or, approximately:
%e = %P - %Pf
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• PPP useful guide to why exchange rates change over time.
• Relative PPP is often defined using an approximation
• Rate of appreciation of the foreign currency = ╥ - ╥f
• ╥ = inflation rate for domestic country
• ╥f = inflation rate for foreign country
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Implications
• A country with a relatively high inflation rate will have a depreciating
currency (a declining nominal-exchange-rate value of its currency).
• A country with a relatively low inflation rate will have an appreciating
currency (an increasing nominal-exchange-rate value of its currency).
• The rate of appreciation or depreciation will be approximately equal
to the percentage-point difference in the inflation rates.
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Implications for money supply
• Monetary approach to exchange rate determination
• A 10 percent cut in money supply should lead to 10 percent higher
exchange rate value of currency
(same effect from 10% increase in money supply of foreign currency)
• Effect of real income – increased productivity passed on in the form of
lower prices increases the external value of currency
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Government polices
• Policies apply to exchange rates – impact on prices
Fixed or flexible (market driven/clean float) rates
• Polices which state who must use the foreign exchange market and
for what purpose – impact on quantity of foreign exchange
Issue of convertibility of currency into foreign currency for all users
Convertibility on current and capital account
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