Description
the various factors which determines exchange rates.
Topics: Exchange Rate, Absolute PPP, Relative PPP, Implications of Money Supply, Disequilibrium in BOP, Balance of payments, Bretton Woods System,
Exchange Rate Determination
1
I. Forces that determine exchange rates in short run
• Exchange rate value of a foreign currency is raised in SR by the demand and supply of assets denominated in different currencies • Assets include all financial assets • Asset approach • Determinants in this approach: • A rise in the foreign interest rate relative to our interest rate (if – i) • A rise in the expected future spot exchange rate
2
3
II 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.
4
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 = Pf?e --or-- e = P/Pf • Limitations of the theory
5
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
6
• 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
7
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.
8
III. 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
9
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
10
Disequilibrium in BoP
• • • • Temporary disequilibrium – defend it or finance it Depreciation of currency Govt intervention – sell $ and buy domestic currency How does it affect BoP? – draw down its official international reserve assets or borrow $ • How does it affect domestic economy and restore equilibrium – buy domestic currency and hence reduce money supply. Increase interest rate and reduce consumption and thereby reduce imports. Compression of economy.
11
Intervention to Defend a Fixed Rate: Preventing Depreciation of the Country’s Currency
12
Disequilibrium in BoP
• Appreciation of the currency • Buy $ and sell domestic currency • Official settlements balance surplus due to increased demand for domestic goods and services by foreigners • $ used to pay back loans or buy US govt. bonds (reserves increase in BoP) • US finances its deficit by issuing financial assets that other countries hold as their reserves • Impact on domestic economy – sale of domestic currency results in increased money supply. Inflation which erodes competitiveness and reduces demand by foreigners. • Equilibrium restored
13
14
Disequilibrium
• Disequilibrium – temporary or fundamental (not temporary) • Fundamental disequilibrium calls for adjustment and not financing • Adjustment calls for change in external value of currency, borrowings and reforms
15
International Currency Experience
Gold Standard, 1870-1914 • Gold value of each currency was fixed • Britain was the central country Interwar Instability Bretton Woods System, 1944-1971 • Adjustable pegged exchange rates • United States and U.S. dollar were at the center • Eventual dollar crisis Current System • A ?nonsystem?—countries can choose almost any exchange rate policy • Many countries use managed floating exchange rates
16
The Bretton Woods System
• Under the gold standard, currency values were determined by specified gold content.
– Nations bought or sold currency at this specified gold ratio.
• Adherence to the gold standard deprived nations of the ability to independently control the money supply. • The strains of World War I brought the classical gold standard to an end. • In 1925, the UK attempted to reestablish the per-war monetary system by reestablishing the convertibility of the pound into gold. • The UK suffered significant gold losses under this system and was forced to abandon convertibility in 1931.
17
The Bretton Woods System
• The Bretton Woods System established a gold exchange standard centered on the U.S. dollar after World War II.
– The value of the dollar was set at $35 per ounce of gold. – Other currencies were pegged in value relative to the dollar.
• Fluctuations were to be kept within a +/- 1 percent bound around the par value.
• Balance of payments disequilibria were to be financed from a nation’s foreign currency reserves or from borrowing from the International Monetary Fund (IMF).
– Funds borrowed from the IMF were to be paid back within 3 to 5 years.
• Only fundamental disequilibrium were to result in currency revaluation. • Long-run development assistance was provided by the International Bank for Reconstruction and Development (IBRD or World Bank).
18
The Bretton Woods System
• Members of the IMF are assigned a quota based on the size of their economy.
– Voting power in the IMF is proportional to the size of the nation’s quota.
• The quota is paid (1) ¼ in gold and (2) the balance in the nations domestic currency • In borrowing from the IMF, a nation receives convertible currencies to fund balance of payments disequilibria. • A nation may borrow no more than 25 percent of its quota during any given year with a maximum borrowing limit of 125 percent.
– The first 25 percent borrowed, the gold tranche, comes without restrictions or conditions. – Subsequent tranches come with higher interest charges and stricter conditions.
• In practice, few currency revaluations occurred.
– This left growing balance of payments disequilibria.
19
The Bretton Woods System
• Beginning in 1958, the U.S. began running significant balance of payments deficits.
– Causes
• Significant net capital inflows • Vietnam War • Oil imports
– Effect
• Depletion of U.S. gold reserves
– 1949: $25 billion – 1970: $11 billion
• Declining gold reserves forced the U.S. to suspend gold convertibility in 1971.
•
Smithsonian Agreement (1971)
– – – – Dollar price of gold increased to $38 Other major currencies revalued Fluctuation bands increased to +/- 2.25 percent Effectively generates a dollar standard
•
Continuing balance of payments deficits forced a subsequent devaluation of the dollar in 1973 ($42.22 per ounce) and finally a suspension of dollar convertibility to gold.
20
The present monetary system
• Following the collapse of the Bretton Woods System, the monetary system moved to a system of managed floats. • International reserves for currency intervention is still provided by the IMF.
– The lending ability of the IMF was expanded in 1997 by the New Arrangement to Borrow. – The use of IMF conditionality has come to be a source great contention within the international monetary system.
21
doc_143955373.ppt
the various factors which determines exchange rates.
Topics: Exchange Rate, Absolute PPP, Relative PPP, Implications of Money Supply, Disequilibrium in BOP, Balance of payments, Bretton Woods System,
Exchange Rate Determination
1
I. Forces that determine exchange rates in short run
• Exchange rate value of a foreign currency is raised in SR by the demand and supply of assets denominated in different currencies • Assets include all financial assets • Asset approach • Determinants in this approach: • A rise in the foreign interest rate relative to our interest rate (if – i) • A rise in the expected future spot exchange rate
2
3
II 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.
4
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 = Pf?e --or-- e = P/Pf • Limitations of the theory
5
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
6
• 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
7
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.
8
III. 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
9
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
10
Disequilibrium in BoP
• • • • Temporary disequilibrium – defend it or finance it Depreciation of currency Govt intervention – sell $ and buy domestic currency How does it affect BoP? – draw down its official international reserve assets or borrow $ • How does it affect domestic economy and restore equilibrium – buy domestic currency and hence reduce money supply. Increase interest rate and reduce consumption and thereby reduce imports. Compression of economy.
11
Intervention to Defend a Fixed Rate: Preventing Depreciation of the Country’s Currency
12
Disequilibrium in BoP
• Appreciation of the currency • Buy $ and sell domestic currency • Official settlements balance surplus due to increased demand for domestic goods and services by foreigners • $ used to pay back loans or buy US govt. bonds (reserves increase in BoP) • US finances its deficit by issuing financial assets that other countries hold as their reserves • Impact on domestic economy – sale of domestic currency results in increased money supply. Inflation which erodes competitiveness and reduces demand by foreigners. • Equilibrium restored
13
14
Disequilibrium
• Disequilibrium – temporary or fundamental (not temporary) • Fundamental disequilibrium calls for adjustment and not financing • Adjustment calls for change in external value of currency, borrowings and reforms
15
International Currency Experience
Gold Standard, 1870-1914 • Gold value of each currency was fixed • Britain was the central country Interwar Instability Bretton Woods System, 1944-1971 • Adjustable pegged exchange rates • United States and U.S. dollar were at the center • Eventual dollar crisis Current System • A ?nonsystem?—countries can choose almost any exchange rate policy • Many countries use managed floating exchange rates
16
The Bretton Woods System
• Under the gold standard, currency values were determined by specified gold content.
– Nations bought or sold currency at this specified gold ratio.
• Adherence to the gold standard deprived nations of the ability to independently control the money supply. • The strains of World War I brought the classical gold standard to an end. • In 1925, the UK attempted to reestablish the per-war monetary system by reestablishing the convertibility of the pound into gold. • The UK suffered significant gold losses under this system and was forced to abandon convertibility in 1931.
17
The Bretton Woods System
• The Bretton Woods System established a gold exchange standard centered on the U.S. dollar after World War II.
– The value of the dollar was set at $35 per ounce of gold. – Other currencies were pegged in value relative to the dollar.
• Fluctuations were to be kept within a +/- 1 percent bound around the par value.
• Balance of payments disequilibria were to be financed from a nation’s foreign currency reserves or from borrowing from the International Monetary Fund (IMF).
– Funds borrowed from the IMF were to be paid back within 3 to 5 years.
• Only fundamental disequilibrium were to result in currency revaluation. • Long-run development assistance was provided by the International Bank for Reconstruction and Development (IBRD or World Bank).
18
The Bretton Woods System
• Members of the IMF are assigned a quota based on the size of their economy.
– Voting power in the IMF is proportional to the size of the nation’s quota.
• The quota is paid (1) ¼ in gold and (2) the balance in the nations domestic currency • In borrowing from the IMF, a nation receives convertible currencies to fund balance of payments disequilibria. • A nation may borrow no more than 25 percent of its quota during any given year with a maximum borrowing limit of 125 percent.
– The first 25 percent borrowed, the gold tranche, comes without restrictions or conditions. – Subsequent tranches come with higher interest charges and stricter conditions.
• In practice, few currency revaluations occurred.
– This left growing balance of payments disequilibria.
19
The Bretton Woods System
• Beginning in 1958, the U.S. began running significant balance of payments deficits.
– Causes
• Significant net capital inflows • Vietnam War • Oil imports
– Effect
• Depletion of U.S. gold reserves
– 1949: $25 billion – 1970: $11 billion
• Declining gold reserves forced the U.S. to suspend gold convertibility in 1971.
•
Smithsonian Agreement (1971)
– – – – Dollar price of gold increased to $38 Other major currencies revalued Fluctuation bands increased to +/- 2.25 percent Effectively generates a dollar standard
•
Continuing balance of payments deficits forced a subsequent devaluation of the dollar in 1973 ($42.22 per ounce) and finally a suspension of dollar convertibility to gold.
20
The present monetary system
• Following the collapse of the Bretton Woods System, the monetary system moved to a system of managed floats. • International reserves for currency intervention is still provided by the IMF.
– The lending ability of the IMF was expanded in 1997 by the New Arrangement to Borrow. – The use of IMF conditionality has come to be a source great contention within the international monetary system.
21
doc_143955373.ppt