Chapter 4

Chapter 4
Exchange Rate Determination
Objectives
To identify the factors causing changes in the
exchange rate.
To describe purchasing power parity and the
monetary model of exchange rates.
To explain how the bid-offer spread and the forward
spread are determined.
To examine the factors affecting the PKR exchange
rate.
Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
4-2
Some stylised facts

The exchange rate follows approximately a random
walk with little or no drift.
The spot and forward rates tend to move in the same
direction and by approximately the same amount.
There is no correspondence between exchange
rates and prices.
(cont.)
4-3
Some stylised facts (cont.)

The relation between the exchange rate and the
current account is not strong .
Rapid monetary expansion leads to rapid currency
depreciation.
(cont.)
4-4
Some stylised facts (cont.)

The behaviour of exchange rates is often described
as bubbles followed by crashes.
Volatility clustering. Periods of calm are followed by
periods of calm, and periods of turbulence are
followed by periods of turbulence.
Exchange rates move in cycles with significant
random variation.

4-5
The equilibrium exchange rate

S(d/f)
Sf
S0
Df

Qf
4-6
Factors affecting the supply of and demand for

FX
Relative inflation rates: A country that has a higher
inflation rate than its trading partners will experience
a depreciating currency.
(cont.)
4-7
The effect of a higher domestic inflation rate

S(d/f)
Sf
S1
S0
Df
Qf
4-8

FX (cont.)
Relative interest rates: Higher interest rates lead to
currency appreciation.
Distinction must be made between nominal and real
exchange rates.

4-9
The effect of a higher domestic interest rate

S(d/f)
Sf
S0
S1
Df
Qf
4-10

FX (cont.)
Relative growth rates: The effect of growth is
ambiguous since it affects the current account and
financial account in different directions.
(cont.)
4-11

FX (cont.)
The role of the government: The government affects
exchange rates by determining the exchange rate
regime, through central bank intervention, by
imposing and removing trade barriers, and by
affecting the variables that determine exchange
rates.
(cont.)
4-12

FX (cont.)
The role of expectations: Speculators buy and sell
currencies on the basis of expectations.

4-13
Speculation
Speculators participate in the foreign exchange
market, buying and selling currencies by anticipating
future movements of exchange rates.
By their actions, speculators affect the supply of and
demand for currencies and therefore exchange
rates.
(cont.)
4-14
Speculation (cont.)
Destabilising speculation, which drives the exchange
rate away from its equilibrium value, occurs when
speculators buy a currency when it is high and sell it
when it is low.
This kind of behaviour arises, for example, when
speculators believe that there is a bubble in the
market .
(cont.)
4-15
Speculation (cont.)
Stabilising speculation occurs when speculators buy
a depreciating currency and sell an appreciating
currency.

4-16
Purchasing power parity

The theory of purchasing power parity (PPP)
describes the relation between prices and exchange
rates.
PPP is important for international business firms
because the validity of this theory precludes the
possibility of real currency appreciation and
depreciation and hence the presence of exposure to
economic risk.

4-17
Deriving PPP
P SP
1
0
*
P0
*
SP0
P1
*
SP1
(cont.)

4-18
Deriving PPP (cont.)
P1
P0
S1 P1
S0 P0
(1 P ) (1 S )(1 P )
S P P

4-19
Deriving PPP from the S-D model
S1 P1 / P1
S0 P0 / P0
P1 / P0
S1 S0
P1 / P0
(cont.)
4-20
Deriving PPP from the S-D model (cont.)
1 P
S1 S0

4-21
The PPP exchange rate
Pt / P0
St S 0
Pt / P0

4-22
Derivation from PPP
S S
D 100
S

4-23
PPP and the real exchange rate
Q0
S0 ( P0
/ P0 )
Q1 S1 ( P1 / P1 )
(cont.)
4-24
PPP and the real exchange rate (cont.)
S1 S0 (1 S )
P1 P0 (1 P )
P1 P0 (1 P )
(cont.)
4-25
PPP and the real exchange rate (cont.)
)
P
(
1
P
0
S0 (1 S )
P0 (1 P )
Q1 Q0

4-26
The empirical validity of PPP

There is little empirical evidence to support the
validity of PPP, particularly in the short run.
There is some evidence for PPP under hyperinflation
and over long periods of time.

4-27
Actual and PPP exchange rates (USD/AUD)

4-28
Percentage deviation of the actual rate from

the PPP rate (USD/AUD)

4-29
Nominal and real exchange rates (USD/AUD)

4-30
PPP as a trading rule
S f
P
S F ( S , X 1 , X 2 , X n )
Buy when
SS
SS
and sell when

4-31
The monetary model of exchange rates

M d kPY
M
P
kY
M
S
kP Y

4-32
Predictions of the monetary model

A monetary expansion leads to depreciation of the
domestic currency.
A rise in income leads to appreciation of the
domestic currency.
A rise in foreign prices leads to appreciation of the
domestic currency.

4-33
Determination of the bid-offer spread

Since the bid rate is the rate at which the dealer buys
and the customer sells, it is determined by the
intersection of the dealers demand curve and the
customers supply curve.
Conversely, the offer rate is determined by the
intersection of the customers demand curve and the
dealers supply curve.

4-34
Determination of the forward spread

The nave model is based on the assumption that
there are independent demand and supply forces in
the spot and forward markets.
It also assumes that there is a separate market with
independent supply and demand forces for forward
contracts with different maturities.
(cont.)
4-35
Determination of the forward spread (cont.)

The equilibrium spot exchange rate is determined in
the spot market, whereas the equilibrium forward
rate (for a particular maturity) is determined in the
forward market.
The forward spread is the difference between the
forward and spot rates.

4-36
Factors affecting the AUD exchange rates
Interest rates
Commodity prices and the terms of trade
Inflation
The external account
The role of the RBA

4-37
Australian dollar exchange rates

(December 1983 = 100)

4-38
Australian and US short-term interest rates

4-39
Commodity prices (December 1983 = 100)

4-40
Consumer prices (December 1983 = 100)

4-41
The role of the RBA

The RBA intervenes in the foreign exchange market
for three reasons:
(i) to calm the market when it tends to become
disorderly;
(ii) to help reverse exchange rate overshooting;
(iii) to give monetary policy greater room to manoeuvre.
(cont.)
4-42
The role of the RBA (cont.)

Direct intervention by the RBA takes the form of
smoothing and testing transactions.
Smoothing transactions aims to ease the volatility of
the currencys path in reaction to news to prevent
exchange rate overshooting.
By testing, the RBA tries to discern market volatility
from trends.

4-43

Chapter 4

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Chapter 4

Exchange Rate Determination

Copyright 2010 McGraw-Hill Australia Pty Ltd

Some stylised facts

Some stylised facts (cont.)

Some stylised facts (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

The equilibrium exchange rate

Copyright 2010 McGraw-Hill Australia Pty Ltd

Factors affecting the supply of and demand for

The effect of a higher domestic inflation rate

Factors affecting the supply of and demand for

Copyright 2010 McGraw-Hill Australia Pty Ltd

The effect of a higher domestic interest rate

Factors affecting the supply of and demand for

Factors affecting the supply of and demand for

Factors affecting the supply of and demand for

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Purchasing power parity

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Copyright 2010 McGraw-Hill Australia Pty Ltd

Deriving PPP (cont.)

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Deriving PPP from the S-D model

Deriving PPP from the S-D model (cont.)

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The PPP exchange rate

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Derivation from PPP

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PPP and the real exchange rate

PPP and the real exchange rate (cont.)

PPP and the real exchange rate (cont.)

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The empirical validity of PPP

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Actual and PPP exchange rates (USD/AUD)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Percentage deviation of the actual rate from

Copyright 2010 McGraw-Hill Australia Pty Ltd

Nominal and real exchange rates (USD/AUD)

Copyright 2010 McGraw-Hill Australia Pty Ltd

PPP as a trading rule

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The monetary model of exchange rates

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Predictions of the monetary model

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Determination of the bid-offer spread

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Determination of the forward spread

Determination of the forward spread (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Factors affecting the AUD exchange rates

Copyright 2010 McGraw-Hill Australia Pty Ltd

Australian dollar exchange rates

Copyright 2010 McGraw-Hill Australia Pty Ltd

Australian and US short-term interest rates

Copyright 2010 McGraw-Hill Australia Pty Ltd

Commodity prices (December 1983 = 100)

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Consumer prices (December 1983 = 100)