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Chapter 2 Outline
A. Introduction to Exchange Rates
B. Factors Affecting the Equilibrium Exchange Rate C. Calculating Exchange Rate Changes D. Asset Market Model of Exchange Rates E. Central Banks and Currency Values F. Central Bank Intervention
Exchange rates are market-clearing prices that equilibrate supplies and demands in the foreign exchange market.
Spot rate e0 the price at which currencies are traded for immediate delivery. Forward rate f1 the price at which currencies are quoted for delivery at a specified future date.
As the value of the dollar falls against the euro, Americans demand fewer Euroland goods, services, and assets.
Supply of a currency
Supply of euros is a function of Euroland demand for U.S. goods. Euroland consumers must buy dollars to buy U.S. goods. As the value of the euro increases against the dollar, increased Euroland demand for U.S. goods increases demand for dollars, which increases the amount of euros supplied.
e S If supply of a currency exceeds demand, the value will fall relative to another currency until it reaches a new equilibrium. If demand for a currency exceeds supply, the value will increase relative to another currency until it reaches a new equilibrium. Q Q*
Surplus
e0
Shortage
Factors that influence the supply and demand for one currency in terms of another affect the equilibrium exchange rate.
Inflation rates
Interest rates Economic growth Political and economic risks
$/ e1
e0
S 6 4
appreciates over time in an amount such that Euroland and U.S. prices are again in equilibrium
e1
D D
Interest rates e.g., U.S. interest rates > Euroland interest rates
$/ /$
S
5 S
S
depreciates: fewer dollars e 0 required to buy
e1 S
3 4 D Qo D
eo
$ appreciates over time in an amount such that U.S. and Euroland prices are again in equilibrium
e1
D D Qo $
1. 2. 3. 4. 5.
Capital shifts from Euroland to U.S. to exploit higher returns Demand for dollars increases Supply of euros increases to buy more dollars Demand for euros decreases as demand to buy U.S. assets decreases Supply of dollars decreases
Economic growth e.g., U.S. GDP growth > Euroland GDP growth
/$ S S e0 3 $/ e1 eo 2 S
e1
D D
$
Qo Qo
1. 2. 3. 4.
As income increases, U.S. consumers spend more on Euroland imports Demand for euros increases Supply of dollars increases to buy more euros Value of euro increases relative to the dollar
Using the $/ as an example, euro appreciation/depreciation is computed as the fractional increase/decrease in the dollar value of the euro. General formula for computing currency appreciation/depreciation in dollar terms
Currency appreciation/depreciation = (new dollar value of currency old dollar value of currency) Old dollar value of currency
The euro has appreciated 8% against the dollar. That is, the amount of dollars required to buy one euro increased by 8%.
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The dollar has depreciated 7.4% against the euro. That is, the amount of euros required to buy one dollar decreased by 7.4%.
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The exchange rate between two currencies represents the price that just balances the relative supplies of and demand for assets denominated in those currencies. Shifts in preferences or expectations of future exchange rate movements affect the exchange rate of two currencies. The desire to hold currency today depends on expectations of the factors that affect the currencys future value. Thus, currency values are forward-looking.
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Central banks use monetary policy, including creating money, to achieve price stability, low interest rates, or a target currency value.
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Currency boards
Replace central banks Issue notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency Have no discretionary monetary policy the market determines the money supply Promote price stability
Without a central bank to monetize a countrys deficit, a currency board compels a government to follow responsible fiscal policy. HOWEVER, a run on the currency causes a sharp contraction in the money supply and jump in interest rates, slowing economic activity.
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Dollarization
A country replaces its currency with the U.S. dollar Promotes price stability and thus low inflation Eliminates local currency risk Results in loss of seignorage, a central banks profit on the currency it prints.
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e1
Appreciation beyond 2% raises the relative price of Euroland goods, increasing U.S. consumption of domestic goods and stimulating domestic employment. Longer term, U.S. inflation will rise to re-establish price parity.
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The effects of sterilized intervention are temporary, because the Fed signals a change in monetary policy to the market, not a change in market fundamentals. The effects of unsterilized intervention are permanent, because they create inflation in some countries and deflation in others.
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