Exchange Rate Theories

7 Key excerpts on "Exchange Rate Theories"

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  eBook - ePub

  Economic Lessons from the Transition: The Basic Theory Re-examined

  The Basic Theory Re-examined

  • Daniel R. Kazmer, Michele Konrad(Authors)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  8 Foreign Exchange Rates and Exchange Rate Crises

  Foreign Exchange Rates

  One pillar of the basic theory on international financial markets has been the theory of trade-determined foreign exchange rates. Essentially, this theory holds that the exchange rate of a country’s currency is determined by trade. The currency appreciates and depreciates based on the demand for its exports and its own demand for imports.

  When more foreigners want to buy that country’s exports and fewer of the country’s residents want to import from foreign countries, then the currency appreciates. When the converse is true, the currency depreciates.

  Thus, a country that runs a trade surplus (its exports exceed its imports) will see its currency appreciate relative to the currencies of its trading partners. The currency appreciates because the trading partners bid up the price of the currency of the country whose exports they demand.

  But the currency appreciation has its own effect. It makes exports more expensive to foreigners. Exports become less attractive, and they decrease. The appreciation also makes imports from foreigners cheaper, so that imports increase.

  Thus, the theory of trade-based foreign exchange rates argues that exports will equal imports at the equilibrium exchange rate. The mechanism of flexible exchange rates on the international currency market automatically balances trade, so that the value of exports equals the value of imports.

  The theory of purchasing power parity exchange rates is sometimes presented as an extension of this theory, and sometimes as a long-run alternative to it. Purchasing power parity exchange rates were originally developed to allow economists to compare the gross domestic product (GDP) of countries with different currencies. Since market exchange rates are volatile, if GDP is calculated using a market exchange rate, the GDP estimate will change whenever the exchange rate does. The constant changes make GDP comparisons awkward, and so the theory of purchasing power parity was developed.

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  eBook - ePub

  Exchange Rates and International Financial Economics

  History, Theories, and Practices

  • J. Kallianiotis(Author)
  • 2013(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  3 Foreign Exchange Rate Determination

  Exchange rate determination is very important for financial economists financial institutions, foreign currency traders, and all professionals in the foreign currency market. This chapter is based on discussions of exchange rate determination on a school of thought, using the asset market approach to solve complex problems. We will explore the different determinants of exchange rates and the theories that deal with its determination. These theories are (a) the monetary approach, divided into the monetarist model (flexible prices) and the overshooting model (sticky prices) and (b) the portfolio balance approach. Other related issues with the Exchange Rate Theories will be discussed, such as efficiency in the foreign exchange market, exchange rate expectations and the “News,” money market and exchange rate, exchange rate and freezing funds risk premium (FFRP), public policies and exchange rate, and lastly, oil prices and Euro-zone debt crisis and exchange rates.

  3.1 Exchange Rate Theories

  The theoretical literature on the asset market view of exchange rate determination has been expanding voluminously since the mid-1970s. The popularity of this view continues for more than 30 years, and generations of economists and practioners are learning and applying them to their theoretical research and their trade practices. The assumption that these models share is the absence of substantial transaction cost, capital control, and other impediments to the flow of capital between nations. Thus, we assume that there is perfect capital mobility among countries. In this case, the exchange rate will adjust instantly to equilibrate the international demand for stocks of national assets. The more traditional view was that the exchange rate adjusts to equilibrate the international demand for flows of national goods. The empirical implication is that floating exchange rates exhibit high variability, which goes beyond the variability of their underlying determinants. Econometric analysis gives specific empirical implications of the various theories. We start with the monetary approach and then, the portfolio balance approach is presented, together with other theoretical and empirical models.

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  eBook - ePub

  Applied International Economics

  • W. Charles Sawyer, Richard L. Sprinkle(Authors)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  CHAPTER 14

  Exchange rates and their determination

  A basic model

  The exchange rate is determined from day to day by supply and demand of home currency in terms of foreign currency. Each transaction is two-sided, and sales are equal to purchases. Any change in the conditions of demand or of supply reflects itself in a change in the exchange rate, and at the ruling rate the balance of payments balances from day to day, or from moment to moment.

  Joan Robinson

  INTRODUCTION

  T he international value of a country’s currency has become an inescapable part of the daily flow of economic information. Most of us are aware that a country’s exchange rate is important, but many of us do not have a clear idea of why the exchange rate matters or what causes it to change. As the chapter’s opening quote indicates, the familiar tools of supply and demand analysis can be used to determine a country’s exchange rate. In this chapter, you will learn why the supply and demand model works in analyzing exchange rates—in the same manner, in fact, that it works in analyzing the price of gasoline or pizza, for one dollar or one yen or one gallon of gasoline is indistinguishable from another. By the end of this chapter you should have a good grasp of why exchange rates are important and what factors cause them to change over the long run. Finally, it is obvious to even a casual observer that exchange rates change frequently. These changes, or volatility, are a source of aggravation for individuals, businesses, and governments. The chapter explains what economists know about the effects of exchange rate volatility on international trade and how changes in exchange rates affect the prices of the goods and services we purchase. The final part of the chapter deals with the underlying value of a currency. While the exchange rate we observe in the market often differs from that value, it is very useful to know what that value is.

  EXCHANGE RATES

  Suppose that a U.S. importer is purchasing British Jaguars. To purchase the Jaguars, the importer needs to obtain British pounds by exchanging dollars for pounds. The demand for foreign currency is derived from individuals demanding foreign goods and services. This relationship can be applied in reverse. As individuals in the U.K. demand U.S. products, there is an increased demand for dollars. However, this raises the question of how many dollars must be exchanged to obtain the requisite number of pounds, or vice versa? In this example, the relevant exchange rate is the U.S. dollar–U.K. pound exchange rate. In general, the exchange rate is the price of one country’s currency in terms of another. The demand for British pounds relative to the supply of pounds will determine the exchange rate, just as the demand for gasoline relative to the supply of gasoline determines the price of gasoline. Exchange rates fluctuate considerably over time. However, unlike the price of gasoline, changes in the exchange rate are expressed as changes in the value of the domestic country’s currency. An increase in the value of a currency is referred to as appreciation. Analogously, a decline in the value of the currency is referred to as depreciation

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  Balance of Payments Adjustment

  Macro Facets of International Finance Revisited

  • Augustine C. Arize, Theologos H. Bonitsis, Ioannis Kallianiotis, Krishna Kasibhatla, John Malindretos(Authors)
  • 2000(Publication Date)
  • Praeger

    (Publisher)

  The Traditional Approach under Flexible Exchange Rates 193 and foreign counterparts are not regarded as perfect substitutes. This creates substantial deviations from the law of one price, at least in the short run. Exchange-rate theory abstracts from the particular details of payment and instead examines the ways in which particular classes of arrangements (fixed exchange rates, flexible exchange rates, etc.) affect the economic system in gen- eral and the international economy in particular. From a Keynesian (Traditional) perspective, under a fixed exchange-rate re- gime, a payments disequilibrium can be corrected, with the use of public policy, through price, income, and interest rate adjustments. A Monetary perspective concludes that the adjustment instead occurs through the money market. Under a true floating-rate regime, a payments correction will occur through changes in currency values. Today, the majority of economists prefer the floating-rate ar- rangement, contending that it is more acceptable than the often slow and inef- fective mechanisms of changes in prices, nominal incomes, and interest rates. Exchange-rate determination and the behavior of the foreign currency market are of importance to investors and multinational firms, to central banks and governments, and to academic researchers, whether they are interested in making speculative profits, protecting their investments, pursuing public objectives or improving social welfare. Exchange rates have been observed to follow certain empirical regularities, which have been formalized in economic relations and models that seek to explain and predict the behavior of the relative values of different currencies. Various econometric techniques and tests have been used to determine the validity of different theories of exchange-rate determination.

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  The Economics of Exchange Rates

  • Lucio Sarno, Mark P. Taylor(Authors)
  • 2003(Publication Date)
  • Cambridge University Press

    (Publisher)

  The most important example of this kind of arrangement was the European Monetary System (EMS), while more informal exchange rate arrangements were established for a while under the Louvre Accord adopted by the G7 countries in 1987. On 1 January 1999, the exchange Exchange rate determination: theories and evidence 99 rates between the currencies of the eleven European countries participating in European Economic and Monetary Union (EMU) were irrevocably fixed as these countries began the final transition to a single European currency, the euro. These exchange rate regime shifts have influenced the focus of researchers on the behaviour of exchange rates. The monetary and the portfolio balance models of exchange rates, developed during the earlier phase of the recent float, for example, may be considered as following the research agenda in open-economy macroeconomics of the Bretton Woods era which focused largely on freely floating exchange rates. The increasing interest in target zone models, official intervention in foreign exchange markets and in the theory of optimum currency areas represents a direct response to the establishment of pegged exchange rate systems, in particular the EMS, and then currency unions, in particular EMU. In this chapter, we shall be concerned with the theory and evidence relating to exchange rate determination under a largely freely floating exchange rate regime. The theory and evidence relating to currency unions, pegged exchange rate regimes, target zones and intervention are discussed later in the book. 4.1 Theories of exchange rate determination In this section we describe the main features of the theory of exchange rate determination as it has developed since the 1960s. The earliest model we discuss – albeit in a modern formulation – is the Mundell–Fleming model.

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  eBook - ePub

  World Economic Outlook, May 1998 : Financial Crises: Causes and Indicators

  • International Monetary Fund. Research Dept.(Author)
  • 1998(Publication Date)
  • INTERNATIONAL MONETARY FUND

    (Publisher)

  Some economists argue that exchange rates, if they are free to clear foreign exchange markets, must always reflect the fundamental forces of supply and demand and should never be regarded as substantially out of equilibrium. Others accept that exchange rates can become misaligned with fundamentals, while remaining skeptical about the adequacy of any particular model, or set of models, for calculating “equilibrium” exchange rates. A third group maintains that some market exchange rates have at times become badly misaligned with fundamentals, and that a quantitative framework is needed to try to identify misalignments at an early stage. Most proponents of the last view recognize, however, that estimates of equilibrium exchange rates are inherently imprecise, and that considerable deference should be given to markets before suggesting that exchange rates have become misaligned.

  Approaches to Calculating Equilibrium Exchange Rates

  There are several approaches to calculating equilibrium exchange rates. The simplest, and perhaps the most widely used, involves measures of purchasing power parity (PPP) or international competitiveness levels. Such calculations generally employ price or cost indices (such as consumer price indices. GDP deflators, export prices, or unit labor costs); they are based on the notion that the prices of (or costs of producing) similar goods, when translated into a common currency, should be similar across countries—that is, should conform to the so-called law of one price—at least in the case of tradable goods. There is strong evidence that rejects the law of one price as a proposition about short-run behavior, but recent years have brought a resurgence of interest in testing the validity of PPP as a long-run hypothesis,1 and thus as a framework for defining equilibrium exchange rates from a medium-to long-run perspective.

  The macroeconomic balance framework provides a second approach to calculating equilibrium exchange rates from a medium-run perspective. Reliance on this approach within the IMF dates at least to the summer of 1967, when views were being developed about the appropriate size of the prospective devaluation of the pound sterling.2

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  eBook - ePub

  The Postwar International Money Crisis

  An Analysis

  • Victor Argy(Author)
  • 2013(Publication Date)
  • Taylor & Francis

    (Publisher)

  Chapter 20

  Exchange Rate Behaviour – Theoretical Analysis

  Introduction

  With exchange rates since early 1973 largely determined by market forces, it is important now to be able to identify the principal influences underlying exchange rate movements. With this general aim in mind, this chapter examines four approaches to the analysis of exchange rate behaviour.1 The first, and oldest, is the Purchasing Power Parity theory (PPP). The second draws on the neo-Keynesian model of Chapter 11. The third is monetarist inspired. The fourth, and most recent, focuses on the role of wealth and portfolio balance.

  Notation used in this chapter

  subscript	A	=	country A
  subscript	B	=	country B
  	Ar	=	real absorption
  	B	=	balance of payments
  	CA	=	current account of the balance of payments
  	DB	=	domestic bonds
  	E	=	exchange rate (units of domestic currency per unit of foreign currency)
  	Ee	=	expected exchange rate
  	FC	=	value of foreign assets in foreign currency held by residents
  	Gr	=	real government expenditure
  	K	=	net capital flows
  	Mo	=	money supply
  	P	=	overall price level
  	Pf	=	foreign prices denominated in foreign currency
  	PN	=	price of non-traded goods
  	PT	=	price of traded goods
  	r	=	domestic interest rate
  	rf	=	foreign interest rate
  	We	=	domestic wealth
  	Yf	=	foreign real GNP
  	Yr	=	real GNP

  A dot over symbol represents percentage change. Relative Purchasing Power Parity Theory

  The relative Purchasing Power Parity theory (PPP) asserts that exchange rates will move over time in line with changes in relative purchasing power.2 For example, the bilateral version of the theory asserts that the percentage change in the exchange rate, from a base year to a terminal year, for any two currencies (say, the German mark and the US dollar) would be determined by the relative rate of inflation in the two countries.

  The theory’s principal difficulties and limitations may be easily summarised. First, there is a problem in the selection of a base year for the exercise. One assumption implicit in any test of PPP is that the exchange rate is in equilibrium in the base year, which of course may not hold.

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