International Economics

By Robert J. Carbaugh
8th Edition

Chapter 13:
Exchange-Rate Determination

Copyright ©2002, South-Western College Publishing

Exchange rates

Factors influencing exchange rates

 Market fundamentals
 Current account balances
 Real income
 Real interest rates
 Inflation rates
 Consumer preferences for domestic or foreign
products
 Productivity changes affecting production costs
 Profitability and riskiness of investments
Carbaugh, Chap. 13 2
Exchange rates

Factors influencing exchange rates

 Market fundamentals (cont’d)
 Product availability
 Monetary policy and fiscal policy
 Government trade policy
 Market expectations
 News about future market fundamentals
 Speculative opinion about future exchange
rates

Carbaugh, Chap. 13 3
Exchange rates

When are these factors important?

 Short run (days) - financial transfers
 Differences in real interest rates
 Shifting expectations of future exchange rates
 Medium run (months)
 Economic cycles

Carbaugh, Chap. 13 4
Exchange rates

When are these factors important?

 Long run (years) - movements of goods,
services, investment, influenced by:
 Inflation rates
 Investment profitability
 Consumer tastes
 Real income
 Productivity
 Trade policy

Carbaugh, Chap. 13 5
Exchange rates

Exchange rate components

Carbaugh, Chap. 13 6
Factors influencing exchange rates

Real income differentials

 A country with faster economic growth than
the rest of the world will have a
depreciating currency (other things being
equal)
 Imports rise faster than exports
 Real income changes can also reflect other
processes, which might lead to rising
exports

Carbaugh, Chap. 13 7
Factors influencing exchange rates

Impact of real income differentials

Carbaugh, Chap. 13 8
Factors influencing exchange rates

Real interest rates

 Short term real interest rate differences
influence international capital movements
 Real interest rate is nominal minus inflation
 Low short term rates lead to less demand
for the currency and depreciation
 High rates lead to greater demand for the
currency and appreciation

Carbaugh, Chap. 13 9
Factors influencing exchange rates

Impact of interest rate differentials

Carbaugh, Chap. 13 10
Factors influencing exchange rates

Purchasing power parity

 In theory, a good should cost the same in
all countries (aside from tariffs or transportation
costs)
 As a result, exchange rates should end up
making prices equal across countries
 By this theory, if two countries have
different inflation rates, exchange rates will
move in the opposite direction to keep
prices the same
Carbaugh, Chap. 13 11
Factors influencing exchange rates

Impact of inflation rate differentials

Carbaugh, Chap. 13 12
Factors influencing exchange rates

Market expectations
 As with stock markets, foreign exchange
markets react quickly to news or even
rumors that point to future changes
affecting rates
 Future expectations can be self-fulfilling;
speculative bubbles can start without any
real information but can become self
sustaining for a while

Carbaugh, Chap. 13 13
Alternative approaches to exchange rates

Monetary approach
 Focus on exchange rates as the result of
supply and demand for money at home and
abroad
 Demand depends on real income, prices,
interest rates
 Supply is controlled by central banks
 Exchange rates seen as returning domestic
money supply to equilibrium after a change

Carbaugh, Chap. 13 14
Alternative approaches to exchange rates

Asset-markets approach
 Investors (firms and individuals) balance
their portfolios among domestic money,
stocks and bonds and foreign stocks and
bonds
 Short run exchange rate changes are
caused by shifts in the kind and location of
financial assets investors want to hold
 Investors shift between assets based on
market expectations for expected returns
Carbaugh, Chap. 13 15
Exchange rate markets

Short, long run equilibrium: overshooting

Carbaugh, Chap. 13 16
Exchange rate markets

Forecasting exchange rates

 Judgmental forecasts
 Subjective forecasts based on economic,
political and other data for a country
 Technical analysis
 Uses historical exchange rate trends to project
short-run future movements
 Fundamental analysis
 Includes macroeconomic and policy
information into a predictive model
Carbaugh, Chap. 13 17
Alternative approaches to exchange rates

Equilibrium in assets-markets approach

Carbaugh, Chap. 13 18
Alternative approaches to exchange rates

Assets-markets approach: shift in demand

Carbaugh, Chap. 13 19
Alternative approaches to exchange rates

Assets-markets approach: shift in supply

Carbaugh, Chap. 13 20