An Introduction to
International Economics
Chapter 12: Exchange Rate
Determination
Dominick Salvatore
John Wiley & Sons, Inc.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 1
Forces the determine exchange rates
• Relative rates of economic growth
– If the U.S. grows more rapidly than the rest of the
world, its demand for imports will increase more
rapidly.
– By itself, this should increase the demand for
foreign currency and lead to depreciation of the
dollar.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 2
Forces the determine exchange rates
• Relative rates of economic growth
• Relative rates of inflation
– If U.S. inflation is greater than the rate of inflation
in the rest of the world, the dollar will decrease in
value.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 3
Forces the determine exchange rates
• Relative rates of economic growth
• Relative rates of inflation
• Changes in interest rates
– If U.S. interest rates fall relative to interest rates in
the rest of the world, the demand for U.S. interest
bearing assets will fall.
– By itself, this will lead to a fall in international
demand for the dollar and a depreciation of the
dollar.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 4
Forces the determine exchange rates
•
•
•
•
Relative rates of economic growth
Relative rates of inflation
Changes in interest rates
Expectations
– If it is expected that the dollar will fall in value,
people will move out of dollar holdings.
– As dollar holdings fall, the dollar will depreciate.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 5
Trade approach
• The trade approach to exchange rate
determination focuses on the role of
international trade in determining exchange
rates.
– Also known as the elasticities approach
– Works better as a long-run model of exchange
rate determination.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 6
Trade approach
• The trade approach to exchange rate
determination focuses on the role of international
trade in determining exchange rates.
• In this approach, the equilibrium exchange
rate is the rate that balances imports and
exports.
– If the nation has a trade deficit, its currency will
depreciate.
– If the nation has a trade surplus, its currency will
appreciate.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 7
Purchasing power parity theory
• 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.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 8
Purchasing power parity theory
• 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.
– In other words, $P = ¥P•R where R is the dollar
price of one unit of foreign currency, $P is the
dollar price of the homogenous commodity, and
¥P is the foreign currency price of the
homogenous commodity.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 9
Purchasing power parity theory
• The law of one price
• If the law of one price holds for all goods, then
absolute purchasing power parity (PPP)will
hold.
– Absolute purchasing power parity holds that
equilibrium exchange rates are equal to the ratio
of price levels in the two nations.
– In other words, P = P*•R where R is the dollar price
of one unit of foreign currency, P is the price level
in the U.S., and P* is the price level in the foreign
nation.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 10
Purchasing power parity theory
• The law of one price
• If the law of one price holds for all goods, then
absolute purchasing power parity (PPP) will hold.
• Absolute purchasing power parity does not
hold in absence to perfect free trade.
– Non-traded commodities
– Barriers to trade
– Transaction costs
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 11
Purchasing power parity theory
• The law of one price
• If the law of one price holds for all goods, then
absolute purchasing power parity (PPP) will hold.
• Absolute purchasing power parity does not hold in
absence to perfect free trade.
• 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.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 12
The monetary model of exchange
rates
• The monetary model of exchange rates holds
that the exchange rate is determined in the
process of equilibrating the domestic demand
and supply of currency.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 13
The monetary model of exchange
rates
• The monetary model of exchange rates holds that
the exchange rate is determined in the process of
equilibrating the domestic demand and supply of
currency.
• An increase in the U.S. money supply
(assuming no change in other money
supplies) will depreciate both nominal (spot)
and real exchange rates.
– The real exchange rate is the nominal exchange
rate weighted by the consumer price index of the
two nations.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 14
The asset model of exchange rates
• The asset model of exchange rates holds that
the exchange rate is determined in the
process of equilibrating the domestic demand
and supply of financial assets.
– It is also known as the portfolio model
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 15
The asset model of exchange rates
• The asset model of exchange rates holds that the
exchange rate is determined in the process of
equilibrating the domestic demand and supply of
financial assets.
• An increase in the U.S. money supply
(assuming no change in other money
supplies) will lower interest rates in the U.S.
and shift investors from domestic to foreign
assets and lead to a depreciation of the dollar.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 16
The asset model of exchange rates
• An increase in the U.S. money supply (assuming
no change in other money supplies) will lower
interest rates in the U.S. and shift investors from
domestic to foreign assets and lead to a
depreciation of the dollar.
• The depreciation in the dollar spurs U.S.
exports and discourages imports.
– This encourages the formation of a trade surplus.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 17
The asset model of exchange rates
• An increase in the U.S. money supply (assuming
no change in other money supplies) will lower
interest rates in the U.S. and shift investors from
domestic to foreign assets and lead to a
depreciation of the dollar.
• The depreciation in the dollar spurs U.S. exports
and discourages imports.
• The movement in trade encourages an
appreciation of the dollar that partially offsets
the initial depreciation.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 18
• In adjusting to long run
equilibrium values,
exchange rates tend to
“overshoot” the final
equilibrium value.
• Suppose that the
exchange rate is initially
at $1/€1.
$/€
Exchange rate dynamics
1
Time
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 19
• Suppose that the
exchange rate is initially
at $1/€1.
• At time A, the money
supply in the U.S.
increases causing the
exchange rate to
depreciate.
$/€
Exchange rate dynamics
1
A
Dale R. DeBoer
University of Colorado, Colorado Springs
Time
12 - 20
• If the long run
equilibrium exchange
rate (determined by the
PPP model) is expected
to be $1.10/ €1, in the
short run the exchange
rate will overshoot this
value (perhaps to $1.16/
€1).
$/€
Exchange rate dynamics
1.16
1
A
Dale R. DeBoer
University of Colorado, Colorado Springs
Time
12 - 21
• The overshooting drives
an improvement in the
balance of trade that
will lead to subsequent
appreciation of the
dollar.
$/€
Exchange rate dynamics
1.16
1
A
Dale R. DeBoer
University of Colorado, Colorado Springs
Time
12 - 22
• The overshooting drives
an improvement in the
balance of trade that will
lead to subsequent
appreciation of the dollar.
• Over time, the dollar will
fall to its long run
equilibrium value.
$/€
Exchange rate dynamics
1.16
1.10
1
A
Dale R. DeBoer
University of Colorado, Colorado Springs
Time
12 - 23
Exchange rate forecasting
• Models of exchange rates have not been very
successful at predicting future exchange
rates.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 24
Exchange rate forecasting
• Models of exchange rates have not been very
successful at predicting future exchange rates.
• Reasons
– Exchange rates are highly influenced by new
information.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 25
Exchange rate forecasting
• Models of exchange rates have not been very
successful at predicting future exchange rates.
• Reasons
– Exchange rates are highly influenced by new
information.
– Expectations in exchange rate markets tend to be
self-fulfilling (at least in the short-run).
• This may generate movements in the market contrary to
what is expected by theory.
Dale R. DeBoer
University of Colorado, Colorado Springs
12 - 26