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
2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-1

Learning Objectives
• Explain how an equilibrium exchange rate is determined
• Describe the factors responsible for movements in the exchange rate
• Identify economic variables affecting an exchange rate and the mechanisms through which this occurs
• Understand the relationship between variables affecting an exchange rate
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-2

Chapter Organisation
16.1 FX Markets and an Equilibrium Exchange Rate
16.2 Factors that Influence Exchange Rate
Movements
16.3 Measuring Exchange Rate Sensitivity to
Changes in Economic Variables
16.4 Summary
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-3

16.1 FX Market and the Equilibrium
Exchange Rate
• Previous chapter
– Focused on the structure and operations of the FX markets
• This chapter
– Focuses on the factors that influence the value of a currency (in a floating exchange rate regime) in order to attempt to forecast future exchange rates with some reliability and accuracy
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-4

16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
• Floating exchange rate regime
– One in which the value of the currency is determined by demand and supply conditions
• Pegged exchange rate regime
– Where a domestic currency is locked into a specified multiple of another currency such as the USD, e.g. Hong
Kong dollar
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-5

16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
• Demand for a currency
– To purchase Australian goods and services foreigners must buy AUD
– Downward-sloping demand curve occurs as the devaluation of AUD results in a greater demand by foreigners
 For foreigners, a fall in the price of the AUD is equivalent to a reduction in the price of everything in Australia
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-6

16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
• Supply of a currency
– Upward-sloping supply curve occurs as the quantity of
AUDs supplied to the FX market increases as the price of the AUD increases
– As the AUD appreciates, the price of foreign currency falls, making foreign goods cheaper for Australian residents
– The demand for foreign currency increases and, therefore, so does the supply of AUD
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-7

16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
• Equilibrium exchange rate
– The equilibrium exchange rate is the rate at which the quantity of AUD supplied to the market is equal to the demand for AUD
– It shows the unique rate at which both the demanders and suppliers of AUD will be satisfied
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-8

16.1 FX Market and the Equilibrium
Exchange Rate (cont.)
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-9

Chapter Organisation
16.1 FX Markets and an Equilibrium Exchange Rate
16.2 Factors that Influence Exchange Rate
Movements
16.3 Measuring Exchange Rate Sensitivity to
Changes in Economic Variables
16.4 Summary
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-10

16.2 Factors that Influence Exchange Rate
Movements
• Main factors influencing exchange rate movements
– Relative inflation rates
– Relative national income growth rates
– Relative interest rates
– Exchange rate expectations
– Government or central bank intervention
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-11

Relative inflation rates
• Relative inflation rates influence the price and, therefore, the demand for foreign goods by residents
• The change in demand for imported goods, in turn, affects the demand for foreign currency used to buy these goods
– This view of the determination of the value of a currency is called purchasing power parity (PPP) and is discussed in detail later
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-12

Relative inflation rates (cont.)
• Example: increase in US rate of inflation relative to
Australia
– Effect for Australian residents
 US imports more expensive, decreasing demand for these goods; therefore, reducing the supply of AUD
– Effect for US residents
 Some US demand for goods and services, and assets will switch to Australian items, increasing demand for AUD to pay for these items
– Net effect is an appreciation of the AUD
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-13

Relative inflation rates (cont.)
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-14

Relative national income growth rates
• Example: Australian income growth rates rise relative to the US
– Australian demand for imports increases, increasing the supply of AUD, which, in turn, causes the AUD to depreciate
– A secondary effect could be an increase in foreign investment in Australia, increasing the demand for AUD, causing the AUD to recover some value
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-15

Relative national income growth rates
(cont.)
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-16

Relative interest rates
• Example: if Australian interest rates rise relative to the US
– Effect for US residents
 US residents and companies may redirect some of their cash into Australian interest-bearing instruments, increasing the demand for the AUD
– Effect for Australian residents
 Australian investors and businesses are more likely to keep their surplus funds invested in Australia, causing a decrease in the supply of the AUD
– Net effect
 AUD will appreciate
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-17

Relative interest rates (cont.)
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-18

Relative interest rates (cont.)
• Expectations about the value of the currency during the investment period
– So far, the role of interest rates on the exchange rate has ignored expectations about the value of the currency during the investment period
– Table 16.1 illustrates the interaction of interest rate differentials and expected changes in the exchange rate over the investment period on currency value
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-19

Relative interest rates (cont.)
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-20

Relative interest rates (cont.)
• From Table 16.1 the following impact on the value of the AUD would be evident
– Scenario 1: AUD would depreciate
 The 3% benefit obtained from placing funds in the
Australian money market would be more than offset by the
5% depreciation of the AUD
– Scenario 2: AUD would appreciate
 The 3% benefit obtained from placing funds in the
Australian money market would only be partly offset by the
2% depreciation of the AUD
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-21

Relative interest rates (cont.)
• Reason for change in nominal interest rate
– The analysis has ignored whether a change in the nominal interest rate is due to a change in the
 Real rate of return or
 Inflation expectations premium i nom
 r
 p e
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-22

Relative interest rates (cont.)
• Example: if nominal interest rates rise due to an increase in the inflation expectations premium
– The currency may not appreciate, and could depreciate due to
 The effect of inflationary expectations (PPP theory)
 Businesses and individuals seeking to invest cash holdings in overseas’ securities to avoid a loss of value
• Example: if nominal interest rates rise due to an increase in the real rate of return
– The currency may appreciate due to an inflow of funds from the rest of the world
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-23

Exchange rate expectations
• Motivation for turnover in the FX market
– Only part of the turnover in the FX market is accounted for by transactions associated with exports, imports and financial assets
– A significant portion of turnover is motivated by changes in exchange rate expectations
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-24

Exchange rate expectations (cont.)
• Exchange rate expectations are based on expectations about future changes in
– Relative inflation
– Relative income growth
– Relative interest rates
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-25

Exchange rate expectations (cont.)
• Example: AUD expected to depreciate
– Effect for Australian residents
 Seek to buy foreign currency before AUD falls
 Increasing supply of AUD on FX markets
– Effect for foreign residents
 Defer purchases of the AUD
 Reduces demand for AUD
– Net effect
 AUD depreciates as expected
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-26

Exchange rate expectations (cont.)
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-27

Government or central bank intervention
• Policies by foreign and/or domestic governments may affect the relative rate of inflation, income growth or interest rates between countries
• Also, the market participants’ expectations that the government will alter its policy affecting these variables in the future
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-28

Government or central bank intervention
(cont.)
• A central bank may also influence the currency by
– Intervening in international trade flows
– Intervening in foreign investment flows
– Directly intervening in the FX market
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-29

Government or central bank intervention
(cont.)
• International trade flows
– Intervention aimed at increasing exports and/or reducing imports by using
 Subsidies to exporters, making exports more competitive
• Increases demand for Australian exports and demand for AUD
 Intervention on the import side
• Tariffs—charge levied on imports increasing their prices
• Quotas—restriction on the amount imported
• Embargo—prohibition on import of specified goods or services
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-30

Government or central bank intervention
(cont.)
• Foreign investment flows
– Governments alter the exchange rate by altering the flow of investment funds between countries by
 Prohibitions on the outflow of funds from a country
 Imposing penalty taxes on
• Residents who earn income offshore
• Non-residents’ interest income earned in the home country
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-31

Government or central bank intervention
(cont.)
• Direct FX market intervention
– Involves purchases or sales of currency
– Two motivations for doing this
 Smoothing
• RBA tries to remove volatility in the currency caused by speculators
 Exchange rate targeting
• RBA tries to push the equilibrium exchange rate to some level
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-32

Government or central bank intervention
(cont.)
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-33

Chapter Organisation
16.1 FX Markets and an Equilibrium Exchange Rate
16.2 Factors that Influence Exchange Rate
Movements
16.3 Measuring Exchange Rate Sensitivity to
Changes in Economic Variables
16.4 Summary
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-34

16.4 Measuring Exchange Rate Sensitivity to Changes in Economic Variables
• Regression analysis can be used to assess how changes in economic variables affect the exchange rate
– It is a statistical technique that determines the relationship between a dependent variable (the exchange rate) and independent variables (relative growth, inflation and interest rates etc.)
Copyright
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-35

Chapter Organisation
16.1 FX Markets and an Equilibrium Exchange Rate
16.2 Factors that Influence Exchange Rate
Movements
16.3 Measuring Exchange Rate Sensitivity to
Changes in Economic Variables
16.4 Summary
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-36

16.4 Summary
• Demand and supply determine the value of a currency in a floating exchange rate regime
• Factors influencing the demand and/or supply of a currency
– Relative inflation rates (PPP)
– Relative national income growth rates
– Relative interest rates
– Exchange rate expectations
– Central bank or government intervention
Copyright

2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
16-37