International Economics
By Robert J. Carbaugh
9th Edition
Chapter 13:
Exchange-Rate Determination
Copyright ©2004, South-Western College Publishing
Exchange rates
Factors influencing exchange rates
 Market fundamentals
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Bilateral trade 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)
 Dominated by financial transfers responding to:
 Differences in real interest rates
 Shifting expectations of future exchange rates
 Medium run (months)
 Primarily influenced by economic cycles
Carbaugh, Chap. 13
4
Exchange rates
When are these factors important?
 Long run (years)
 Dominated by movements of goods, services,
investment, which are influenced by:
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Inflation rates
Investment profitability
Consumer tastes
Real income
Productivity
Trade policy
 How these factors interact to affect exchange
rates depends on the relative importance of trade
and financial relations between the countries
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, so demand for
foreign currency rises faster than its supply
 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
 Law of one price: 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
 The theory may be more useful for predicting
long-term trends than short-run fluctuations
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 in a predictive model
Carbaugh, Chap. 13
17
Alternative approaches to exchange rates
Equilibrium in asset-markets approach
Carbaugh, Chap. 13
18
Alternative approaches to exchange rates
Asset-markets approach: shift in demand
Carbaugh, Chap. 13
19
Alternative approaches to exchange rates
Asset-markets approach: shift in supply
Carbaugh, Chap. 13
20