Lecture 8 Determination of Exchange
International Finance
Rates
The Markets and Financial Management of Multinational Business
Chapter 6, 7
Maurice D. Levi, 3rd Edition
Supply-and Demand View of Exchange Rate
Modern Theories of Exchange Rates
Summary
Supply-and Demand View of Exchange Rate
1.
Imports, exports, and exchange rates
1) Deriving a currency’s supply curve
 If we limit consideration to goods and services, the supply of a currency equals the
value of imports(wheat).
2) Deriving a currency’s demand curve
 If we limit consideration to goods and services, the demand for a currency equals the
value of exports(oil).(F1)
2.
The factors affecting exchange rates
1) Terms of trade and the amount of trade
 It is clear that the pound will appreciate in value as a result of an improvement of
Britain’s terms of trade.
2) Inflation
Import demand curve(wheat) (F2)
Export supply curve(oil) (F3)
Let us assume that Britain experiences a 25 percent inflation. We see that inflation in all
prices and incomes shifts demand and supply curves vertically upward by the amount of
inflation.(F3,4)
There are different effects of inflation on currency supply and demand curves and hence
exchange rates according to whether inflation occurs only in Britain or in Britain and elsewhere.
Inflation in only one country
The supply of pounds:
P$WHEAT  QM
 P&WHEAT  QM
E$ &
The demand for pounds:
E& $  P$OIL  QX  P&OIL  QX
 Inflation on one country reduces the exchange rate of that country’s currency by
approximately the same percentage as the country’s inflation.
Inflation also in other countries
 A country’s exchange rate depreciates by approximately the extent that the country’s
inflation exceeds that of other countries.
3)
4)
3.
1)





Service trade, income flows, and transfers
Foreign investment(F6)
The stability of exchange rates
The conditions required for instability
Currency supply and import elasticity(F7)
Stability of foreign exchange markets(F8，9，10)
Marshall-Lerner condition
Will a depreciation of the home currency lead to a decrease in the excess demand for
foreign exchange? The problem is to assess the change in the current account balance
that results when there is a change in the exchange rate.
the link between the demand curve for imported goods and services and the supply curve of
foreign exchange(F11，12)
Exchange market stability and the Marshall-Lerner condition(F11):
In the case of unbalanced trade(expressed in units of home currency)
X
  Dx   Dm  1
M
2) Unstable exchange rates and the balance of trade
 The foreign exchange market is unstable only if the value of exports does not increase
sufficiently to compensate for inelastic import demand.
4.
Short-run versus long-run trade elasticities and the J curve
1) Complete exchange rate pass-through
It is assumed that a change in the exchange rate registered fully as a change in goods prices
facing consumers in the buying country.
Appleyard and Field(2001): PP 535-544
2) Adjustment time and the foreign exchange market(F13)
3) Exchange rate pass-though of foreign exports to the United States
 Jiawen Yang(1997)
Elasticity of exchange rate pass-through on an industry basis is the percentage change
in the import price index for a good(in dollars) divided by the percentage change in the (nominal
effective) exchange rate.
 Yang’s estimates were that, in 77 of the 87 industries, the elasticities of
pass-through were positive but less than 1.0.
 He postulated that the elasticity of pass-through would be higher with greater
product differentiation in an industry.
 Yang expected that pass-through would be smaller the greater the elasticity of
marginal cost of production with respect to output in the supplying firms in the
industry.
 Yang specified that the degree of pass-through could be affected by the market
share of foreign firms----his hypothesis was that the degree of pass-though would
be inversely relayed to a foreign firm’s market share
4) Japanese export pricing and pass-through in the 1990s
 Thomas Klitgaard(1999)
During the 1990s, the yen strongly appreciated relative to the dollar from 1991 to 1995 and
strongly depreciated from 1995 to 1998. In general, Klitgaard concluded that a 10 percent
change in the price of the yen would lead to roughly a 4 percent offsetting change in the profit
margin (relative to the profit margin on goods sold in Japan).
5) J-curve
Modern Theories of Exchange Rates
1.
Stock versus flow theories of exchange rates
 The supply-and demand view of exchange rtes considers flows of currencies. An alternative
way of viewing exchange-rate determination is in terms of the stocks of currencies relative
to the willingness of people to hold these stocks. Several variants of stock-based theories of
exchange rtes have been developed in recent years.
Monetary approach
Asset approach
Portfolio-balance approach
2.
The monetary theory of exchange rates
1) The monetary theory of exchange rates is the flexible-exchange-rate form of the
monetary approach to the balance of payments which pertains to fixed exchange rates.
2) There are two essential components to the monetary theory of exchange rates.
The first relates the price levels in different countries to the countries’ money supplies, and
the second relates price levels to exchange rates.
A specific version of the demand equation for money(John Bilson):
M US

 QUS
e US
PUS
M UK

 QUK
e UK
PUK
If the money demand equals the money supply,
   US
PUS  MUS QUS
e
   UK
PUK  MUK QUK
e
PPP principle,
S$ & 
S$ &




PUS
PUK
M
 US
M UK
 QUK

 QUS
The money supply
Real GNP
Interest rate 
Expected inflation

  (  US   UK )
 e

3)
A brief look at empirical work on the monetary approach
 the monetary approach under fixed exchange rates
Junichi Ujiie(1978): 1959-1972
BOP = a + bΔD + cΔi* + fΔY
BOP=an official reserve transactions surplus
ΔD=the change in domestic credit, b<0test is robust
Δi*=the change in foreign interest rates, c>0? (monetary approach)
ΔY=the change in Japanese real income, f>0?
 the monetary approach under flexible exchange rates
Jacob Frenkel(1978): February 1921-August 1923(the German hyperinflation period)
log e  a  b log M s  c log E ( p )
e=units of German marks per one U.S. dollar; 1=b>0,c>0
The Frenkel test gives substantial support for the monetary approach to the exchange rate.
Rudiger Dornbusch(1980): 1973-1979
e  a  b(ms  ms *)  c( y  y*)  d (i  i*) S  f (i  i*) L
home country =Canada, France, Japan, the UK, the US
foreign country =West Germany,*
Dornbusch concluded that, at least from his testing, there is “little doubt that the
monetary approach … is an unsatisfactory theory of exchange rate determination”
MacDonald and Taylor(1992): the summary statement that the “monetary approach appears
reasonably well supported for the period up to 1978” but that this is not true for studies using
sample years after that time.
Mark Taylor(1995): the later estimating equations for exchange rates often contained incorrect
signs.
3.
The asset approach to exchange rates
The asset approach to exchange rates looks at the current spot exchange rate as a reflection
of the market’s best evaluation of what is likely to happen to the exchange rate in the
future.
 The random component fluctuates around the expected change in the exchange
rate.
The effect of fiscal policy as well as monetary policy:
4.
The portfolio-balance approach to exchange rates
1) People might want to hold both monies and bonds. It recognizes that supplies and
demands for monies and bonds must balance. We find effects of bond supplies and
demands on exchange rates and interest rates.
2) The portfolio-balance theory(F14)
The line MM represents all of the interest rate/exchange rate combinations consistent with
equilibrium in the U.S. money market.
E $ /&
rUS  M D  , M S
 ValueBritishbonds  Wealth  M D 
currency
The line BB represents all of the interest rate/exchange rate combinations consistent with
equilibrium in the U.S. bond market.

rUS  Demand U . S . Bond , Supply
E$ /&  ValueBritishbonds  Wealth  Demand U . S . Bond 
currency
5.
1)
2)
3)
4)
 Effect of open-market operations
The portfolio-balance theory recognizes that in addition to the direct effect of the
money supply, there is also an effect of the excess demand for bonds caused by the
central bank’s purchase of bonds; the supply of bonds available to the public is
reduced.
Unlike the monetary approach, the portfolio-balance approach predicts that the effect
of changes in money supplies on exchange rates depends on how money supplies are
changed.
 The effect of a higher U.S. real GNP(F14)
We see that the exchange-rate appreciation is the result of adjustments in both the
money and bond markets and therefore is larger than the exchange-rate appreciation
occurring only via the money market.
Theories of exchange-rate volatility
The Dornbusch sticky-price theory
 Exchange-rate overshooting
“overshooting” occurs when exchange rates go beyond their new equilibrium before
returning to it.
 Dornbusch(1976)(F15)
Varying elasticities
Stock adjustment and flow fluctuations
Other theories of overshooting
Summary
Several theories of exchange rates have been advanced which are based on the stocks of
countries’ monies versus the demands to hold these monies.
The sock-based theories differ according to the assets they consider and whether they
involve expectations of the future
The monetary approach to exchange rates is based on links between money supplies and
price levels and between price levels and exchange rates.
The monetary approach predicts that an exchange rate will depreciate by the excess of
money growth in one country over another. It also predicts that faster growth of real GNP
will cause appreciation and that higher interest rates and expected inflation will cause
depreciation.
The asset approach to exchange rates suggests that the current exchange rate depends on
the expected future exchange rate. Since the expected future rate can depend on expected
inflation or anything appearing in the balance-of-payments account, the asset approach is
consistent with other theories of exchange rates.
The portfolio-balance approach assumes different countries’ bonds are not perfect
substitutes. As a result, changes in preferences for bonds of one country over another, or
changes in bond supplies, can affect exchange rates.
If prices are sticky, exchange rates may overshoot their equilibrium. Other explanations of
exchange-rat overshooting include varying elasticities of import demand and export supply,
and jumps in currency supplies or demands caused by portfolio readjustment.