Determinants of Exchange
Rates
Why Study Exchange Rates?

To understand the economic environment
– Forecasting for planning purposes

To understand exposure to currency risk
– Financial impact of exchange rate move varies
• With the nature of the asset/liability
• With the cause of the move
Outline:
Exchange Rate Determination
1.
Market Forces
1. Real economic effects
2. Monetary effects
2.
Role of Government
Exchange rates are determined by supply
and demand for the currencies
Market Forces:
Real Effects
To focus on real effects assume:
1.
No currency market intervention
2.
No inflation in either country
Real exchange rates are determined by
real economic events affecting supply
and demand for the currencies
Current Event
“Good News Boosts Dollar,
for a Change”
Balance of Payment Accounts
Components:
 Current
Account - Goods and Services
 Financial Account - Investment
 Reserve Account - Government Reserves
Factors Affecting Trade
(Current Account)

Real price “shocks”
– Example: Oil price shock

Government policy change
– Tariff/ Trade policy
Factors Affecting Investment
(Financial Account)

Real return “shocks”
– example: turn of business cycle

Government policy (affecting real returns)
– tax policy
– labor law

Perceived risk
– war, political risk
Conclusions about real effects
Changes in any of these real factors
 Shifts supply or demand for currency
– Affects exchange rate
– Of interest to currency forecasters

Is also reflected in balance of payments data
– Thus BOP data of interest to forecasters
Market Forces:
Monetary Effects
Purchasing Power Parity

Logic:
“arbitrage” in market for goods
U.S.
Russia
Exchange Rate
Now
$1.00/loaf
25 Rb/loaf
25 Rb/$
.04 $/Rb
Next year
$1.00/loaf
50 Rb/loaf
50 Rb/$
.02 $/Rb
PUS
e($ / Rb) 
PRus
 1   US 
et  e0 

1


Rus 

t
Definitions: PPP

Absolute Purchasing Power Parity
The purchasing power of the dollar is
the same everywhere in the world

Relative Purchasing Power Parity
Exchange rates move to offset
differences in rates of inflation.
How well does PPP predict in
practice?
Absolute PPP – Not at all
Relative PPP
 Works well
– In the long run
– When differences in inflation are dramatic

Works much less well in the short run
Zimbabwe
Inflation rates and currency redenomination
1994:
1998:
2002:
2006:

August 2006: 1st redenomination ZWD$1,000 → ZWN$1
2007:

25%
48%
199%
1,281%
66,212%
August 2008: 2nd redenomination ZWN$10b → ZWR$1
Dec. 2008 (estimate):

6.5x10108 % or 91% per day
March 2009: Zimbabwe dollar suspended: informal (U.S.)
dollarization
(C) 2014 Melvin H Jameson
Real Exchange Rate

Definition: Exchange rate after removing
the effects of inflation

If Purchasing Power Parity holds, then real
exchange rates never change
Exchange Rate Policy
The role of government
How governments affect
exchange rates

Currency market intervention
– (intentional)
– Central Bank buys/sells home currency in
exchange for its foreign currency reserves.

Monetary policy
– (unintentional through impact of inflation)
– Central Bank buys/sells home currency in
exchange for bonds
Types of Exchange Rate Policies
free float (no intervention)
 “dirty”or managed float(some intervention)
 fixed exchange rate or “peg” (unlimited
intervention at a fixed rate)

– through central bank policy
– currency board
– dollarization
Lessons about Exchange Rate Policy

Policy matters (especially in the short run).

In the long run no policy can overcome
market forces.