8/10/2019 AFC3240 Topic 05 S1 2011

1/27

1

Topic 5 Determination of ExchangeRate (Shapiro, Chapter 2)

Balance of Payments (BOP)

Balance of payments refers to the net value of alleconomic transactions including trade in goodsand services, transfer payments, loans, andinvestments between residents of the samecountry and those of all other countries.

8/10/2019 AFC3240 Topic 05 S1 2011

2/27

2

Balance of Payments (BOP) categories:1. Current account: records imports and

exports of goods, services, income, andcurrent unilateral transfers.

2. Capital account: includes debt

forgiveness, transfers of goods andfinancial assets by migrants as they enteror leave the country.

3. Financial account: shows public andprivate investment and lending activities.It records inflows and outflows of capital.

8/10/2019 AFC3240 Topic 05 S1 2011

3/27

3

A countrys balance of payments (BOP) canhave significant impact on its exchange rateand vice versa, depending on that countrysexchange rate regime.

BOP is equal to the sum total of currentaccount balance (X M), capital accountbalance (CI CO), financial account balance(FI FO) and reserve balance (FXB)

BOP = (X M)+(CI CO)+(FI FO)+(FXB)

8/10/2019 AFC3240 Topic 05 S1 2011

4/27

8/10/2019 AFC3240 Topic 05 S1 2011

5/27

5

The balance of payments approach is thesecond most utilized theoretical approach in

exchange rate determination: The basic approach argues that the equilibriumexchange rate is found currency flows match upvis a vis current and financial account activities.

This framework has wide appeal as BOPtransaction data is readily available and widelyreported.

Critics may argue that this theory does not takeinto account stocks of money or financial assets.

8/10/2019 AFC3240 Topic 05 S1 2011

6/27

6

Supply and Demand analysis in thedetermination of exchange rates

(A) Foreign Currency Demand:- derived from the demand for foreigncountrys goods, services, and financial

assets. e.g. Americans demand Australian goods such as minerals.

8/10/2019 AFC3240 Topic 05 S1 2011

7/27

7

The Demand for AUD in the U.S.

Qty

USD0.96

USD/AUDD

At higher exchange rates, Americans

demand less AUD and vice versa.

USD0.97

USD0.95

8/10/2019 AFC3240 Topic 05 S1 2011

8/27

8

(B) Foreign Currency Supply:- derived from the foreign countrys

demand for local goods.- Foreign buyers must convert theircurrency in order to purchase.e.g. Australians demand for USgoods, such as Dell computers means

Australians must convert AUD toUSD in order to buy .

Therefore, foreign currency supply anddemand are derived supply and demand

8/10/2019 AFC3240 Topic 05 S1 2011

9/27

9

The Supply of AUD in the U.S.

USD/AUD

Qty

USD0.96

SUSD0.97

USD0.95

At higher exchange rates, Australians

supply more AUD and vice versa.

8/10/2019 AFC3240 Topic 05 S1 2011

10/27

8/10/2019 AFC3240 Topic 05 S1 2011

11/27

11

(D) How Exchange Rates Change

1. Increased demandas more foreign goods are demanded, moreof the foreign currency is demand at each

possible exchange rate

2. The price of the foreign currency in localcurrency increases.3 . Home Currency Depreciation

a. Foreign currency more valuable thanthe home currency.

b. Conversely, the foreign currencysvalue has appreciated against thehome currency.

8/10/2019 AFC3240 Topic 05 S1 2011

12/27

12

The USD Depreciates

QtyUSD0.95

S

USD/AUD

D

D

USD0.96

Q1 Q2

8/10/2019 AFC3240 Topic 05 S1 2011

13/27

13

Exchange rate determination is complex. The following exhibit provides an overview

of the many determinants of exchangerates. This road map is first organized by the

three major schools of thought (parityconditions, balance of paymentsapproach, asset market approach), andsecondly by the individual drivers withinthose approaches.

These are not competing theories butrather complementary theories.

8/10/2019 AFC3240 Topic 05 S1 2011

14/27

14

Without the depth and breadth of the variousapproaches combined, our ability to capture thecomplexity of the global market for currencies islost.In addition to gaining an understanding of thebasic theories, it is equally important to gain a

working knowledge of: the complexities of internationalpolitical economy;

societal and economic infrastructures;and,

random political, economic, or socialevents affect the exchange rate markets.

8/10/2019 AFC3240 Topic 05 S1 2011

15/27

15

Parity Conditions1. Relative inflation rates

2. Relative interest rates3. Forward exchange rates4. Interest rate parity

Balance of Payments1. Current account balances2. Portfolio investment3. Foreign direct investment4. Exchange rate regimes

5. Official monetary reserves

Asset Approach1. Relative real interest rates2. Prospects for economic growth3. Supply & demand for assets4. Outlook for political stability5. Speculation & liquidity6. Political risks & controls

SpotExchange

Rate

I s there a well-developed

and li quid money and capitalmarket in that currency?

I s there a sound and secur e

banking system i n-place tosupport currency tradingactivities?

Exhibit: Determinants of Exchange Rates

8/10/2019 AFC3240 Topic 05 S1 2011

16/27

16

The previous exhibit, with its tripartitecategorization of exchange rate theory is a

good start but in our humble opinion isnot robust enough to capture the multitude oftheories and approaches.

Therefore, in the following slides, we willintroduce several additional streams of

thought.

8/10/2019 AFC3240 Topic 05 S1 2011

17/27

8/10/2019 AFC3240 Topic 05 S1 2011

18/27

18

The Monetary Approach

PPP can be reformulated into the Monetaryapproach (Shapiro pp140-42) based on thequantity theory of money:

M/P = y/v

where M is the national money supply, P is

the general price level, y is real GNP, and vis the velocity of money.

8/10/2019 AFC3240 Topic 05 S1 2011

19/27

19

After rewriting, in terms of growth rates togive the determinants of domestic inflation:

ih = h - g yh + g vhwhere i

his the domestic inflation rate,

h is

the rate of domestic money supply expansion,gyh is growth in real domestic GNP, and g vhthe change in the velocity of the domesticmoney supply.

8/10/2019 AFC3240 Topic 05 S1 2011

20/27

20

For example, U.S. money supply growth isforecast at 5%, real GNP is expected to to

grow at 2%, the velocity of money is expectedto fall by 0.5%, U.S. inflation will be

ih = h - g yh + g vh= 5% - 2% + (-0.5%) = 2.5%

Foreign inflation rate can be obtained in thesame way. Combining these two equationsalong with PPP leads to the following predictedexchange rate change:

8/10/2019 AFC3240 Topic 05 S1 2011

21/27

21

Where h and f refers to the correspondingrates for the home and foreign country.

The monetary approach in its simplest formstates that the exchange rate is determined

by the supply and demand for nationalmonetary stocks, as well as the expectedfuture levels and rates of growth of monetary

stocks.

)()()(0

01vf vh yf yh f h f he

ee g g g g ii

8/10/2019 AFC3240 Topic 05 S1 2011

22/27

22

Other financial assets, such as bonds are notconsidered relevant for exchange rate determination,as both domestic and foreign bonds are viewed asperfect substitutes.

Expectations and Asset Market ModelCurrency values: affected by current events andcurrency supply and demand flows in FX market, alsodepend on expectations.

Asset Market Model: the exchange rate between twocurrencies represents the price that just balances therelative supplies of, and demands for, assetsdenominated in those currencies. Shifts inpreferences can lead to massive shifts in currency

values.

8/10/2019 AFC3240 Topic 05 S1 2011

23/27

23

The asset market approach assumes thatwhether foreigners are willing to hold claims inmonetary form depends on an extensive set ofinvestment considerations or drivers (amongothers): Relative real interest rates are a majorconsideration for investors in foreign bonds andSTMM instruments Prospects for economic growth and profitability

are an important determinant of cross-borderequity investment in both securities and foreigndirect investment (FDI)

8/10/2019 AFC3240 Topic 05 S1 2011

24/27

8/10/2019 AFC3240 Topic 05 S1 2011

25/27

25

Contagion: the spread of a crisis in one country toits neighbouring countries and other countries thathave similar characteristics. Speculation can both cause a FX crisis or makean existing crisis worse.

The asset market approach argues that exchangerates are determined by the supply and demand fora wide variety of financial assets:

Shifts in the supply and demand for financialassets alter exchange rates.

Changes in monetary and fiscal policy alterexpected returns and perceived relative risks offinancial assets, which in turn alter exchangerates.

8/10/2019 AFC3240 Topic 05 S1 2011

26/27

Foreign investors are willing to hold securities andundertake foreign direct investment in highlydeveloped countries based primarily on relative realinterest rates and the outlook for economic growthand profitability.The asset market approach is also applicable toemerging markets, however in these cases there is anumber of additional variables contribute toexchange rate determination.

Although different schools of thought on exchange

rate determination (parity conditions, monetaryapproach, balance of payments approach, assetapproach) make understanding exchange ratesappear to be straightforward, that it rarely the case.

26

8/10/2019 AFC3240 Topic 05 S1 2011

27/27

27

The large and liquid capital and currency marketsfollow many of the principles outlined so farrelatively well in the medium to long term.

The smaller and less liquid markets, however,frequently demonstrate behaviors that seeminglycontradict the theory.

The problem lies not in the theory, but in therelevance of the assumptions underlying thetheory.