The Determination of Exchange Rates

© 2002 by Stefano Mazzotta

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Overview of the lecture1. Presentation of the Problem

2. The Balance of Payments Approach

3. The Economic Approaches

4. The Asset Pricing Approaches

5. Forecasting

1. Presentation of the Problem

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A very difficult task• Many theories of exchange rates determination

exist. None of them is preeminent. All of them are used.

• Many people are involved in trying to determine exchange rates: Academics in economics and in finance, political men, central bankers, bankers, international financial institutions, practitioners... Within each profession, people do not agree.

• Example: the current value of the CAD

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What should be the value of the CAD? (July 2002)

• An global investment bank’s monthly report.• Another global investment bank’s short-term

view• An internationally renowned research analyst

group’s forecast.• The prime minister and the finance minister of

Canada’s opinions.• A currency options trader’s comment.

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Potential FX determinants

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Different dual approaches

• Short-term/Long-term

• Monetarist/Keynesian

• Economics/Finance

• Fundamentals/Technical analysis

2. The Balance of Payments Approach

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Assumptions

• The flow supply of, and demand for, currencies determine the equilibrium exchange rate.

• Original model focused only on the role of trade flows.

• More general models include also the role of capital flows.

• Data needed: the flows of the balance of payments and the elasticities of trade flows in response to a movement in exchange rate.

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The usual “Demand and Supply” picture

S

D

Q0 Q(CAD)

e(JPY/CAD)

e0

e1

S’

D’

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Interpretation

• An increase in inflation in Japan for example would lead Japanese and Canadian people to consume more Canadian goods and services relative to Japanese ones:– Japanese will demand more CAD– Canadians will supply less CAD

• Other scenarios include changes in interests rates, economic growth, political uncertainty...

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BOP of the big five

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Bloomberg Article• U.S. Trade Gap Widened to a Record $40.1 Billion in

NovemberBy Carlos Torres

• Washington, Jan. 17 (Bloomberg) -- The U.S. trade deficit widened to a record $40.1 billion in November as imports surged following a resumption of business at West Coast ports, a government report showed.

• The wider trade gap in goods and services followed a revised $35.2 billion shortfall in October and reflected a record inflow of holiday and other consumer merchandise, the Commerce Department said. Imports had declined in October, when ports in California, Oregon and Washington closed early in the month after shippers locked out union dockworkers in a labor dispute. …..

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• Faster growth in the U.S. compared with its trading partners will probably keep imports growing faster than exports and widen the trade gap in coming months, economists said.

• The U.S. economy is expected to grow 2.8 percent this year while Japan, the world's second-biggest economy, is seen expanding 0.9 percent, according to consensus estimates of economists polled by Blue Chip Economic Indicators. The economy of the 12 nations that share the euro as their common currency is projected to grow 1.7 percent.

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• A drop in the value of the dollar last year may help stimulate exports by making American-made goods less expensive relative to foreign products, some economists say. The dollar is down 5 percent from its peak in January 2002 against a trade- weighted basket of currencies from 37 of the country's largest trading partners.

• ``Eventually you would expect some relief to our exports from the lower dollar, but I don't expect it until the end of the year,'' said Lara Rhame, an economist at Brown Brothers Harriman & Co. in New York, before the report.

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Conclusions

• Difficult to justify the big swings in the observed exchange rates by the BOP

• The driving forces behind the changes in the BOP cannot be easily identified by looking only at the BOP (e.g. which one came first, current account deficit or capital account surplus?)

• The “pure” foreign exchange market forces are not taken into account

• The size of trade flows are much smaller than the level of foreign exchange volumes.

3. The Economic Approaches

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Overview

• There are two basic models of exchange rates: monetarist and Keynesian.

• Some models try to combine the two approaches, keeping the Keynesian reasoning for the short run and the monetarist one for the long run.

• Both models reach opposite conclusions.

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Monetarists

• Also called the Chicago School.

• The exchange rate reflects the relative price of money supplies in two countries.

• For example, if a country creates too much money, the result will be purely nominal: high inflation and weak currency.

• It is equivalent to the PPP conclusions.

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Keynesians

• Also called disequilibrium theory.

• The exchange rate reflects “real” developments.

• Frictions in the real economy cause goods prices to adjust slowly while nominal exchange rates adjust quickly. Therefore, changes in nominal exchange rates propagate into changes in real exchange rates.

• High interest rates will attract capital: It is the opposite to the Fisher effect conclusion.

4. The Asset Pricing Approaches

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Assumptions

• Currencies are like any other financial asset.

• The price of a given currency (i.e. exchange rates) is determined by investors’ desire to hold assets denominated in that currency.

• This desire depends on investors’ expectations of the future worth of assets they hold and on investors’ risk preferences.

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Intuition

• Current international trade flows should not affect exchange rates if there are already expected by the market participants.

• The volatility of exchange rates is the consequence of the news assimilation process.

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Conclusions

• News: It is important to specify the types of news that affect exchange rates; It is even better to quantify their effect.

• Central Banks: As an institutional “news provider”, their behavior needs to be modeled.

• Risk: The risk preferences and perceptions of foreign exchange market participants are crucial.

5. Forecasting

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Different methods for different questions

• Market efficiency: are exchange rates random walk?

• Econometric models: can we quantify the relationship between exchange rates and their determinants?

• Technical analysis: do exchange rates past values tell us anything about future values?