6.2 Exchange rate determination

Exchange rates are the prices of currencies, influenced by various factors. Short-term movements are driven by interest rates, inflation, trade balances, and stability. Long-term trends are shaped by purchasing power parity, productivity, and economic growth.

Understanding exchange rate determination is crucial for international trade and finance. Theories like purchasing power parity and interest rate parity explain currency relationships, while market expectations and risk factors impact currency values in practice.

Exchange Rate Determination

Factors in exchange rate movements

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• Short-run factors
  • Interest rate differentials
    • Higher interest rates attract capital inflows increasing demand for the currency causing appreciation (US dollar strengthens when Federal Reserve raises interest rates)
  • Inflation rate differentials
    • Higher inflation rates lead to currency depreciation as purchasing power decreases (Venezuelan bolivar depreciated due to hyperinflation)
  • Current account balance
    • Trade surpluses increase demand for the currency causing appreciation (Chinese yuan appreciated due to large trade surpluses)
    • Trade deficits decrease demand for the currency causing depreciation (US dollar depreciated due to persistent trade deficits)
  • Political and economic stability
    • Stable conditions attract capital inflows leading to currency appreciation (Swiss franc is a safe-haven currency)
    • Instability causes capital outflows leading to currency depreciation (Turkish lira depreciated during political turmoil)
• Long-run factors
  • Purchasing power parity (PPP)
    • Relative price levels between countries determine the long-run equilibrium exchange rate (Big Mac Index compares burger prices across countries)
  • Productivity differentials
    • Higher productivity growth leads to currency appreciation as competitiveness improves (Japanese yen appreciated during post-war economic boom)
  • Economic growth prospects
    • Stronger economic growth attracts capital inflows causing currency appreciation (Australian dollar appreciates when commodity prices rise)

Purchasing power parity theory

• Absolute PPP
  • Exchange rate between two currencies should equal the ratio of their price levels
  • Formula: $E = \frac{P_d}{P_f}$
    • $E$: Exchange rate (domestic currency per unit of foreign currency)
    • $P_d$: Domestic price level
    • $P_f$: Foreign price level
  • Example: If a basket of goods costs $100 in the US and £80 in the UK, the PPP exchange rate is$1.25/£
• Relative PPP
  • Change in exchange rate should equal the difference in inflation rates between two countries
  • Formula: $\frac{E_1}{E_0} = \frac{1 + \pi_d}{1 + \pi_f}$
    • $E_1$: Exchange rate at time 1
    • $E_0$: Exchange rate at time 0
    • $\pi_d$: Domestic inflation rate
    • $\pi_f$: Foreign inflation rate
  • Example: If US inflation is 2% and UK inflation is 4%, the dollar should appreciate by 2% against the pound
• Limitations of PPP
  • Assumes perfect competition and no trade barriers which is unrealistic
  • Ignores non-traded goods and services that aren't exposed to international competition (haircuts, housing)
  • Prices are sticky in the short run and don't adjust immediately to changes in exchange rates

Interest rate parity theory

• Covered interest rate parity (CIRP)
  • No-arbitrage condition between spot and forward exchange rates and interest rates
  • Formula: $\frac{F}{S} = \frac{1 + i_d}{1 + i_f}$
    • $F$: Forward exchange rate
    • $S$: Spot exchange rate
    • $i_d$: Domestic interest rate
    • $i_f$: Foreign interest rate
  • Example: If the 1-year forward rate is $1.30/€ and the spot rate is$1.20/€, the interest rate differential must be 8.33% for CIRP to hold
• Uncovered interest rate parity (UIRP)
  • Relates expected change in exchange rate to interest rate differential
  • Formula: $\frac{E_1^e}{E_0} = \frac{1 + i_d}{1 + i_f}$
    • $E_1^e$: Expected exchange rate at time 1
    • $E_0$: Exchange rate at time 0
  • Example: If US interest rates are 2% and EU rates are 1%, the dollar is expected to depreciate by 1% against the euro
• Implications of IRP
  • Higher interest rates lead to currency appreciation in the short run as capital flows in (carry trades)
  • Arbitrage opportunities are eliminated in equilibrium ensuring parity holds

Market expectations and risk

• Market expectations
  • Influence short-run exchange rate movements based on new information
  • Based on anticipated changes in economic fundamentals, monetary policy, and geopolitical events (Brexit, US-China trade war)
• Risk factors
  • Exchange rate risk
    • Uncertainty about future exchange rates affects investment and trade decisions (exporters prefer stable rates)
  • Country risk
    • Political, economic, and financial risks associated with investing in a particular country (Argentina defaulted on debt)
  • Liquidity risk
    • Difficulty in buying or selling currencies without affecting the market price (illiquid exotic currencies)
• Risk management techniques
  • Hedging
    • Using financial instruments to mitigate exchange rate risk
      1. Forward contracts lock in future exchange rate
      2. Options provide the right but not obligation to buy/sell at a predetermined rate
  • Diversification
    • Investing in multiple currencies to spread risk (portfolio includes dollars, euros, yen)