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 , productivity, and economic growth.
Understanding exchange rate determination is crucial for international trade and finance. Theories like purchasing power parity and 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
Higher interest rates attract capital inflows increasing demand for the currency causing appreciation (US dollar strengthens when Federal Reserve raises interest rates)
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 (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=PfPd
E: Exchange rate (domestic currency per unit of foreign currency)
Pd: Domestic price level
Pf: Foreign price level
Example: If a basket of goods costs 100intheUSand£80intheUK,thePPPexchangerateis1.25/£
Relative PPP
Change in exchange rate should equal the difference in inflation rates between two countries
Formula: E0E1=1+πf1+πd
E1: Exchange rate at time 1
E0: Exchange rate at time 0
πd: Domestic inflation rate
πf: 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: SF=1+if1+id
F: Forward exchange rate
S: Spot exchange rate
id: Domestic interest rate
if: Foreign interest rate
Example: If the 1-year forward rate is 1.30/€andthespotrateis1.20/€, 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: E0E1e=1+if1+id
E1e: Expected exchange rate at time 1
E0: 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 )
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
Forward contracts lock in future exchange rate
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)