CHAPTER 19WHAT DETERMINES EXCHANGE RATES?Objectives of the ChapterIn the short run, fluctuations in exchange rates can be related to demands for and supplies of assets denominated in different currencies—what we call ―the asset market approach to exchange rates.‖ Here, we revisit the international financial investors and incorporate the impact of interest rate differentials and exchange rate expectations into the determination of the current spot exchange rate.In the long run, purchasing power parity suggests that movements in exchange rates are determined by differences in countries’ inflation rates. The ―monetary approach to exchange rates‖ explains inflation rates as functions of relative demands for and supplies of domestic and foreign monies. Linking the two, we get a model that ties exchange rates to ―fundamentals‖ such as incomes and relative money supplies. After studying Chapter 19 you should be able to explain1. the impact of interest rates on the current exchange rate.2. the impact of expectations about future spot rates on the current exchange rate.3. what exchange rate overshooting is, and why it can occur.4. how short-run exchange rate movements can diverge from what would be predicted by marketfundamentals.5. the purchasing power parity hypothesis, in both its absolute and relative forms.6. the quantity theory of money in a two-country world.7. the difference between nominal and real exchange rates.Important ConceptsAsset market approach Explains exchange rates in terms of demands and supplies to exchange rates: of all assets denominated in different currencies. The monetaryapproach to exchange rates is a variant of this approach in whichonly demands and supplies of the money asset are considered. Bandwagon: A situation in which investors expect the recent trend in exchangerates to extend into the future.Law of one price:Asserts that a single commodity will have the same price everywhereonce the prices are expressed in the same currency. This is anotherway of stating the purchasing power parity hypothesis. It seems to betrue chiefly for commodities that are standardized and heavily tradedinternationally.Monetary approach Seeks to explain exchange rates by focusing on the demands to exchange rates: for and supplies of national monies.Nominal bilateral exchange rate: The exchange rate we see quoted in foreign exchange markets.Nominal effective exchange rate: The weighted-average exchange value of a country’s currency,where the weights reflect the importance of the other countries int he home country’s total international trade.Overshooting: When the exchange rate is driven past its ultimate equilibrium rate(usually thought to be the PPP level), and then back to that rate later,during the adjustment of the macroeconomy to an exogenous shock.This effect is the consequence of goods prices that are sticky in theshort run.Purchasing power parity: In its absolute form, this hypothesis says that the exchange rate willequal the ratio of the domestic price level to the foreign price level,or e= P/P f. (In its relative form, the hypothesis states that thedifference over time in inflation rates will be offset by changes inthe exchange rate over that period)] An approximation of relativepurchasing power parity is [e future–e today]= [(inflation rate at home)minus (inflation rate in the foreign country]).Quantity theory Theorizes that, in any country, the money supply is equal to the of money: demand for money, which is directly proportional to the value ofnominal gross domestic product. This is symbolized as M = kPY.Here, money’s only role is as a medium of exchange.Real exchange rate: A way of measuring the price of foreign goods, not just in currency-adjusted terms, but also in price-level-adjusted terms. The realexchange rate on a currency at any moment in time is calculated as:[(foreign cost of home currency) x (P/P f) x (100)]. If purchasingpower parity holds between the two countries, the real exchange ratewill be 100. When the real exchange rate is above 100, the homecurrency is overvalued and the foreign currency is undervalued;when the real exchange rate is less than 100, the home currency isundervalued and the foreign currency is overvalued.Speculative bubble: A self-confirming upward or downward movement in a price (here,the exchange rate) that is out of line with the changes in thefundamental factors that determine the price of that object.Warm-up QuestionsTrue or False? Explain.1. T / F An expectation that the yen will appreciate can cause the yen to appreciate.2. T / F An increase in the domestic interest rate will cause the home currency to depreciate.3. T / F International interest rate differentials drive exchange rates in the short run; internationalprice differentials drive exchange rates in the long run.4. T / F The purchasing power parity hypothesis is unlikely to be true for countries that do nottrade commodities internationally.5. T / F If the inflation rate in the United States is lower than the inflation rate in France, the eurowill depreciate relative to the dollar.Multiple Choice1. If there is a sudden five percent decrease in the domestic money supply, we should expectA. the domestic currency to appreciate by five percent in the long run.B. the domestic currency to appreciate by six percent in the short run.C. the foreign currency to depreciate as demand for foreign assets decreases.D. all of the above.2. Under the asset market approach, if both U.S. and British interest rates rise by three percentagepoints, we could expectA. the dollar to appreciate.B. the dollar to depreciate.C. the exchange rate between the dollar and the pound to remain unchanged.D. investors to move their funds to a third country.3. If a country’s nominal interest rate increases b y the same percentage that the inflation rate hasincreased,A. international investors will withdraw their funds from the country.B. international investors will pour more funds into the country.C. international investors will demand an increase in the real interest rate they are paid.D. none of the above.4. All other things being equal, if the British government increases the money supply by 5% whilethe British economy is experiencing 5% real growth, the exchange rate on the pound will beA. unaffected.B. higher.C. lower.D. a mystery.5. All other things being equal, which of the following would not cause the price of a foreigncurrency (e) to fall?A. A rise in the home country’s expected inflation rate.B. A rise in the foreign coun try’s expected inflation rate.C. A drop in the foreign country’s real income.D. A rise in the foreign country’s money supply.Problems1. What impact will each of the following events have on the current spot exchange rate betweenthe Saxon scudo (Ss) and the Leinster lira (Ll)? You should assume that each event was notpredicted in advance.a. Leinster residents expect the scudo to appreciate.b. Saxony’s new government was voted in on a ―Whip Inflation Now‖ platform.c. A change in saving behavior causes the real interest rate in Leinster to increase.d. The Minister of Trade announces that Saxony has incurred a much larger trade deficit thanhad been predicted.e. An earthquake flattens the major telephone factory in Leinster.f. The Minister of Finance in Leinster is charged with embezzling one billion lira from theTreasury.2. Consider the following information:▪Today’s spot exchange rate between the scudo and the lira is Ss 100/Ll.▪People believe that in the next 90 days the lira is going to appreciate to Ss 101/Ll.▪The 90-day interest rate in Saxony is 2 percent; the 90-day interest rate in Leinster is1.5 percent.a. Does uncovered interest parity hold?b. If it does not hold, at what current spot rate would it hold?3. A group of Saxon economics students is planning to spend a summer in Leinster when theygraduate from college in two years. Obviously, they are concerned about how much it will cost to vacation in Leinster. They know that, currently, the typical vacation basket of goods costs 12,000 scudos in Saxony; the same array of goods costs 120 lira in Leinster. The exchange rate now isSs 100/Ll. Suppose they have taken a course in international finance and know that the newlyelected Finance Minister of Leinster is going to decrease the lira supply by one-third in the next two weeks.a. What can the students expect the exchange rate on the lira to be when they graduate in twoyears?b. Will that exchange rate be the same one they can expect to see in the next few months?4. Suppose the Saxon monetary authorities are prone to flooding their country with new scudo,whereas Leinster’s government officials hate t o increase the supply of lira. In light of this, what would you expect to be the long-run trend in the exchange rate between the scudo and the lira?5. Calculate the real exchange rate on the British pound, assuming the following hypothetical data:e = $2/₤P UK = ₤150P US = $2006. Suppose the U.S. price level in 2008 is 120 (where the year 1998 = 100) and the price level inMexico is 180 (where the year 1998 = 100). The exchange rate in 1998 was 150 Mexican pesos per U.S. dollar. According to the purchasing power parity hypothesis, what would be theequilibrium exchange rate between the peso and the dollar in 2008?7. The ―Cambridge k‖ from the money demand formula is thought to depend on behavioralvariables that do not change much in the short run. Suppose that some sort of financialinnovation in the United States causes ―k‖ to decrease. (A good example might be theproliferation of credit cards.)a. What impact would this have on the demand for money in the U.S.?b. What impact would this have on the exchange rate between the dollar and the Mexican peso?Discussion Topics1. If the prices of goods and services are flexible even in the short run, will exchange rateovershooting occur?2. Try to match recent changes in the exchange rate of some currency to political events in thatcountry, such as elections or new criminal investigations; also compare changes in the exchange rate to economic ―news‖ about the country’s budget or trade balance.3. Discuss how a substantial movement away from free trade would nullify the purchasing powerparity hypothesis.4. If a country wants to peg its exchange rate, should it peg its nominal rate or its real rate?5. What would you expect to happen to the currency value of a country engaged in war? Relateyour answer to the observation that few countries maintain fixed exchange rates during periods of war.。