# Exchange Rates and Their Determination Basic Model by alicejenny

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```									             Chapter 12: Exchange Rates and Their Determination: A Basic Model

Introduction

The familiar tool of supply and demand analysis works very well in explaining exchange
rates.

Volatility, or the frequent changes of exchange rates, is a source of aggravation for

Exchange Rates

The demand for foreign currency is derived from the demand for foreign goods and
services.

The exchange rate is the price of one country’s currency in terms of another.

The demand for a currency relative to the supply of that currency will determine the
exchange rate just as the demand for gasoline relative to the supply of gasoline
determines the price of gasoline.

An increase in the value of a currency is referred to as appreciation.

A decline in the value of the currency is referred to as depreciation.

When the exchange rate is quoted as a direct quote—domestic currency per unit of
foreign currency—an increase in the ratio means depreciation of the dollar.

When the exchange rate is expressed as units of foreign currency per unit of domestic
currency—an indirect quote—an increase in the ratio means appreciation of the dollar.

Table 12.1
Daily Quotations of Spot Foreign Exchange Rates
Currency per US
Exchange Rates                                                                                                    US \$ Equivalent                     \$
Country                        Thu.           Wed.           Thu.      Wed.
The foreign exchange mid-range rates below apply to trading among banks in
amounts of \$1 million and more, as quoted at 4 p.m. Eastern time by Reuters and   Kuwait (Dinar)                    3.3113        3.30808        .3030     .3023
other sources. Retail transactions provide fewer units of foreign currency per
dollar.                                                                           Lebanon (Pound)                 .0006605 .0006606            1514.00 1513.75
Currency per US
US \$ Equivalent                  \$               Malaysia (Ringgit)-b                  .2632          .2632    3.8001    3.8000
Country                        Thu.         Wed.           Thu.        Wed.       Malta (Lira)                      2.3906         2.3725        .4183     .4215
Argentina (Peso)-y                  .2736       .2751          3.655    3.6350    Mexico (Peso)
Australia (Dollar)                  .5504       .5488        1.8167     1.8223                   Floating rate          .0982          .0999   10.1850 10.0150
Bahrain (Dinar)                   2.6525      2.6525           .3770     .3770    New Zealand (Dollar)                  .4755          .4720    2.1030    2.1186
Brazil (Real)                       .2889       .2983        3.4620     3.3525    Norway (Krone)                        .1341          .1330    7.4588    7.5165
Britain (Pound)                   1.5559      1.5492           .6427     .6455    Pakistan (Rupee)                  .01688         .01688       59.225    59.225
1-month forward       1.5533      1.5465           .6438     .6466    Peru (new Sol)                        .2762          .2777    3.6205    3.6008
3-months forward      1.5478   1.5411     .6461    .6489   Philippines (Peso)               .01912       .01912        52.295     52.295
6-months forward      1.5396   1.5329     .6495    .6524   Poland (Zloty)                    .2419        .2406        4.1345     4.1565
Canada (Dollar)                 .6355    .6336    1.5736   1.5784   Russia (Ruble)-a                 .03158       .03158        31.665 .31.664
1-month forward      .6349    .6330    1.5750   1.5798   Saudi Arabia (Riyal)               .266        .2666        3.7509     3.7507
3-months forward       .6336    .6317    1.5783   1.5831   Singapore (Dollar)                .5653        .5639        1.7689     1.7735
6-months forward       .6314    .6295    1.5837   1.5885   Slovak Rep. (Koruna)             .02278       .02251        43.894     44.426
Chile (Peso)                  .001369 .001369     730.25   730.25   South Africa (Rand)               .0946        .0941       10.5755 10.6305
China (Renminbi)                .1210    .1210    8.2669   8.2669   South Korea (Won)              .0008299 .0008278           1205.00 1208.00
Colombia (Peso)              .0003561 .0003588   2808.50 2787.25    Sweden (Krona)                    .1083        .1073        9.2320     9.3182
Czech. Rep. (Koruna)                                                Switzerland (Franc)               .6739        .6652        1.4838     1.5034
Commercial rate      .03281   .03228    30.475   30.978            1-month forward          .6747        .6658        1.4821     1.5020
Denmark (Krone)                 .1328    .1315    7.5318   7.6051           3-months forward          .6759        .6670        1.4795     1.4993
Ecuador (US Dollar)            1.0000   1.0000    1.0000   1.0000           6-months forward          .6777        .6687        1.4756     1.4954
Hong Kong (Dollar)              .1282    .1282    7.7998   7.7999   Taiwan (Dollar)                  .02894       .02887        34.560     34.640
Hungary (Forint)              .004061 .004011     246.22   249.34   Thailand (Baht)                  .02328       .02330        42.960     42.920
India (Rupee)                  .02067   .02067    48.390   48.380   Turkey (Lira)                 .00000060 .00000060         1665000 1668000
Indonesia (Rupiah)           .0001108 .0001111     9025     9000    United Arab (Dirham)              .2723        .2723        3.6730     3.6730
Israel (Shekel)                 .2091    .2088    4.7825   4.7900   Uruguay (Peso)
Japan (Yen)                   .008243 .008214     121.32   121.74                     Financial      .03636       .03584        27.500     27.900
1-month forward .008255 .008227        121.14   121.55   Venezuela (Bolivar)             .000681     .000689        1468.25 1451.75
3-months forward .008279 .008251         120.78   121.20   SDR                              1.3158       1.3094          .7600     .7637
6-months forward .008314 .008287         120.28   120.67   Euro                              .9864        .9767        1.0138     1.0239

Jordan (Dinar)                 1.4104   1.4104     .7090    .7090
Special Drawing Rights (SDR) are based on exchange rates for the US, British,
and Japanese currencies. Source: International Monetary Fund.

a-Russian Central Bank rate. B-Government rate. Y-Floating rate.

Source: Adapted from Wall Street Journal, September 20, 2002, p. C16.

The spot market for foreign exchange is the market where transactions are concluded at
the same time the price is agreed on. To measure the percentage appreciation or
depreciation of the spot rate over time using direct quotes, the following equation is used:

%  in Spot Rate = [(beginning rate – ending rate)/beginning rate] * 100

When showing movements in the exchange rate over time, a rise in the exchange rate
means the domestic currency has depreciated, and if the exchange rate falls, the domestic
currency has appreciated.

Figure 12.1 indicates the US dollar has both appreciated and depreciated against the four
major currencies at different points in time.
Figure 12.1

The Demand for Foreign Exchange

Demand for foreign exchange – the demand for the currency of one country by
residents of another country
Figure 12.2

It results from domestic residents demanding foreign goods and services.
The exchange rate is simply the price of foreign exchange.
Example: The U.S. buying British Jaguars  cost 30,000 pounds. The dollar price
depends on the exchange rate.

If the exchange rate is:

   \$3 per pound, a Jaguar would cost \$90,000.
   \$2 per pound, a Jaguar would cost \$60,000 and a larger quantity would
be demanded.
   \$1 per pound, a Jaguar would cost \$30,000 and a still larger quantity
would be demanded.

As the exchange rate decreases, the dollar appreciates and Jaguars become less expensive
and quantity demanded increases.

There is a change in quantity demanded when the only thing that changes is the price of
the Jaguar. The same principle applies to all British goods and services in general such
as British vacations, and stocks and bonds.

If any other factor that influences the demand for the good in question changes, the entire
demand curve shifts.

Shifts in Demand for Foreign Exchange

The changes in demand for foreign exchange are related to:

1.   The country’s tastes and preferences
2.   Income level
3.   Relative price levels
The two most important factors that shift U.S. demand for British pounds are:

1. Changes in U.S. income
2. Prices in U.S. relative to the prices in the UK

This analysis can be generalized to other countries.

Figure 12.3

Changes in Domestic Income

If U.S. income changes, the demand for British goods will change along with the demand
for most other products, both foreign and domestic.

A U.S. income increase generates a rightward shift of demand for British pounds. This
also accompanies an increase in demand for British goods and services. It shifts the
original demand curve to the right to D1. At any given exchange rate, the amount of
British pounds demanded in the foreign exchange market is higher because U.S. income
is higher. A decline in U.S. income would do the opposite. There would be movement to
the left from the original demand curve to D2. When U.S. GDP rises rapidly, personal
disposable income of U.S. citizens also increase and the demand for British goods
increases as well. A U.S. recession will cause a decrease in the demand for British
goods.

Changes in Relative Prices

An increase in British prices with no change in exchange rates would cause the price of
Jaguars and other goods to increase in the U.S. market. This would cause U.S. citizens to
substitute U.S. goods for previously preferred British goods. It causes a decline in the
demand for British pounds, shifting the demand curve to the left. The reverse would
happen if U.S. prices rose relative to British prices. The U.S. people would purchase
more inexpensive British goods and the demand for pounds would also increase.
Summary

If domestic prices increase relative to foreign prices, then the demand for foreign
exchange will increase. If foreign prices increase relative to domestic prices, then the
demand for foreign exchange will decrease.

Countries with higher levels of inflation relative to their trading partners would tend to
experience an increase in demand for foreign goods and exchange causing a depreciation
of domestic currency over time.

In a simple model of exchange rate determination, three important factors tend to cause a
change in demand for foreign exchange:

1. A change in domestic income
2. A change in foreign prices
3. A change in domestic prices

1. The rate of growth of domestic income would tend to affect imports.
2. The rate of foreign economic growth would tend to affect exports.
GDP and income are highly correlated.

A positive percentage indicates that U.S. incomes were rising more slowly than income
in the fifteen largest trading partners.

Box Graph

Looking at the graph, it is possible to see that:

1. U.S. income growth was slow from 1990-1991. This was a recession.
2. There were narrowed differentials during the 1990s to less than one percent.
3. There was a large negative growth during 1998 due to an exceptionally large growth
in the U.S. economy.
4. The U.S. economic growth slowed during the late 1990s and differentials became
positive.

Everything else equal, a positive growth differential for the U.S. would tend to decrease
imports and increase exports. A negative growth differential would tend to increase
imports and decrease exports.

Domestic income versus foreign income is an important factor in exports and imports.

The Supply of Foreign Exchange

The supply of foreign exchange is the amount of foreign exchange supplied in the
foreign-exchange market.

For example, if a British importer wishes to buy a U.S. computer costing \$100,000 then
he would have to obtain the requisite dollars from a British bank by exchanging pounds
for dollars. If the exchange rate were two dollars per pound, then the importer would
have to exchange (supply) 50,000 pounds.

This British demand for dollars to buy U.S. Goods effectively creates a supply of pounds
in the foreign exchange market.

Consider now, if the exchange rate were one dollar per pound. At an exchange rate of
1:1 there would be less computers sold to British importers and would be fewer pounds
supplied in the foreign-exchange market.

If the rate were 3:1 the effect would be opposite of the example stated previously. More
computers would be sold to British importers and there would be more pounds supplied
in the foreign-exchange market.
Figure 12.4

When a change in the exchange rate causes a movement along this supply curve,
everything else being constant, it is called a change in the quantity supplied.

We have implicitly assumed that the British demand for U.S. goods is elastic. This
means that as the pound price of U.S. goods declines the increase in the quantity of U.S.
goods demanded is larger than the fall in price. Under these conditions the total revenue
of the exporting firm increases and the supply of pounds is positively sloped. Under
conditions when the demand for U.S. products is inelastic the supply of pounds will be
negatively sloped.

The amount of domestic currency supplied to the foreign-exchange market depends on
the foreign demand for imported goods.

Page 249: On currency substitution.
Guillermo Calvo and Carlos A. Vegh, “Currency Substitutions in High Inflation
Countries,” Finance and Devleopment, March 1993, 30(1), pp. 34-37.

Shifts in the Supply of Foreign Exchange

As was true with the demand for foreign exchange, the supply of foreign exchange can
shift in response to changes in the factors that influence it. The two most important
factors that shift the supply of foreign exchange are changes in income and relative
prices.

Changes in Foreign Income

What would happen to the supply of pounds in the foreign-exchange market if Britain’s
income rises?
As British income rises, the demand for all goods and services rises. As British importers
purchase more U.S. products, they would need to sell more pounds in order to obtain the
necessary dollars. As a result, there is a change in the supply of foreign exchange at any
given exchange rate. This rightward shift in the supply of foreign exchange is illustrated
in figure 12.5 as the movement of the original supply curve to the curve labeled S1.

The reverse would occur if income in the U.K. fell. This shift is illustrated in figure 12.5
as the movement to the curve labeled S2.

Changes in Relative Prices

If prices in the U.K. rise relative to prices in the U.S., then the British demand for U.S.
exports would rise. The increase in the supply of foreign exchange occurs as British
consumers substitute relatively higher-priced domestic goods for relatively lower-priced
U.S. goods. This effect is represented by a rightward shift of the supply curve (to S1) in
Figure 12.5.

An opposite effect would occur if U.S. prices rose relative to British prices, a leftward
shift of the supply curve (S2) in Figure 12.5.

Figure 12.5

Equilibrium in the Foreign-Exchange Market

The concept of demand and supply of foreign exchange can now be combined to explain
the concept of the equilibrium exchange rate.

Equilibrium exchange rate is the exchange rate where the quantity demanded of foreign
exchange equals the quantity supplied.

The amount of pounds U.S. consumers want to purchase exactly matches the number of
pounds the British are willing to supply in order to obtain dollars. “Exactly” may be hard
to understand because exchange rates fluctuate over the course of a trading day and
considerably more over longer periods of time. The graph shown should be thought of as
an equilibrium that the foreign exchange market would achieve if everything else
remained the constant. However, exchange rate move very quickly as economic
conditions and expectations change.

Figure 12.6

Figure 12.6 The Equilibrium Exchange Rate Given income and relative prices in the U.K. and
the U.S., the equilibrium exchange rate is \$2 per pound.

Figure 12.7

Figure 12.7 Changes in U.S. Income and the Equilibrium Exchange Rate An increase in
American income causes a rightward shift in the demand for pounds. Everything else equal, the dollar
would tend to depreciate.

The effect of changes in income and relative prices on the equilibrium exchange rate:
The demand for imports in the U.S., and the demand for British pounds have increased.
With the supply of pounds held constant, the exchange rate has increased from two
dollars per pound to three dollars per pound. The demand for pounds has increase
relative to the supply and the price for the pounds relative to dollars has risen. A
plausible explanation for this change is that U.S. incomes have risen and U.S. demand for
imports has increased. With no changes in British income or relative prices, the
exchange rate would tend to increase.

A second situation would be, suppose prices in the U.S. are rising faster than prices in the
U.K. Rising U.S. prices would tend to shift the demand for pounds outward and to the
right (increase) as U.S. consumers buy more relatively inexpensive British goods. Also,
the supply of pounds would also shift to the left as U.S. exports fall as U.S. goods
become relatively more expensive. The new equilibrium exchange rate is shown at three
dollars per pound, which is the intersection of the new demand and supply curves.

The general principle is that countries with relatively high or low rates of inflation will
tend to have currencies that depreciate or appreciate over time. The depreciation of the
currency in the foreign exchange market is simply the market’s way of compensating for
differential rates of inflation.

There are of course many different combinations of events that could shift the demand
and/or supply of foreign exchange and thereby change the exchange rate.

Figure 12.8

Figure 12.8 Changes in Relative Prices and the Equilibrium Exchange Rate An increase in
American prices would cause the dollar to depreciate. This occurs because the demand for imports would
increase while the amount of exports demanded by the British would decrease.

Box: The Dollar as a Vehicle Currency

An estimated 90 percent of foreign exchange trades involve the dollar. The dollar is truly
an international currency.

TABLE 12.2
Impact of Changes in the Demand and Supply
Of Foreign exchange on the Equilibrium Exchange Rate
Change in the Dollar-Pound
Change in Determinant                                             Exchange Rate
Increase in U.K. demand for U.S. Exports                          Appreciation
Decrease in U.K. demand for U.S. Exports                          Depreciation
Increase in U.S. demand for U.K. Exports                          Depreciation
Decrease in U.S. demand for U.K. Exports                          Appreciation
Increase in U.S. Prices                                           Depreciation
Decrease in U.S. Prices                                           Appreciation
Increase in U.K. Prices                                           Appreciation
Decrease in U.K. Prices                                           Depreciation
Increase in U.S. Income                                           Depreciation
Decrease in U.S. Income                                           Appreciation
Increase in U.K. Income                                           Appreciation
Decrease in U.K. Income                                           Depreciation

within a large country such as U.S and Brazil (which was presented in this chapter

Exchange rate changes can be mitigated to a certain extent through use of forward or
future markets for foreign exchange:

 They are not free.
 Purchased for some cost.
 Changes in exchange rates are difficult to forecast in the long run and impede
the ability of individuals and businesses to make plans over any time horizon
longer than 6 months.
 Direction of the effect is no doubt negative, but exact magnitude of the effect is
not known.
 This type of risk and uncertainty does not exist in domestic trade.

Fluctuations in exchange rates have also led to a cottage industry in forecasting exchange
rate changes:

 Need reasonably accurate forecasts of changes in 2 countries GDP as well as
similar forecast of changes in their price levels.
 A forecast would frequently mis-forecast actual exchange rates in the future.
 The basic supply and demand model described in this chapter is a useful
representation of the world producers and consumers face in the long run.

Box: Current Exchange Rate Arrangements

 The International Monetary Fund classifies the exchange rate of a country into
1 of 9 different categories (Table 12.3 shows the countries in each category)
 184 countries in Table 12.3
 46 are independently floating (exchange rate is allowed to find its equilibrium).
 54 countries have a managed float (managed float is a situation market
determined, but central bank may buy and sell foreign exchange to influence the
exchange rate).
 Remaining countries either have a fixed exchange rate or exchange rate with
limited flexibility.

Table 12.3 (pg 256-259)
Key Concepts

Exchange rate - the price of one currency in terms of another

Appreciation - an increase in the value of a currency

Depreciation - a decrease in the value of a currency

Demand for foreign exchange - the demand for the currency of one country by residents
of another country

Supply of foreign exchange - the amount of foreign exchange supplied in the foreign-
exchange market

Equilibrium exchange rate - the exchange rate where the quantity demanded of foreign
exchange equals the quantity supplied

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