EXCHANGE RATE DETERMINEATION

National Balance of Payments;

International Monetary Systems;

Methods of determining exchange rates:

Methods of determining exchange rates:

• Balance of payments approach;• Monetary Approach;• Sterilised and Unsterilized Intervention • PPP and overshooting - Disequilibrium

Theory;• Portfolio Balance theory;• Technical Analysis;• Foreign Exchange Market Efficiency.

National balance of payments

• A record of transactions over a period between its residents and foreign residents national cash flow.

• Transactions include:· Exports and imports of goods and

services;· Cash receipts and payments;· Gifts;· Loans and investments.

National balance of payments

• Balance of payments Accounts classify transactions into four major groups:

· Current Account – goods and services and unilateral transfers (gifts and grants);

· Capital Account –measures international economic transactions of financial assets i.e. direct, portfolio & other investments

· Statistical errors – errors and omissions;· Official reserve – Official reserve assets and foreign

official assets.

Balance of Payment

Current Account

Net Goods Trade (BOT)

Net Service Trade

Net Income

Net Current Transfers

Capital Account

Direct Investment

Portfolio Investment

Other Investment

Official Reserves

Statistical Error

Balance of payments approach.

• Current account - ignoring the capital account

Fixed exchange rate – Current account deficit (higher national

income):importing current account deficit currency weakens.

– Domestic government: sells foreign currency buys domestic currency correction in the current account.

• Similarly for a surplus, purchase of foreign currency and sale of domestic currency corrects.

Balance of payments approach.• Current account - ignoring the capital account.

Floating regime – Current account deficit (= higher national income):

excess importing demand for foreign currency at the expense of domestic currency buying of foreign currency domestic currency weakens exports more competitive improving the current account.

– Current account surplus - demand for domestic currency causes appreciation. This makes exports less competitive and improves the current account balance.

Balance of payments approach.

Considering the current account and capital account.

• Overall balance = current account + capital account. • Assume deterioration in the current account balance

(deficit).

• If the overall balance of payments is to be maintained at zero interest rate rise improves capital flows compensation for current account deficit dampens domestic demand reduces demand for imports.

• Interest rate increases can be used to avoid weakening of domestic currency. (Mundell 1967 and Fleming 1962).

Monetary Approach

• Excess money supply results to lower domestic currency exchange rate

• Restrictive money supply will increase the exchange rate of domestic currency

Expansionary Monetary PolicyCurrent Account

1. Domestic GDP will increase2. Resulting in demand for import and current account

to deteriorate3. Need to convert domestic currency to foreign

currency will increase4. This will decrease the exchange rate of domestic

currency

Expansionary Monetary PolicyCapital Account

1. Real interest rates will decline2. Foreign investment will decline due to lower rate of

returns3. Domestic investors will invest in foreign countries4. Causing capital account deficit5. Decline in domestic investment by foreigners and

residents will decrease the demand of domestic currency and increase foreign currency demand

6. Resulting in depreciation of domestic currency

Monetary Approach• Monetary theory suggests prediction of exchange

rates can be made on the basis of inflation and interest rate differentials based on PPP.

• But PPP is a long-term phenomenon – money supply and prices tend to move slowly whereas exchange rates change rapidly.

Sterilized and Unsterilised Intervention

SterilizedThe purchase or sale of foreign currency or government securities by a central bank to influence the exchange value of the domestic currency, without changing the monetary base.

UnsterilizedAn attempt by a country's monetary authorities to influence exchange rates of domestic currency by allowing monetary base to change. This does not include buying or selling domestic or foreign currencies or assets

Sterilised and unsterilized intervention• US wishes to raise the value of the dollar relative to

the German mark. · The US Federal Reserve Bank buys dollars with DM;· The Bundes bank sells DM for dollars.• The demand for dollars will increase and the supply DM will

increase.

• Effect of:· Reducing the US money supply and inflation;· Increasing the German money supply and inflation.

· Changing interest rates in both countries.

Sterilised and unsterilised intervention• Unsterilized intervention.

• Federal Reserve Bank buys domestic Treasury bills and the Bundes bank sells German Treasury bills:

· The public will hold more $ cash and fewer US Treasury securities;

· The public will hold less DM cash and more German Treasury bills;

· This money supplies in both countries can return to their pre-intervention levels.

• Sterilised Intervention through open-market operation.

• Assumes investors consider US and German bonds to be perfect substitutes.

International monetary systems· Free Float· Managed Float· Target Zone Arrangements· Fixed rate Systems

INTERNATIONAL MONETARY SYSTEMS IN PRACTICE

· Gold Standard;· Bretton Woods System· Floating Systems· European Monetary System· European Monetary Union

Disequilibrium Theory of Exchange Rates

ExchangeRateS0,f0

0 t0 Time

Price Level

P0

0 t0 Time

InterestRate

i0

0 t0 Time

SLR = f1

PLR

i1

Portfolio Balance Theory

• Assumes money and foreign bonds are not perfect substitutes.

• Exchange rates are partially determined by supply and demand for money and partly by supply and demand for other assets.

Portfolio Balance Theory

Increase in Impact on domestic currency

Supply of home country bond depreciate

Supply of foreign country bond appreciate

Domestic interest rate appreciate

Foreign interest rate depreciate

Home Wealth appreciate

Home country surlus appreciate

Portfolio Balance Theory

NominalInterest b1

Rate (i) m1

b

m

Depreciation of home currency.

The role of news• Simple method of prediction of exchange rates?

• Theories: • They may contradict each other;

· Are unable to predict shocks and surprises.

• Unpredictable Events = News.

• This may affect:• Interest rates, • Inflation, • Incomes • Exchange rates. • Short-term deviation from PPP equilibrium

Technical Analysis

• Identifying trends in price movements or exchange rates in order to predict future prices or rates.

• Efficient Markets Hypothesis? CurrencyRate

Time

New Trend

Foreign Exchange Market Efficiency• Giddy and Duffy (1975) - except for very short periods trading rules

are no use in forecasting foreign exchange;

• Cornell and Dietrich (1978) - weak-form efficiency of Forex markets.

• Rogalski and Vinso (1977) - Forex markets semi-strong form efficient

• Poole (1967)- serial correlation implying rejection of random walk - Filter rules yielded substantial profits (method problems).

• Sweeny (1977) - filter rules yielded significant excess profits.

• Takagi (1991) - Chartism works for short-run forecasts PPP for longer-run forecasts.