Intl Economics – Chapter 12: Exchange Rate Determination


[Music] Interest rates and inflation drive a currency's exchange rate: when combined, both signifya country's relative level of economic health.

Currency Exchange rates play a vital rolefor commercial trade activities.

Because of that importance, exchange ratesare the most watched, analyzed and governmentally manipulated economic measures.

Currency Exchange Rates are also importantat the business operations level: as they impact the real return of an investor's portfolio.

We will discover some of the major forcesbehind exchange rate oscillations! In this chapter we will explore the factorsthat underlie currency value movements.

These factors include market fundamentalsand market expectations.

We will experiment with the determinants ofexchange rate fluctuations as behaving different in the short-run versus the long-run.

Although exchange rate overshooting can persistfor significant periods, fundamental forces tend to push the currency back to its long-runequilibrium path.

We will begin by considering how exchangerates are determined in the long run by studying relative productivity levels, relative pricelevels, consumer preferences for domestic or foreign goods, and trade barriers suchas tariffs and quotas.

Individually these factors give certain insightto the end result of exchange rate determinations, but when taken together a clearer pictureof their synergistic effect is formed.

According to the purchasing power parity approach,changes in relative price levels determine exchange rate fluctuations over the long-run.

A currency maintains its purchasing powerparity if it depreciates by an amount equal to the excess of domestic inflation over foreigninflation.

In the short-run, decisions as to which assets- domestic or foreign – are more preferable to hold, play a primary role in exchange ratefluctuations.

According to the asset market approach toexchange rate determination, investors consider two key factors when deciding between domesticand foreign investments: relative interest rates and expected changes in exchange rates.

Modifications of these factors result in exchangerate fluctuations that we observe in short run trends.

Another factor influencing exchange ratesis the phenomenon of exchange-rate overshooting.

An exchange rate is said to overshoot whenits short-run response to a change in market fundamentals is greater than its actual long-runresponse.

Finally, we will consider the methods thatcurrency forecasters use to predict exchange-rate movements, as judgmental forecasts, technicalanalysis, and fundamental analysis.

[Music] As I said earlier, we should treat currencies as a commodity.

With that approach in mind, it is reasonableto apply the "supply and demand" principle to identify forces determining a currency'sequilibrium value.

Unfortunately, that is where the ease of priceforecasting ends.

The factors influencing supply and demandare unique when applied to such a specific commodity as money.

These factors representing economic variablesfall into the category of Market Fundamentals.

They range from productivity and inflationrates to consumer preferences, and government trade policies of the subject nation and allof its major trading partners.

Market expectations are associated with the"human factor".

When multiple nations are involved in currencytransactions, a substantial amount of individual forecaster expectations influence decisionmaking choices.

Forecast horizons for exchange rate changesexpress a time interval expected forecasts will be realized within.

These are highly variable, and are groupedas short-term speculative lasting a few days or weeks, medium-run cyclical – lasting afew months, to long-run structural – lasting from one to five years.

Often it happens that a long-run, or evena medium-run forecast will be adverse to the short-term forecast, but this is not an indicationof forecast errors.

Often spot exchange rates between currencieswill counter-react to economic policies enacted for long-term growth, or to changing economicactivities enacted for mid-term goals.

It is common for these forecasts to differin their specificity with the shortest-term predictions focusing on specific rate estimates,broadening for the medium-run predictions to be seen "within a range" of values.

The longest-run predictions are necessarilyviewed as a trend-line type of forecast indicating the direction of anticipated trends.

Some of the more advanced long-term predictionsdepart from the straight-line forecasts to make predictions of future value moderatingreturn to general baseline conditions.

[Music] Long-run exchange rate predictions are based on a variety of macro-economic forces suchas relative price levels, productivity levels, consumer preferences for foreign or domesticgoods, and trade barriers.

Because of the interactive nature of thesefactors, a change in one variable in a positive direction can be offset by a counter movingvalue for an associated variable.

Domestic productivity may increase while tradebarriers increase and the offsetting effect on the domestic currency exchange rate mayremain unchanged.

The relative effects of each category of changeare not uniform for the domestic currency, but when interactions with exchange ratesfor other currencies are considered, the offsetting factors require counteracting balances.

For example, we can consider the exchangeof US Dollars and British Pounds while evaluating effects of relative price levels, productivitylevels, country of origin preferences, and effects of trade barriers.

We look into each category of change to explorethe impacts.

Domestic price levels are an indicator manydomestic firms use as a barometer of acting economic forces while making daily businessdecisions.

It is the information first made availableto most analysts.

We may consider the effect of domestic pricesrapidly climbing in the US, while they remain stable in the United Kingdom.

This results in an increase for imported goodsfrom the UK, because of the price comparative advantage.

This in turn increases the demand for UK Pounds,purchased by US companies so they can import more UK made goods.

At the same time, the US made goods are pricedrelatively higher in the UK, making the supply of Pounds decrease.

The increase in the demand for Pounds, metwith the decrease in Supply for Pounds establishes a new equilibrium intersection of the supplyand demand curves establishing a new currency price.

In this simplistic example, the quantity remainsconstant, but that is not obligatory for real life situations.

Productivity is a leading national characteristicdetermining competitive power globally.

It moves to the fore when other inputs toproduction remain constant, increasing domestic output as a result of maturing industrialtechniques, and established workforces.

In highly developed economies, the productivityfactor extends well beyond manufacturing sectors to include technology, services, and otherspheres of a national economy.

In this example, we will look into an increasein productivity in the US, while UK productivity remains constant.

When exported to the UK, US goods become lessexpensive as compared to UK goods, product demand increases causing an increase in thesupply of Pounds – a supply curve shift to the right.

Also, the US demand for UK goods drops, thedemand for Pounds will decrease causing a shift to the left of the demand curve forPounds.

The result is an appreciation of the US Dollaras compared to the British Pound and the currency exchange changes from $1.

50 to $1.

40 per pound.

Again, the shift in value was seen with nochange to volume.

Country of origin preferences may be the resultof effective marketing efforts, or consumer choice of better designed products, or perceptionsabout differences in quality, or because consumers seek just plain good deals.

Assume US consumers develop a stronger demandfor UK produced goods.

Because of the stronger demand, US importersdemand more pounds to purchase their products.

The demand for Pounds shifts to the right,causing a new equilibrium between price and quantity to establish.

Interestingly, an increased demand for a country'sexports causes its currency to appreciate in the long-run, while increased demand forimports, results in the devaluation in the domestic currency.

We have earlier investigated barriers to tradebetween countries that serve to modify the demand for foreign products by creating anincreased demand for domestic import-competing products – on a cost basis.

The effect of those barriers on currency valuesbecomes obvious with a decrease in consumption of imported goods, as they enter the domesticmarket.

Since the demand for the foreign made goodsdecreases, it also decreases demand for British Pounds, causing a shift to the left of thedemand curve and a new equilibrium price and quantity established for Dollars per Poundrate in the international currency market.

In this situation the US Dollar appreciatesfrom $1.

50 to $1.

45 per Pound, while the quantity decreases from 6 to 5 million pounds.

Trade barriers generally cause currency appreciationin the long-run for the country imposing trade barriers.

[Music] [Music] many economists believe exchange rates should eventually adjust to make theprice of a basket of goods the same in each country but the average basket ofgoods in America is different from the average basket in China to overcome thisproblem the Economist introduced the Big Mac index in 1986 because apart from afew exceptions the Big Mac has the same ingredient worldwide comparing the priceof the Big Mac in different countries we can see which country's currencies arecurrently under or overvalued but the theory does have some flaws while sesameseeds might be cheaper in China the cost of transporting them to America mighteliminate any profits and there are import taxes too it's not just theingredients that matter the price of labour and rent is different fromcountry to country and even if you can import all the goods unless yourMcDonald's you can't sell Big Macs so what can you use the Big Mac indexfor if you're an economist it still gives some indication how exchange rateswill move in the long run if you're a consumer it gives you a rough idea ofprices in other countries and how far your money will go and if you're reallyinto Big Macs it's your Travel Guide.

In Chapter 11, we introduced Purchasing PowerParity in the context of real and nominal exchange rates.

By combining those ideas with inflation ratesexisting in between national currencies, and price forecasting we will find extended applicationsof this concept.

Purchasing Power Parity involves the effectsof arbitrage and also the existing economic reality that consumers, where possible, willseek lower prices for identical goods in adjacent markets, and more directly within a singlemarket.

Taken to the next level, consumers will seekcomparable goods, with price adjustments, in nearest neighbor markets, or shipping fromadjusted markets, all to seek the "lowest adjusted price" for goods.

Sellers use the same strategies as they seekthe "highest price" to sell their goods, with similar distance adjusted factors.

Again, the uniqueness of currency as a commodity,plays into these discussions as a topic of most interest.

The "Law of One Price" asserts that identicalgoods, in different markets, will sell for identical currency adjusted prices.

Producers seek misaligned markets by locatingwhere their product families are not in sync with Purchasing Power Parity, signaling anopportunity for market development in the foreign land.

A bit of a misnomer, the "Law of One Price"has no official police enforcement squad.

Prices will normalize within economic realitiesof profitable decision making.

Barriers to Trade, shipping expenses, andcountry of origin concepts can easily erase arbitrage efforts.

The McDonalds' BIG MAC example delivers thismessage nicely and illustrates another measure of cross-country price arbitrage – consumertastes.

We explored Purchasing Power Parity as a toolto explain how prices of goods within countries serve to direct currency exchange rates.

In the long-run, currency exchange rates normalizeto make the cost of goods and services level-out across countries.

We can explore the example of US and Japantrade of steel, as an indicator of relative currency exchange rates illustrating how theconcept is applied to one product in two countries.

The example illustrates how changes in productprices indicate a change in the currency through cross-currency exchange rates, as appreciatingor depreciating in relation to each other.

Economists recognize the characteristics ofthese changes, but we are more interested in economy-wide price migrations in more thantwo countries.

In the US, the Bureau of Labor Statistics,the BLS, manages the longest running database of monthly price indexes, called the ConsumerPrice Index and the Producer Price Index, the CPI and PPI.

These provide users will an inflation indicatorfor the US within each sector of the economy, one for consumers and one for commercial producers.

These indices give users the ability to converta series of Nominal prices into Real prices, with inflation removed.

This allows analysts to make cross-sectorcomparisons of price differentials, while extending the nation's Real price migrationcycles to other nations.

The BLS maintains equivalent indices for ourmajor trading partners, based on the products from those countries as they are importedinto the US.

Of highest interest to economists is the relativeinflationary differences between one economy and another and how they interact.

Inflationary differentials will instigatecommodity price competition between products from different nations, a change in demandand supply for cross-currency trades.

Ultimately, exports and imports of goods andservices constitute a mechanism that makes a currency depreciate or appreciate, accordingto the Purchasing Power Parity theory.

The linkages identified within price indicesbetween nations, establish the connection between commodity prices and currency prices,giving a method for measuring comparative inflation rates and therefore, currency exchangerates.

We take a look at price indexes of the USand Switzerland using the variables seen here.

The Purchasing Power Parity theory directsus to create a ratio of the change in US prices over a set period of time divided by the ratioof prices in Switzerland for the same period, multiplied by an equilibrium exchange ratein the base period.

In this example, we can pull data from sourcessuch as the BLS, and currency exchange rates from Forex, to establish a simplistic predictionof long-run exchange rates.

In this example, we see US prices climbingby a factor of 100%, a result of inflation, while prices in Switzerland remain constant.

We have a current exchange rate of $0.

50 perSwiss franc.

Putting the numbers through the formula, wesee that the future exchange rate is expected to migrate to US$1.

00 per Swiss franc – theUS Dollar depreciates.

This is an easy migration calculation giventhe variables used, but in practice you would process your estimates with different variables,and would forecast both P1 and S1 to predict what the future exchange rates would be.

It is an interesting exercise to participatein, but it fails to incorporate all of the factors affecting currency exchange rates,such as trade barriers or new entrants to commodity or service markets.

Of critical importance becomes selecting "indicatorgoods" to serve as the cross-economy's talisman.

Indices such as the PPI from the BLS are goodstarting points for US analysts, but locating identical index measurements for trading partnerscan be difficult.

In the short-run, these estimates prove tobe weak, but their utility improves as projections are extended into the future.

Of course, the further out in time the projectionsare made, the higher the probability that political effects will influence the results,or that technological changes will alter prices.

We see an example of the US and England from1973 to 2003, where the UK price level increased about 99% as opposed to the US price level.

Following the Purchasing Power Parity theorylogic, the Pound depreciated against the Dollar, but only by about 73%, less than the PPP theorypredicted.

Other factors were at play when determiningsupply and demand for currency change and price predictions.

While studying this chart, it becomes evidentto us that PPP theory is not explicitly useful for the short-run, but it can provide long-runtrend forecasting.

Additional factors must be integrated intoaccurate predictive models – accounting for price level behavior, productivity trends,technological advances, country of origin preferences, or barriers to trade.

[Music] The Asset Market Approach may be one of those additional factors needed to increase forecastingaccuracy.

Currency exchange was initially establishedfor companies in different countries, using different currencies, making currency tradea key component of international trade.

In those early days of trading, there wereno computer networks, telephones, or even speedy land-mail systems.

It was done in person, often at the dock.

Today, as I have mentioned earlier, currencytrading has evolved to the level of trading commensurate with a commodity.

In fact, the daily trading in currencies,through the largest trading network in the world, is completed by investors in assetssuch as Treasury securities, corporate bonds, bank accounts, stocks, and real property,making up about 98% of all trades.

The remaining 2% of trades involves commodityexchange, the initial nexus of international currency trading.

During short periods of time, decisions madeto the effect of which kind of assets it is more important to hold – domestic or foreign- play a much greater role in exchange rate determination than demand for imports andexports does.

According to the Asset Market Approach, investorsconsider two key variables when deciding between domestic and foreign investments: first, therelative interest rate levels, and second, expected changes in exchange rates over theterm of the investment forecast.

These factors are attuned to the short-runforecast scenario, giving it an increased advantage for that purpose.

This summary table demonstrates some of thesefactors comparing the US and UK for a short-term investment horizon.

These are causal responses, but be preparedto apply changing values to these factors as they are applied to your industry.

Because investors are the primary playerson the field of currency exchange, understanding investment decisions for this sector willhelp to explain how decisions are made and executed.

The rate of return for an investment beginswith the establishment of the Nominal Interest Rate on an investment, within different investmentcountries.

This approach is like "chasing the Rabbit"to seek where high rates of return have been captured in the recent past.

Others will seek the emerging markets sportingsimilar characteristics.

As these "lands of opportunity" are identifiedand investments are made, the international flow of money will increase and currency valuationmigrations will be realized, from the less demanded – to the higher demanded currencies.

Currency Appreciation and Devaluation willensue, and economies will adjust to the changing reality.

We have walked through charts like these whileaddressing other migrations of prices, interest rates, supply and demand.

I invite you to track the shifts of the supplyand demand curves on these charts, understanding that these curves "shift to the left", and"shift to the right" identifying new equilibrium price and quantity solutions.

They are all in the textbook, so study them,and develop your personal understanding, and how you will "think like an economist".

Investment rates of return, inflationary forces,and predictions of the rising stars of international investments are considered strong factorswhen making investment decisions; there are other factors, sometimes less important, andsometimes of great importance.

Because of the substantial amount of corporateinvestors in the currency market and in the investment profession, caution is given toover-concentration in one investment class, or one region.

Decisions involve choices for commodity over-intensificationand country concentration.

Attention is given to Diversification of investmentexposure by spreading sectors of investment into different classes.

In a similar mode, decisions are made to diversifyinvestment countries to not put too much reliance on one country's rates of return.

Conversely, the Safe Haven Effect, emphasizesconfidence on investments in countries with a reliable track record of performance thatoverrides lower estimated rates of return.

These decisions are made on an investment-by-investmentbasis, with generalities and specifics investigated and understood.

In the day's other news: Federal Reserve BoardChair Janet Yellen affirmed that short-term interest rates are likely to rise again inthe coming months.

But she also left the door open to changingthose plans.

Yellen told a congressional hearing that arecent slowdown in inflation might make the Central Bank recalculate.

JANET YELLEN, Federal Reserve Chair: Monetarypolicy is not on a preset course.

We're watching this very closely, and standready to adjust our policy if it appears that the inflation undershoot will be persistent.

JUDY WOODRUFF: Separately, Yellen said theFed could begin to unload its massive bond holdings this year.

It bought government bonds during and afterthe recession in order to lower long-term interest rates and to boost economic activity.

Wall Street took heart from Yellen's talkof going slow on rate hikes.

The Dow Jones industrial average gained 123points to close at 21532.

That's a new record.

The Nasdaq rose nearly 68 points, and theS&P 500 added 17.

[Music] Since early 2014, business-news-consumers have listened to the US Federal Reserve Chairman,Dr.

Janet Yellen, make announcements about the Fed's decision to "raise interest ratessoon".

These announcements, as they are delivered,have immediate impacts on the stock market, interest rates, exchange rates, and investmentportfolios as investors react to this news with emotions.

Frequent changes in policy, or warnings ofchanges leading to unfavorable conditions contribute to volatile exchange rate responses.

In reaction to these policy related statements,investment patterns migrate to anticipated safe havens, or to reduced risk investments.

The volatility of international exchange ratesis intensified by the phenomenon of overshooting, when the short-term response to a change inthe macro-economic fundamentals, is greater than its observed long-term reality.

As we sit in late 2017, a new Federal ReserveChairman nomination for Jerome Powell is being promoted by the Whitehouse.

This brings with it an entire slate of newFederal Reserve realities to ponder.

The Phenomenon of overshooting will be mitigatedacross the realm of forecasters and forecasts.

[President Trump] Thank you very much, please.

I'm pleased to welcome members ofthe cabinet members of Congress and distinguished guests to the White HouseRose Garden this afternoon.

Also I want to welcomethe chairman of the Senate Banking Committee who's done an incredible jobMike Crapo, where's Mike please Mike great job appreciate it.

As president there are a few decisionsmore important than nominating leaders of integrity and good judgment to holdtrusted positions in public office and few of those trusted positions are moreimportant than the chairman of the Federal Reserve.

Accordingly it is mypleasure and my honor to announce my nomination of Jerome Powell to be thenext chairman of the Federal Reserve congratulations Jay.

We explore rate overshooting in terms of overshootingelasticity effects in the short run versus the long run.

The short run supply and demand schedulesof the UK Pound are explored.

We find the supply and demand line intersection,with equilibrium quantity at 60 billion Pounds, at a price of $2.

00 per Pound, in the shortrun.

If the demand for Pounds increases to D1,the US Dollar depreciates to $2.

20 per Pound, again in the short run.

This devaluation of the US Dollar leads tothe UK Price of US exports to decrease, the US exports to the UK increase, and thus, thequantity of pounds supplied to the US economy increasing through the foreign trade effect.

As more time elapses, the quantity of exportgrows, and the rise in the quantity of pounds supplied to purchase the US goods, increases.

The long run supply schedule of Pounds ismore elastic than the short run supply schedule, as shown here with easing of the elasticityof Supply.

Following the increase in demand for Poundsto D1, the long run equilibrium exchange rate is $2.

10 per Pound, for 150 billion Pounds,as compared to the short run price of $2.

20 per Pound.

Because of the effect of price elasticities,the Dollar's depreciation in the short run overshoots its long run depreciation results.

[Music] Creating reliable Forecasts of Exchange Rates involves extensive market research, constantattention to market forces, solid economic judgements, and a ton of good luck.

Nevertheless, short-term exchange rate forecastsare desired by exporters, importers, investors, bankers, foreign exchange dealers, and theforecasting Economist wanting to do it right.

A global industry has been formed to makethese projections, sometimes made public and often held confidentially by the clients payingfor the projections.

Econometric modelling combined with statisticalanalyses and economic projection formulas are combined to create forecasts of short-termto long-term projections, tempered by heuristic adjustments to prepare them for final clientuse.

Two levels of understanding are required,one for the analyst, and the other – for the user of the data.

Very often, a drastic prognostication of futureevents may not be anticipated by most, while a small group or even a single analyst willmake the projection, understanding current economic variables and the anticipated results.

Investment advisors using the data cannotsimply TRUST the analyst with their client"s hard-earned money, they need to understandit as well.

Several forecasting organizations have emergedin the US and abroad.

Their growth potential is based on their recordof achievements in good and bad economic times.

Forecasters tend to develop techniques toachieve a reputation of knowing their sector, country of expertise, or even the time periodsthey are best accustomed to project.

One of the forecaster types recognized inthe industry is a Judgmental Forecaster, who becomes known as the "Russian Expert" or "ChinaWonk", or the specialist knowing how and when forces in a target country will emerge asa currency investment factor.

Their resources will reach into politicaland economic realms, knowing not only the interactions of the US and the target country,but also the target country's interactions with other trading partners.

The Judgmental Forecaster is known for havinga "feel of the market".

Often called the "History Repeats Itself"forecast, Technical Forecast estimates are best applied in the short term horizon, andcan extend only as long as predicted patters remain in force.

When initiation criteria in the current situationmatch past conditions, the Technical Forecasting Econometrician will make predictions basedon past performance with adjustments for current circumstances.

Fundamental Analyses use the plethora of economicdata accumulated for countries, currencies, commodities, labor employment, productivity,and inflation rates in their domestic economy, and other countries, to create econometricmodels showing past response patterns for supply and demand, fitted to current economicconditions.

Because of the complexity involved, severalforecast sub-models may be created, each feeding into the forecast model.

These econometric models are best known forthe realm of long run forecasting, but short- and mid-range estimates are achievable.

They are just much more difficult to achieve.

Currency traders generally prefer Technicalanalysis over Fundamental analysis when forming a trading strategy.

Still, most forecasters use a combinationof Fundamental, Technical, and Judgmental analyses when making their projections.

Conditions are best, when all three techniquesagree about the recommended response for investments, but really that is seldom the case.

At the critical time for action, when a decisionneeds to be executed, it is based on the Chief Analyst's best arrangement of the data provided.

Currency movement across nations has beeninvestigated as we looked at factors of market fundamentals and market expectations.

We explored the determinants of exchange ratefluctuations as being different in the short run and long run.

Exchange rate overshooting can persist forsignificant periods of time, while fundamental forces tend to push the currency back to itslong-run equilibrium path.

We considered how exchange rates are determinedin the long run, and how the long-run determinants of exchange rates include relative productivitylevels, relative price levels, consumer preferences for domestic or foreign goods, and trade barrierssuch as tariffs and quotas.

We examined how the purchasing power parityapproach determines changes in relative exchange rate price levels over the long run.

A currency maintains its purchasing powerparity if it depreciates by an amount equal to the excess of domestic inflation over foreigninflation.

In the short run, decisions whether to holddomestic or foreign assets hold a primary role in exchange rate determination as investorsconsider two key factors when deciding between domestic and foreign investments: relativeinterest rates and expected changes in exchange rates.

Changes in these factors result in fluctuationsin exchange rates that we observe in the short run.

We also looked at the phenomenon of exchange-rateovershooting.

An exchange rate is said to overshoot whenits short-run response to a change in market fundamentals is greater than its long-runresponse.

Finally, we wrapped up this chapter to considerthe methods that currency forecasters use to predict exchange-rate movements as judgmentalforecasts, technical analysis, and fundamental analysis.


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Intl Economics - Chapter 12: Exchange Rate Determination

Interest rates and inflation drive a currency’s exchange rate: when combined, both signify a country's relative level of economic health. Currency Exchange rates play a vital role for commercial trade activities. Because of that importance, exchange rates are the most watched, analyzed and governmentally manipulated economic measures. Currency Exchange Rates are also important at the business operations level: as they impact the real return of an investor's portfolio. We will discover some of the major forces behind exchange rate oscillations!