Chapter 16
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FINS1612 tutorial answers...
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Financial Institutions, Institutions, Instruments and Markets 8th edition Instructor's Resource Manual
Christopher Viney and Peter Phillips
Chapter 16 Foreign echange! "actors that in"luence the echange rate
Learning objective objective 1: Explain how factors factors that affect affect the demand for a currency, currency, or the supply of of a currency, affect the determination of an equilibrium exchange rate •
An exchange rate is the price of one currency in terms of another currency.
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Most developed economies operate a floating exchange-rate regime whereby the price of the currency is determined by the demand for and the supply of that currency in the FX markets.
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Any change in the factors that impact upon the demand for and supply of a currency will result in a change in the exchange rate.
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A country that maintains a linked exchange rate, crawling peg or managed float exchange rate regime, whereby the local currency is tied to another currency such as the USD, or a basket of other currencies, is effectively tied into supply and demand factors that affect the currency or the basket of currencies to which it is linked or pegged.
Learning objective objective 2: nderstand how the major factors that influence influence exchange exchange rate movements movements operate, particularly relative inflation rates, relative national income growth rates, relative interest rates, exchange rate expectations, and central ban! or government intervention 1# Relati$e in"lation rates •
Of the theories advanced to explain the exchange rate and changes in the e!uilibrium rate the purchasing power parity "###$ theory is the longest longest standing.
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%nder ### ### a country with a higher inflation rate r ate relative to another country can expect e xpect its
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currency to depreciate. •
#erhaps the most critical shortcoming of ### is that there are variables in addition to inflation that affect the value of a currency.
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&he 'xtended learning section considers ### calculations that apply inflation differentials between two countries to determining the expected change in the exchange rate.
%# Relati$e national income gro&th rates •
&here is wide agreement that changes in the relative rates of growth in national incomes affect the exchange rate.
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&here is disagreement however as to the nature of the effect.
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An increase in the relative rate of growth is likely to result in an increased demand for imports which will result in a depreciation of the currency.
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On the other hand an increase in the growth rate may also result in an increase in foreign investment inflows which will cause the currency to appreciate.
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(oth mechanisms are likely to operate with the balance between the two changing from time to time.
# Relati$e interest rates •
&he interest rate differential between two countries is also important in determining the demand for and supply of a currency in the FX market) however the effects of a change in the interest rate differential are ambiguous.
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*t is important to determine whether the change is due to a change in inflationary expectations or a change in the real rate of interest.
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*f the increase in interest rates is a result of an increase in inflation expectations a currency should depreciate. +owever if the increase is due to a rise in the real rate of interest then the currency should appreciate.
(# )change rate epectations •
*n addition to the economic fundamentals exchange rate expectations are important in determining the FX value of a currency.
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*f the markets expect the exchange rate to depreciate this will ultimately result in FX buy or sell transactions that cause the depreciation) if an appreciation is expected an appreciation typically will be experienced.
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&he modelling of expectations is a particularly difficult task. &heoretically expectations should be formed on the basis of the expected values of economic fundamentals. fundamentals. +owever the FX
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market often reacts to new information before the impact on the longer-term economic fundamentals is fully analysed. •
*t may be possible to adopt a specific market indicator as a proxy for exchange rate expectations. For example in Australia the commodity price index is often used as such a proxy.
*# Central +ank or go$ernment inter$ention •
At times the actions of governments or central banks are another variable that may be important in the FX markets.
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&he monetary policy setting of a central bank will impact upon the demand and supply factors that affect an exchange rate. Also a central bank or government may intervene in the FX markets to influence directly the level of an exchange rate by intervening in international trade flows intervening in foreign investment flows or conducting FX transactions in the markets.
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For example in an attempt to increase the FX value of its currency a central bank may sell foreign currency and buy the local currency) alternatively to reduce the value of its currency the central bank may buy foreign currency. Alternatively a government may implement policies that change tariff !uota or embargo settings relating to goods and services.
Learning objective ": Explore regression analysis as a statistical technique applied to variables
that impact on an exchange rate •
Regression analysis is a statistical technique that may be used to try to ascertain the relationship between a dependent variable and changes in independent variables
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An exchange rate may be the dependent variable.
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Major independent exchange rate variables are relative inflation rates, relative national income growth, relative interest rates, government or central bank intervention, and market expectations.
)ssay uestions The following suggested answers incorporate the main points that should be recognised by a student. An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example. On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion.
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1# -se the theory o" demand and supply to eplain ho& euili+rium emerges &ith the F. markets# Is this theory consistent &ith the $olatility that F. markets are o+ser$ed to ehi+it/ 02 16#13 •
&he !uantity demanded of a currency will increase as its price "exchange rate$ falls and decreases as its price rises. ,eometrically this traces a negatively sloped line.
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&he !uantity supplied of a currency will decrease as its price falls and increase as its price rises. ,eometrically this traces a positively sloped line.
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emand and supply correspond at some point. ,eometrically this is the point at which the two lines intersect or cross.
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At points to the left of the intersection demand is greater than supply. As such the price of the currency will tend to increase as more supply is called forth.
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At points to the right of the intersection supply is greater than demand. As such the price of the currency will tend to decrease.
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(y this logic there is a tendency towards the point of intersection between demand and supply. &his point of intersection is an e!uilibrium point.
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&heoretically divergences from the e!uilibrium point should be fleeting and !uickly corrected.
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olatility is not necessarily inconsistent with this model. *t could be the case that demand and supply curves oscillate a lot and new e!uilibria are constantly being formed. +owever if one views e!uilibrium as a calm almost static state the volatility exhibited by FX markets is unlikely to accord well with such a view.
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*t should be recognised that e!uilibrium is not a /real0 phenomenon. *t is never observed in practice. As such there will only be a tendency towards e!uilibrium which is disturbed before it can fully work itself out.
%# 4ra& a graph that depicts the 5-4)-R demand cur$e and supply cur$e# Plot the euili+rium echange rate at 5-4)-R7#777# I" the spot echange rate is 5-4)-R7#*77 )uro cents, &hat impact &ill that ha$e on the demand and supply position in the F. markets/ (LO 16.1)
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AUD/EUR
Supply curve
0.7500 0.7000
Demand curve Quantity of the currency
E
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Assume the Australian dollar is the local currency.
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At the A%1'%23.4533 exchange rate the price of local goods and services in the international markets increases and the demand for the A% will fall. Also the cost of imports is cheaper therefore the supply of A% increases as locals buy the '%2 to purchase overseas goods and services.
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*n order to sell the increased supply of A% market participants will bid down the currency until it comes into e!uilibrium at A%1'%23.4333.
# -nder a "loating echange rate regime, the echange rate &ill al&ays ad9ust so that the demand "or and the supply o", a currency in the F. market &ill +e eual# 0a3 :a$ing regard to this statement, descri+e the mechanisms through &hich euili+rium is maintained in the e$ent o" a change in the demand or supply cur$es# •
,iven the data in the diagram below the e!uilibrium exchange rate based on the supply and demand curves is A%1%67.3885
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&his is the exchange rate that is sustainable over time assuming there is no change in factors influencing the supply and demand curves.
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Any other exchange rate is not sustainable) for example at a rate of A%1%63.9:83 the !uantity of A% demanded is 85 billion but the !uantity supplied is only 75 billion.
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&here is an excess demand for the A%.
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&he FX dealers would not be able to meet the demands of their clients.
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&heir clients would have to instruct their dealers to offer a higher price.
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&he effect of the higher price is twofold) first as the price of the A% is bid up the !uantity supplied would increase) second some who demanded the A% at 3.9:83 would withdraw from the market as the exchange rate appreciates. &he combined effect is that the increase in the price reduces the excess demand.
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&he price would continue to be bid up to a rate of 7.3885 at which point there is no pressure in the marketplace for the price to change further.
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&his conclusion stands only while the demand and supply curves remain where they are.
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Factors that determine the positions of the curves change through time.
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;ith changes in these variables and thus in the positions of the curves the e!uilibrium exchange rate will change.
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ariables that may affect the positions of the demand and supply curves include the relative inflation rates relative national income growth relative interest rates exchange rate expectations and central bank or government intervention.
0+3 4ra& a diagram sho&ing the appropriate demand and supply cur$es# (LO 16.1)
AUD/USD Price S 1.0225
0.9820 D
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20
25
Quantity of AUD (billion $)
(# ;he Reser$e C5>) >;-4
#urchasing power parity or ### is a core component of the economic theory of exchange rates. As our discussion and examples have shown throughout this chapter the idea is very simple. &he prices of the same goods in different countries should be the same after taking factors like transport costs into account. *f purchasing power parity holds for example * should be able to purchase the same basket of goods in Australia with Australian dollars as * can if * convert my Australian dollars into %6 dollars and purchase that basket of goods in America. *f by converting my Australian dollars into %6 dollars * can obtain the same basket of goods cheaper than * can in Australia then the Australian dollar might be perceived to be overvalued and vice versa.
(ecause ### provides an easy-to-understand indication of the relative value of exchange rates different examples emerge in the press from time to time. *n fact The Economist magaGine has been running its /(ig Mac *ndex0 for many years. *n Australia recent debate has been focused on the strength of the Australian dollar which has placed the manufacturing and agricultural industries under pressure. &he big !uestion is whether the Australian dollar is overvalued. According to ### theory we should be able to get some idea by comparing the prices of some popular consumer items in different parts of the world. As in the example above if * can purchase the good more cheaply by converting my Australian dollars into say %6 dollars or 'uros and purchasing the item in America or ,ermany this would be an indication that the Australian dollar is relatively overvalued. &his debate and the relevance of ### is reflected in
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the following observation regarding the price of the i#ad@
Australia is one of the cheapest places in the world to buy a new iPad, a survey suggests, raising uestions about whether the Australian dollar is overvalued! An analysis by "ommonwealth #ecurities, which loo$ed at the prices of a %&'gigabyte iPad across (& countries, found that Australia was the fourth'cheapest place to buy the device, behind )alaysia, *ong +ong and apan!
The survey compares the price of the iPad according to purchasing power parity -PPP.! PPP loo$s at the prices of a particular good in different countries according to the local currency! A similar survey by &he 'conomist maga/ine, the 0ig )ac Inde1, recently concluded that the Australian dollar was near fair value in uly 23%4 when it was around U#536!
0ut economists say the dollar has some way to fall to reach fair value!
6O%2I'@ 'xtract from Hwek ,. /Fair or = ot the Australian ollar 2emains Overvalued0 6ydney Morning +erald 8> 6eptember 837D. Available at@ http@11www.smh.com.au1business1fair-or-not-the-australian-dollar-remains-overvalued-837D398D-8ua:9.html
4I>C->>I2? P2I?;> •
;his ne&s article contends that the 5-4 is o$er$alued +ecause the price o" a ne& iPad is relati$ely lo& in 5ustralia# )plain ho& this conclusion can +e supported +y appealing to the theory o" purchasing po&er parity#
Iomparing the cost of the i#ad in different countries amounts to comparing the relative cost of a basket of goods that contains a single item "i#ad$. &he logic remains the same. *f the basket of goods can be purchased more cheaply in Australia than in another country there is an indication that the Australian dollar is relatively overvalued. Identi"y some potential strengths and &eaknesses o" the analysis presented in the ne&s article# For eample, is an iPad an international consumer item/ Is it epensi$e to transport/ Is it likely to +e indicati$e o" the relati$e prices o" a +roader B+asket o" goods@/
*n some respects an i#ad is a reasonable choice of product to use in this type of /analysis0. *t is an international product that can be transported easily etc. +owever when a single
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product is chosen there are doubts about its representativeness. *t depends for example on how much of a commitment out of consumers0 disposable income an i#ad purchase represents in different countries. *t depends for example on nuances of pricing policy. *f the Australian consumers view different tablet devices as more or less perfect substitutes the price of the i#ad may be lower due to competition that does not exist elsewhere. &he difficulties appear to stem from choosing a single item for the /basket of goods0 rather than any particular features of the i#ad.
;rueFalse uestions
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F Although the FX markets exhibit considerable volatility it is possible to construct reliable
and accurate forecasts of movements in the FX markets. 8.
; *f the A%1%6 exchange rate moves from A%1%63.9>53J55 to A%1%63.9538J
39 there is said to have been an appreciation of the Aussie dollar. D.
F All other things e!ual the !uantity of a currency demanded will increase as its price or
value increases. >.
F *n e!uilibrium the demand curve becomes exactly paralle l to the supply curve and both are
upward sloping. 5.
; &he supply of a currency into the FX markets should increase if holders of the local
currency purchase foreign currency in order to fund investment and consumption overseas. .
; As the exchange rate of a country depreciates the price of goods exported from that
country becomes relatively cheaper to foreign buyers. 4.
F ;here there is excess supply of a currency in the FX markets dealers will bid up the price
in order to create a demand for the currency and therefore maintain the exchange rate e!uilibrium. :.
; ;ith the %61A% currency pair a reduction in the demand for the %6 is e!uivalent to
a reduction in the supply of the A% in the FX markets and would result in the supply curve moving upwards to the left. 9.
; A surge in inflation in the %6A relative to that in another country could be expected to
result in increased demand by %6 residents for goods from that lower inflation country and the FX demand curve would move upwards to the right. 73.
; A change in the inflation differential between two countries will theoretically be offset by a
corresponding change in the e!uilibrium exchange rate.
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77.
; &he purchasing power parity theory contends that an e!uilibrium exchange rate will
prevail such that the price of a specific asset in one country will cost the e!uivalent amount in another country. 78.
F 2esearch into ### tends to support the view that the theory is more reliable in the short
term and therefore is a less appropriate measure of exchange rate determination over the longer term. 7D.
F &he exchange rate will always change to reflect variations in inflation differentials between
countries because in a modern global economy goods and services are perfect substitutes. 7>.
; A significant relationship between changes in the relative growth rates in national incomes
and the exchange rate operates through changes in the demand for imports and exports. 75.
F &here is conclusive evidence that an increase in national output growth and income will
result in an immediate and sustained appreciation of the exchange rate. 7.
F &here is no relationship between interest rates and the exchange rate because interest rates
reflect the current yield on financial assets whereas exchange rates are the relative prices of different currencies. 74.
; All else being constant it is to be expected that a currency will appreciate if there is an
increase in real interest rates relative to those in other countries. 7:.
F A central bank is said to be smoothing the FX markets when it carries out transactions to
purchase foreign currency to pay for goods purchased by the government. 79.
F Ientral banks of countries that operate a floating exchange rate regime no longer intervene
in the FX markets to influence the direction or speed of movements in the exchange rate. 83.
F 2egression analysis is used to calculate accurately future changes in an exchange rate over
a range of forward periods.
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