Exchange Rate Determination

Dr. C S Shylajan
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Introduction
 An exchange rate is the relative price of one

currency in terms of another  It influences allocation of resources within and across countries  During the Bretton Woods era exchange rate was treated as an exogenous variable  With the advent of floating rates in 1973, attention once again shifted to determinants of exchange rates themselves

Introduction
 Exchange rates are affected by many factors.  For instance, Balance of payments, inflation,

interest rates, money supply, political factors, market sentiments, technical factors etc.

 Important ones are Price and Interest rates  What is the relationship of these two variables with

exchange rates?

Some Fundamental Relationships

 There are two popular forms of Purchasing Power

Parity theory.

 Absolute form of PPP &  Relative form of PPP  Absolute form of PPP: Without international

barriers, consumers shift their demand to wherever prices are lower.

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Some Fundamental Relationships

Absolute Purchasing Power Parity (PPP)
The price levels in different countries determine the exchange rates of these countries currencies. Exchange rates reflects the purchasing power of these currencies.
Rs.2000 for a basket of goods in India. Same basket costs $50 in US. Then exchange rate between the Rupee and the dollar is 2000/50 =Rs40/$ PURCHASING POWER PARITY : A DOLLAR IS WORTH 40 RUPEES BECAUSE WHAT COSTS $1 IN US COSTS Rs.40 IN INDIA

Law of one price: Price of a specified bundle of goods and services, denominated in a given currency is same everywhere St = Ph / P*f
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Some Fundamental Relationships

St is the spot rate expressed as number of units of home currency per unit of foreign currency Pt is the price index in the home country and Pt* is the price index in the foreign country, both price indices with reference to a common base year

Some Fundamental Relationships

 Based on some assumptions  Free movement of goods  No transportation cost  No transaction cost  No tariff or quota

Some Fundamental Relationships

.IS IT EMPIRICALLY VALID?
THE ANSWER IS NO (why). This "law" is not valid in practice because of transport costs, tariffs, quality differences etc. Empirical testing also difficult. (composition of index is different, base year different)

PURCHASING POWER PARITY

IN THIS FORM, IT MAY BE VALID OVER THE LONG RUN PERIODS OF 10-15 YEARS OR LONGER. NOT OF MUCH USE IN FORECASTING EXCHANGE RATES FOR SHORT TERM PURPOSE WITH DIFFERENCES IN PRODUCTIVITY GROWTH RATES, IT MAY NOT BE VALID EVEN IN THE WEAK FORM.

PPP
 PPP states that the exchange rate between

currencies of two countries is equal to the ratio between the prices of the two countries

 In relative terms, PPP states that the exchange

rate between the currencies of the two countries will adjust the changes in the inflation rate of the two countries.

Some Fundamental Relationships

 Relative Purchasing Power Parity  Percent change in exchange rate equals inflation differential % Change in Rupee/Dollar Exchange Rate = Inflation Rate in India Inflation Rate in US

This will be true if St = k(Pt/P*t)

k : Some constant

Faster inflation at home Home currency depreciates at a rate equal to its excess inflation rate.
IF DURING A YEAR INFLATION IN US IS 5% WHILE INFLATION IN JAPAN IS 3%, DOLLAR WILL DEPRECIATE AGAINST THE YEN BY 2%. CHANGE IN EXCHANGE RATE EQUALS INFLATION DIFFEENTIAL. 11

Some Fundamental Relationships

 According to relative form of PPP principle, the

percentage change in the spot exchange rate equals the difference in the inflation rates divided by 1 plus the inflation rate in country B  Example:  If the inflation rate in India (country A) is 10% and that in the US (country B) it is 3%, the Rs/$ rate would change over a period of one year by  (0.10-0.03)/(1+.03) =0.068 =6.8 %  Indian rupee will depreciate by 6.8 %

Some Fundamental Relationships

 Real Exchange Rate is a measure of

exchange rate between two currencies adjusted for relative purchasing power of the currencies


Re = Ste (Pd/Pf)

 Ste denotes the nominal exchange rate at time t

while Ptd and Ptf are price indices (say CPIs) in countries A and B with reference to a common base year. The real exchange rate Rt is also expressed as an index with reference to the same base year
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Interest Rate Parity (IRP)

 How is it possible to determine the rate of

exchange under a forward contract?  A forward exchange rate is the rate that is currently paid for the delivery of a currency at some future date.  It has the spot rate as its base, plus the interest factor.  The interest factor which is factored into the rate is called the interest rate parity

Interest Rate Parity

 It states that the exchange rate between currencies

of two countries will be affected by their interest rate differential.

 interest rate differential = exchange rate differential

OTHER BASIC RELATIONSHIPS COVERED INTEREST PARITY: AMONG CONVERTIBLE CURRENCIES SPOT-FORWARD MARGIN EQUALS INTEREST RATE DIFFERENTIAL INTEREST RATE DIFFERENTIAL EQUALS EXPECTED CHANGE IN EXCHANGE RATE. UIP NOT FOUND EMPIRICALLY VALID (WHY?)

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Some Fundamental Relationships

 If Relative PPP holds, Real Exchange rate would remain    

constant The nominal and real exchange rates we have considered are bilateral rates The concept of Effective Exchange Rate (EER) is utilized to make multilateral comparisons Nominal EER (NEER) captures movements in a currency vis--vis a basket of currencies. Real Effective Exchange Rate (REER) attempts to capture changes in competitiveness vis-a-vis a group of competitors in world markets rather than pair-wise comparisons. It is NEER adjusted for inflation differences between home and basket currency countries
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Some Fundamental Relationships

 Purchasing Power Parity (PPP) as a Model of 

  

Exchange Rate Behaviour and Predictor Absolute PPP does not hold in practice. Reasons are transport costs, non-homogeneous goods, non-traded goods, trade barriers, non-homogeneous tastes etc. Relative PPP is found to hold approximately over long periods of time several years. Not very useful for short-term prediction of exchange rates Can provide an indication of long term trends if inflation trends can be reasonably assessed.
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Some Fundamental Relationships

Fisher Effect
 Relationship between interest rate, inflation rate and

exchange rate  According to Fisher,

i=r+
where i = nominal interest rate; r = real interest rate; and rate = inflation

 If money were free from all controls when transferred

internationally, the real rate of interest should be the same in all countries (otherwise it will create an arbitrage opportunity)

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Some Fundamental Relationships

 Combine UIP with relative PPP  Let e denote the expected proportionate change in

the exchange rate

e= S
 Take UIP

A-

iA iB =

= TeA - TeB

iA - TeA = rA iB - TeB = rB
 This implies that with free capital flows and risk neutral

investors real interest rates are equalized between A and B

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Some Fundamental Relationships

 Principle that a difference in nominal interest rates

supported by two countries currencies will cause an equal but opposite change in their spot exchange rates countries

 Real interest rates are theoretically equal across  Any difference in interest rates in two countries

must be due to different expected rates of inflation

 A country that is experiencing inflation higher than

that of another country should see the value of its currency fall
 The exchange rate must be adjusted to reflect this

change in value.

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Some Fundamental Relationships

Reasons for Departure from Interest Rate Parity
Capital Controls:  restrictions on investing or borrowing abroad  restrictions on repatriation of investments made by foreigners  restrictions on conversion of currencies Transaction Costs:  the bid-ask spread, the cost involved in conversion of currencies;  deposit lending spread, the difference between the deposit and lending rates in the money market Political Risks, Taxes, etc

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Exchange Rate Forecasting

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Introduction
 Many theories on the exchange rate determination  Exchange rates (floating), like any price, is determined

by the forces of supply and demand

 The problem is to correctly model all the factors that  Another complication is that foreign exchange is an

influence the demand for and the supply of a currency

asset like equity shares

 Like any such assets, its price at any time is heavily  These expectations are very sensitive to economic

influenced by expectations about future course of price events, political developments, technological developments, resource discoveries, etc.

Exchange Rate Forecasting

 Several factors affect the movements in exchange

rates, often in a conflicting manner rate forecasting

 Exchange rate theories can be used for exchange  But prediction of the exact level of future exchange

rates is not possible

 But forecasting of exchange rate is vital for important

players in the international markets and also for the speculators. unbiasedness

 Effectiveness of a forecasting tool accuracy and

Forward Rate as a Predictor

 Forward rate, an unbiased predictor of future

spot rate provided,

 Market should be competitive, the currencies

should be freely floating

 However, no evidence that the forward rates

as accurate predictors of future rates

 Reason: future spot rates are affected by all

the expected and unexpected developments the forward rates

 The unexpected factors cannot be factored in

Demand Supply Approach

 Exchange rates can be forecasted by analyzing the  These factors are listed out in the BoP account.

factors that affect the demand and supply of a currency Therefore, this approach also known as balance-ofpayments approach these demands and supplies

 Exchange rate is the equilibrium price that equates  Different models of exchange rates differ in the

emphasis they put on the different components of demand for and supply of a currency

Demand Supply Approach

Demand for currency A arises from: 1. Rest of the World (ROW) purchasing goods and services from country A and making payments in As currency (including payments for factor services) or making unilateral transfers to residents of A 2. ROW wishing to hold financial assets denominated in currency A; ROW wishing to make direct investments in A Supply of currency A arises from: 1. Residents of country A wishing to buy goods and services from ROW or make unilateral transfers to ROW 2. Residents of country A wishing to make direct and portfolio investments abroad including central bank of A
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Demand Supply Approach

 Simplest view of exchange rate focuses on demand for

and supply of foreign exchange arising out of imports and exports (known as Flow Models) depreciates, imports become more expensive while exports become cheaper in terms of foreign currency

 According to Flow Models, as the home currency

 Demand for imports falls while for exports expands  Supply of foreign currency rises while demand shrinks,

putting upward pressure on the home currency

Demand Supply Approach

 Suppose, demand for imports rises (due to faster

economic growth at home, etc), other things remaining the same, the home currency will depreciate

 Alternatively, exports shrink (due to supply

problems in export industries, economic slow down in buyer country, competition, etc), home currency depreciate that for exports rises, the home currency appreciate

 Conversely, when demand for imports shrinks or

Demand Supply Approach

 Thus, in this approach the exchange rate is

influenced by the forces affecting demand and supply of imports and exports affect the level of economic activity, productivity changes, changes in consumer preferences, tariffs and trade barriers, etc

 These include fiscal and monetary policies that

Demand Supply Approach

E: Equilibrium Exchange Rate

Exchange Rate Rupee/$

E

S D

No. of Dollars

Figure 1
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Demand Supply Approach

 This theory says, any change in the value of currency

   

is only an instrument to correct the temporary imbalance in the system At the same time, imported goods are more expensive due to depreciation, reducing imports This improves the current account balance But despite a depreciation, the current account balance may worsen. Why? J-curve effect
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Demand Supply Approach

 Some times, while the physical volume of our exports

may increase, but the amount of foreign currency earned from those exports may decrease. exports.

 This happens due to low price elasticity of demand for

 When both imports and exports are price inelastic in

the short run but price elastic in the long run, volume of exports and imports do not immediately respond to the change in relative prices of exports and imports, caused by depreciation of currency. This leads to deterioration in the Balance of Trade. Then currency depreciates further.-J Curve

 People take some time to adjust to the changes in

relative prices (time lag)

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Demand Supply Approach

 Major problem with the model is its total neglect of

capital account

 Mundell-Fleming model attempts to correct this by

including capital flows.

 Capital flows dependent on interest rate differential

between home and the ROW Income and exchange rate; rate differential

 Current account balance depends upon the National  Capital account balance depends upon the interest  National income and interest rates are influenced by

the fiscal and monetary policy.

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Asset Market Models

 The Monetary Model

According to this approach, exchange rates are essentially monetary phenomena. Assumptions:  There is only one asset viz. money. Residents of a country hold only that countrys money.  Purchasing Power Parity holds (an increase in countrys price level results in the depreciation of that countrys currency and vice versa)


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The Monetary Model

 The core of the model is the assertion that

domestic residents, when faced with a discrepancy between the stock of (domestic) money they wish to hold and the actual stock of money created by the monetary authority, will attempt to correct it by running a balance of payments deficit or surplus

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The Monetary Model

 Suppose, real GNP of a country increases, resulting in an 

   

increase in the real money demand With no change in money supply, lesser money is left for purchase of goods, services that brings down the price level A reduction in price level causes appreciation of the currency Thus, increase in real GNP brings an appreciation of the currency Suppose, there is excess supply of money, resulting in increased demand for domestic as well as foreign goods The domestic price level rises and the exchange rate depreciates 38

The Monetary Model

 Thus, the monetary approach predicts that strong

economic growth coupled with moderate growth in money supply and credit will result in a strong and stable currency, while excessive credit creation, especially when the economy is not growing rapidly, will cause a fall in currency

 Is it true with Rupee appreciation and depreciation

episodes?

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The Monetary Model

 This model also predicts that an increase in home

country interest rate, given other things, will lead to a depreciation of a home currency

 Why?  This go against the common notion (that higher

interest rate leads to higher capital inflows)

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Expectations, News. Technical analysis etc

   

Expectations, the Efficient Markets Hypothesis and the Role of "News" EMH does not talk about the effect of changes in the basic economic variables. Current exchange rate is the reflection of the expectations of the market as a whole.

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Structural Models of Exchange Rate

Any new pertinent information alters traders' views regarding future course of prices and is immediately reflected in the current price Importance of expectations and unanticipated events Technical Analysis Economic variables are ignored. Using historical data

   

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Summary-Exchange Rate Forecasting

 Exchange rate forecasts are an important input into a

number of corporate financial decisions  Forecasting methodologies can be divided into two broad categories  Structural economic models of exchange rate determination such as the PPP or the monetarist model  Pure forecasting models" that includes time series methods and "technical analysis"  Recent developments in modeling and predicting financial time series have applied mathematical tools.  Composite Forecasts A combination of different forecasts

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Exchange Rate Forecasting

 The value of a forecast depends upon


How much does the forecast contribute to better decision making given that the firm has its own sources of information and is able to generate its own forecasts The forward rate is always available as a forecast free of charge. Any forecast paid for must do considerably better than forward rate in predicting direction and magnitude of movement

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The Exchange Rate of the Rupee

 Central Bank has still an important role  RBI acts to moderate excessive fluctuations and

prevent panics.

 Behavior of the spot rate in India is largely governed by

trade related flows since the capital account continues to be strictly controlled generate significant volatility in the rupee exchange rate as we have seen recently.

 In the very short run, portfolio decisions of FIIs can

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Thanks