Foreign Exchange Rate Determination(or chapter 5).ppt

Agenda How BOP explains exchange rates? Asset market approach to exchange rates. Forecasting in practice. How different theories combine to explain recent currency crises? Exchange Rate Determination Basic approaches Parity conditions Flow (BOP) approach Stock (asset market) approach In addition, need to account for important social economic events, such as: Infrastructure weaknesses, Speculation, Cross-border FDI, Foreign political risks. Flow (BOP) Approach Forex as a medium of exchange. BOP Approach Fixed Exchange Rate Countries Government bears responsibility to ensure BOP near 0. If CA+CAP =/= 0, government must intervene If government lacks reserves, will have to devalue. Managed Float Countries To “defend” currency, may raise interest rates. = raises cost of capital for domestic firms Stock (Asset Market) Approach Forex as a store of value Willingness to hold monetary claims depends on relative real interest rates on country’s economic growth profitability. Asset approach “forward looking”: discounted future value Movements in exchange rate reflect news. Current exchange rate is set to equilibrate risk-adjusted expected return on assets denominated in different currencies. Asset Model: Monetary Approach Spot exchange rate is relative price of two monies. Flexible price model: Domestic good prices fully flexible If domestic money supply increases domestic currency will depreciate. If domestic real income Y rises/ domestic interest rate i falls, domestic currency will appreciate as money demand is increased Stick price model: Goods prices are sticky (slow to adjust) relative to asset prices. Asset prices have to move by more than in flexible price case, in order for markets to reach equilibrium. Asset Model: Portfolio-Balance Portfolio-balance model has two financial assets (money bonds) and two countries (home foreign). Exchange rate establishes equilibrium in investor portfolios of domestic money domestic and foreign bonds. Bal