ECON216

International Economics

Dr. Florian Gerth

Faculty of Business
FlorianGerth@uowdubai.ac.ae

ECON216 International Economics 1

What did we do?
Foreign Exchange Markets as place where domestic currency can be
exchanged for foreign currency.

Supply and demand (for foreign currency) determine the equilibrium level of
the exchange rate.

What is hedging and speculation?

ECON216 International Economics 2

Chapter 12 – Exchange Rate Determination
But what exactly determines supply and demand?

What explains the exchange rate in the short and long run?
Financial markets International trade and
and international price (inflation) changes
financial flows

What role do commodity markets and capital (financial) markets play?

ECON216 International Economics 3

 Forces determining exchange rates
• Demand (for foreign) currency
• Import of goods and services
• Investment into foreign country
• Speculators that expect the foreign currency to appreciate

• Supply (for foreign) currency

• Export of goods and services
• Investment flowing into domestic country
• Speculators that expect foreign currency to depreciate

But what determines these factors?!?

Notes on board
4
Forces determining exchange rates
1. Relative rates of economic growth
• If the domestic economy (U.S.) grows more rapidly than the rest of the world,
its demand for imports will increase more rapidly.
• By itself, this should increase the demand for foreign currency and lead to a
depreciation of the domestic currency (dollar).

Notes on board
5
 Forces determining exchange rates
1. Relative rates of economic growth
2. Relative rates of inflation
• If domestic (U.S.) inflation is greater than the rate of inflation in the rest of the
world, the domestic currency (dollar) will depreciate.

Notes on board
6
 Forces determining exchange rates
1. Relative rates of economic growth
2. Relative rates of inflation
3. Changes in interest rates
• If domestic (U.S.) interest rates fall relative to interest rates in the rest of the
world, the demand for domestic (U.S.) interest bearing assets will fall.
• By itself, this will lead to a fall in international demand for the domestic
currency (dollar) and a depreciation of the domestic currency (dollar).
• Watch out! It will NOT lead to a fall in demand for the foreign currency, but rather a rise!

Notes on board
7
 Forces determining exchange rates
1. Relative rates of economic growth
2. Relative rates of inflation
3. Changes in interest rates
4. Expectations
• If it is expected that the domestic currency (dollar) will depreciate (fall in value),
people will move out of domestic currency (dollar) holdings.
• As the domestic currency (dollar) holdings fall, the domestic currency (dollar) will
depreciate.

Notes on board
8
 Forces determining exchange rates

1. Relative rates of economic growth

2. Relative rates of inflation
3. Changes in interest rates
4. Expectations

Can we form a pattern (theory) that tells us formally, first, the influence of
the above mentioned points, and second, combines these theories into one
concept?

9
Building blocks
Ideas (building blocks) we have to understand before we can set up the
whole model:

Long run
1. Trade/elasticity approach
2. Purchasing Power Theory

Short run
1. Monetary model
2. Asset/Portfolio model

10
 Long Run

Trade approach
• The trade approach to exchange rate determination focuses on the role
of international trade (flow of goods and services) in determining
exchange rates.
• In this approach, the equilibrium exchange rate is the rate that balances
imports and exports.
• If the nation has a trade deficit, its currency will depreciate.
• If the nation has a trade surplus, its currency will appreciate.

This makes the nation’s exports cheaper to

foreigners and imports more expensive to domestic
residents. The result is that the nation’s exports rise
and its imports fall until trade is balanced.
Notes on board
11
Purchasing power parity theory
Long Run

• The law of one price

• Commodity arbitrage  till each currency has the same purchasing power!
• The idea that in the absence of barriers to trade the price of homogenous traded
commodities will be identical in all markets.
• Example
• Suppose that cars sell in the U.S. for $1/unit.
• If the exchange rate is ¥100/$1, the price in Japan should be ¥100/unit.
• If this does not occur, then profitable opportunities for arbitrage exist.
• In other words, $P = ¥P•R where R is the dollar price of one unit of foreign
currency, $P is the dollar price of the homogenous commodity, and ¥P is the
foreign currency price of the homogenous commodity.
We also call this  Absolute Purchasing Power Parity

Notes on board
12
 Long Run

Purchasing power parity theory

• If the law of one price holds for all goods, then absolute purchasing
power parity (PPP)will hold.
• Absolute purchasing power parity holds that equilibrium exchange rates are
equal to the ratio of price levels in the two nations.
• In other words, P = P*•R where R is the dollar price of one unit of foreign
currency, P is the price level in the U.S., and P* is the price level in the foreign
nation.

Notes on board
13
 Long Run

Purchasing power parity theory

• Absolute purchasing power parity does not hold in absence to perfect
free trade.
• Non-traded commodities
• Barriers to trade
• Transaction costs
• Relative purchasing power parity postulates that the change in the
exchange rate is equal to the difference in the change in the price
levels (rates of inflation) of the two countries.

Notes on board
14
Big Mac Index (The Economist)
• https://www.economist.com/node/21569171/digital?page=26

• https://www.thebalance.com/what-is-the-big-mac-index-1978992

• https://www.investopedia.com/ask/answers/09/big-mac-index.asp

ECON216 International Economics 15

 Short Run

The monetary model of exchange rates

• The monetary model of exchange rates holds that the exchange rate is
determined in the process of equilibrating the domestic demand and
supply of currency (money balances).
• An increase in the domestic (U.S.) money supply (assuming no change
in other money supplies) will depreciate exchange rate.
• Furthermore, it will lead to a proportionate increase in prices!

Notes on board
16
 Short Run

The asset (portfolio) approach to exchange rates

• The asset approach of exchange rates holds that the exchange rate is
determined in the process of equilibrating the domestic demand and
supply of financial assets.
• Also known as the portfolio approach
• An increase in the domestic (U.S.) money supply (assuming no change
in other money supplies) will lower interest rates in the domestic
country (U.S.) and shift investors from domestic to foreign assets and
lead to a depreciation of the domestic currency (dollar).

Notes on board
17
 Short Run
The asset (portfolio) approach to exchange rates

Remember the Trade approach and the PPP theory?!!

• The depreciation in the domestic currency (dollar) spurs domestic
(U.S.) exports and discourages imports.
• This encourages the formation of a trade surplus.
• The movement in trade encourages an appreciation of the dollar that
partially offsets the initial depreciation.

Notes on board
18
 Exchange rate dynamics  in the short run

• In adjusting to long run equilibrium values,

$/€
exchange rates tend to “overshoot” the
final equilibrium value.
1
• Suppose that the exchange rate is initially
at $1/€1.

Time

19
 Exchange rate dynamics  in the short run
• Suppose that the exchange rate is
initially at $1/€1.

$/€
• At time A, the money supply in the
U.S. increases causing the exchange
rate to depreciate. 1

A Time

20
 Exchange rate dynamics  in the short run

• If the long run equilibrium exchange

$/€
rate (determined by the PPP model) is 1.16
expected to be $1.10/ €1, in the short
run the exchange rate will overshoot 1
this value (perhaps to $1.16/ €1).

A Time

21
Exchange rate dynamics  in the short run
• The overshooting drives an

$/€
improvement in the balance
of trade that will lead to 1.16
subsequent appreciation of
the dollar. 1

A Time

22
 Exchange rate dynamics  in the long run
• The overshooting drives an

$/€
improvement in the balance of trade
that will lead to subsequent 1.16
appreciation of the dollar. 1.10

• Over time, the dollar will fall 1

(appreciate) to its long run
equilibrium value.

A Time

23
 Exchange rate overshooting
• The tendency of exchange rates to Overshooting

$/€
immediately depreciate or appreciate by
more than required for long-run 1.16
equilibrium, and then partially reversing 1.10
their movement as they move towards their 1
long-run equilibrium levels.

• Financial markets clear or adjust

immediately to any disequilibria.
• Capital market imbalances A Time

• Commodity (goods and services) take much

longer.
• Trade imbalances
24
 Exchange rate forecasting
• Models of exchange rates have not been very successful at predicting
future exchange rates.
• Reasons
• Exchange rates are highly influenced by new information.
• Expectations in exchange rate markets tend to be self-fulfilling (at least in the
short-run).
• This may generate movements in the market contrary to what is expected by theory.

25
Questions?

ECON216 International Economics 26

Quiz 2
• Week 10
• 20 minutes in duration
• To be found on Moodle (online quiz)
• Week 4, 6, 7, 8, 9 and 10 material
• 10 compulsory multiple choice questions
• Tutorial Group 1: Start 01/12 (10.30am) until 08/12 (8.30am)
• Tutorial Group 2: Start 01/12 (4.30pm) until 08/12 (2.30pm)

ECON216 International Economics 27