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Topic 5 Determination of Exchange

Rate (Shapiro, Chapter 2)

Balance of Payments (BOP)
Balance of payments refers to the net value of all
economic transactions including trade in goods
and services, transfer payments, loans, and
investments between residents of the same
country and those of all other countries.

Balance of Payments (BOP) categories:

1. Current account: records imports and
exports of goods, services, income, and
current unilateral transfers.
2. Capital account: includes debt
forgiveness, transfers of goods and
financial assets by migrants as they enter
or leave the country.
3. Financial account: shows public and
private investment and lending activities.
It records inflows and outflows of capital.

A countrys balance of payments (BOP) can

have significant impact on its exchange rate
and vice versa, depending on that countrys
exchange rate regime.
BOP is equal to the sum total of current
account balance (X M), capital account
balance (CI CO), financial account balance
(FI FO) and reserve balance (FXB)
BOP = (X M)+(CI CO)+(FI FO)+(FXB)

Exchange Rate and the Trade Balance

Trade deficits are financed by reducing
domestic foreign exchange reserves. The
relative value of domestic currency will fall.
Trade surplus increases the holding of
foreign exchange reserves. The relative
value of foreign currency will fall.
Trade deficits
Trade surpluses


The balance of payments approach is the

second most utilized theoretical approach in
exchange rate determination:
The basic approach argues that the equilibrium
exchange rate is found currency flows match up
vis a vis current and financial account activities.
This framework has wide appeal as BOP
transaction data is readily available and widely
Critics may argue that this theory does not take
into account stocks of money or financial assets.

Supply and Demand analysis in the

determination of exchange rates
(A) Foreign Currency Demand:
- derived from the demand for foreign
countrys goods, services, and financial
assets. e.g. Americans demand
Australian goods such as minerals.

The Demand for AUD in the U.S.


At higher exchange rates, Americans
demand less AUD and vice versa.

(B) Foreign Currency Supply:

- derived from the foreign countrys
demand for local goods.
- Foreign buyers must convert their
currency in order to purchase.
e.g. Australians demand for US
goods, such as Dell computers means
Australians must convert AUD to
USD in order to buy.
Therefore, foreign currency supply and
demand are derived supply and demand

The Supply of AUD in the U.S.




At higher exchange rates, Australians
supply more AUD and vice versa.

The USD/AUD Equilibrium Rate




(C) Equilibrium Exchange Rate
This occurs where the quantity supplied equals
the quantity demanded of a foreign currency at a
specific local price.

(D) How Exchange Rates Change

1. Increased demand
as more foreign goods are demanded, more
of the foreign currency is demand at each
possible exchange rate
2. The price of the foreign currency in local
currency increases.
3. Home Currency Depreciation
a. Foreign currency more valuable than
the home currency.
b. Conversely, the foreign currencys
value has appreciated against the
home currency.


The USD Depreciates







Exchange rate determination is complex.

The following exhibit provides an overview

of the many determinants of exchange
This road map is first organized by the
three major schools of thought (parity
conditions, balance of payments
approach, asset market approach), and
secondly by the individual drivers within
those approaches.
These are not competing theories but
rather complementary theories.

Without the depth and breadth of the various

approaches combined, our ability to capture the
complexity of the global market for currencies is

In addition to gaining an understanding of the

basic theories, it is equally important to gain a
working knowledge of:
the complexities of international
political economy;
societal and economic infrastructures;
random political, economic, or social
events affect the exchange rate markets.

Exhibit: Determinants of Exchange Rates

Parity Conditions
1. Relative inflation rates
2. Relative interest rates
3. Forward exchange rates
4. Interest rate parity
Is there a well-developed
and liquid money and capital
market in that currency?


Asset Approach
1. Relative real interest rates
2. Prospects for economic growth
3. Supply & demand for assets
4. Outlook for political stability
5. Speculation & liquidity
6. Political risks & controls

Is there a sound and secure

banking system in-place to
support currency trading

Balance of Payments
1. Current account balances
2. Portfolio investment
3. Foreign direct investment
4. Exchange rate regimes
5. Official monetary reserves 15

The previous exhibit, with its tripartite

categorization of exchange rate theory is a
good start but in our humble opinion is
not robust enough to capture the multitude of
theories and approaches.
Therefore, in the following slides, we will
introduce several additional streams of


The Parity Approach

The theory of purchasing power parity is the most
widely accepted theory of all exchange rate
determination theories:
PPP is the oldest and most widely followed
of the exchange rate theories.
Most exchange rate determination theories
have PPP elements embedded within their
PPP calculations and forecasts are however
plagued with structural differences across
countries and significant data challenges in

The Monetary Approach

PPP can be reformulated into the Monetary
approach (Shapiro pp140-42) based on the
quantity theory of money:

M/P = y/v
where M is the national money supply, P is
the general price level, y is real GNP, and v
is the velocity of money.

After rewriting, in terms of growth rates to

give the determinants of domestic inflation:

ih = h - gyh + gvh
where ih is the domestic inflation rate, h is
the rate of domestic money supply expansion,
gyh is growth in real domestic GNP, and gvh
the change in the velocity of the domestic
money supply.


For example, U.S. money supply growth is

forecast at 5%, real GNP is expected to to
grow at 2%, the velocity of money is expected
to fall by 0.5%, U.S. inflation will be

ih = h - gyh + gvh
= 5% - 2% + (-0.5%) = 2.5%
Foreign inflation rate can be obtained in the
same way. Combining these two equations
along with PPP leads to the following predicted
exchange rate change:

e1 e0

ih i f (h f ) ( g yh g yf ) ( gvh gvf )

Where h and f refers to the corresponding

rates for the home and foreign country.
The monetary approach in its simplest form
states that the exchange rate is determined
by the supply and demand for national
monetary stocks, as well as the expected
future levels and rates of growth of monetary

Other financial assets, such as bonds are not

considered relevant for exchange rate determination,
as both domestic and foreign bonds are viewed as
perfect substitutes.

Expectations and Asset Market Model

Currency values: affected by current events and
currency supply and demand flows in FX market, also
depend on expectations.
Asset Market Model: the exchange rate between two
currencies represents the price that just balances the
relative supplies of, and demands for, assets
denominated in those currencies. Shifts in
preferences can lead to massive shifts in currency

The asset market approach assumes that

whether foreigners are willing to hold claims in
monetary form depends on an extensive set of
investment considerations or drivers (among
Relative real interest rates are a major
consideration for investors in foreign bonds and
STMM instruments
Prospects for economic growth and profitability
are an important determinant of cross-border
equity investment in both securities and foreign
direct investment (FDI)

Capital market liquidity: cross-border investors

are not only interested in the ease of buying
assets, but also in being able to sell those assets
quickly for fair market value.
A countrys economic & social infrastructure:
ability to survive unexpected external shocks and
to prosper in a rapidly changing world economic
Political stability.
The credibility of corporate governance practices
is important to cross-border portfolio investors


Contagion: the spread of a crisis in one country to

its neighbouring countries and other countries that
have similar characteristics.
Speculation can both cause a FX crisis or make
an existing crisis worse.
The asset market approach argues that exchange
rates are determined by the supply and demand for
a wide variety of financial assets:
Shifts in the supply and demand for financial
assets alter exchange rates.
Changes in monetary and fiscal policy alter
expected returns and perceived relative risks of
financial assets, which in turn alter exchange

Foreign investors are willing to hold securities and

undertake foreign direct investment in highly
developed countries based primarily on relative real
interest rates and the outlook for economic growth
and profitability.
The asset market approach is also applicable to
emerging markets, however in these cases there is a
number of additional variables contribute to
exchange rate determination.
Although different schools of thought on exchange
rate determination (parity conditions, monetary
approach, balance of payments approach, asset
approach) make understanding exchange rates
appear to be straightforward, that it rarely the case.

The large and liquid capital and currency markets

follow many of the principles outlined so far
relatively well in the medium to long term.
The smaller and less liquid markets, however,
frequently demonstrate behaviors that seemingly
contradict the theory.

The problem lies not in the theory, but in the

relevance of the assumptions underlying the