International Financial Management

Alan Shapiro and Peter Moles

1st Edition
John Wiley & Sons, Inc.

1 www.wiley.com/college/shapiro
 CHAPTER 2

The Determination of
Exchange Rates

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CHAPTER OVERVIEW:
CHAPTER OVERVIEW:
2.1 SETTING THE EQUILIBRIUM SPOT
EXCHANGE RATE
2.2 EXPECTATIONS AND THE ASSET MARKET
MODEL OF EXCHANGE RATES
2.3 THE FUNDAMENTALS OF CENTRAL BANK
INTERVENTION
2.4 THE EQUILIBRIUM APPROACH

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Equilibrium Exchange Rates

2.1 SETTING THE EQUILIBRIUM SPOT

EXCHANGE RATE
A. The exchange rate
is the price of one unit of foreign currency
expressed as a certain price in local currency.

For example, $1.30/€ means the euro is worth

$1.30.

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Equilibrium Exchange Rates
B. When Americans purchase German
goods:
1. Foreign currency demand derived from the
demand for foreign country’s goods, services, and
financial assets,

e.g. the demand for German cars by

Americans.

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The Demand for € in the U.S.
$/€

D
$1.20/€

$1.10/€
$1.00/€
Qty
At higher exchange rates, Americans demand fewer euros and
vice versa. www.wiley.com/college/shapiro 6
Equilibrium Exchange Rates
2. Foreign currency supply
a. derived from the foreign country’s demand for
local goods.

b. foreigners must convert their currency to

purchase,

e.g. German demand for U.S. goods means

Germans convert € to US$ in order to buy.

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The Supply of € in the U.S.
$/€

$1.20/€
S
$1.10/€
$1.00/€
Qty

At higher exchange rates, Germans supply more euros

and vice versa.
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Equilibrium Exchange Rates
3. Equilibrium spot exchange rate
occurs where the quantity supplied equals the quantity
demanded of a foreign currency at a specific local
exchange rate.

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The $/€ Equilibrium Rate

$/€ Equilibrium
D
S
$1.10

Qty

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Equilibrium Exchange Rates
C. How exchange rates change:

1. Increased demand
as more foreign goods are demanded, more of
the foreign currency is demanded at each possible
exchange rate.

2. The exchange rate of the foreign currency in

local currency increases.

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Equilibrium Exchange Rates
3. Home currency depreciation
a. foreign currency more valuable than the
home currency.

b. conversely,
the foreign currency’s value has
appreciated against the home currency.

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The US$ Depreciates when
$/€ D’
D
$1.20/€
S

$1.10/€

Q1 Q2
Qty
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Equilibrium Exchange Rates
Computing a currency appreciation:

= (e1 - e0)/e0

where e0 = old currency value

e1 = new currency value

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Equilibrium Exchange Rates
Computing a currency depreciation:

= (e0 - e1)/e1

where e0 = old currency value

e1 = new currency value

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Equilibrium Exchange Rates
D. Factors affecting exchange rates:
1. Inflation rates.
2. Interest rates.
3. GNP growth rates.

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Expectations and the Asset Market
Model of Exchange Rates

2.2 THE ROLE OF EXPECTATIONS

A. Currency = financial asset.

B. Exchange rate = simple relation of two financial assets.

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Expectations
C. The nature of money and currency values:
1. Asset market model

exchange rates reflect the supply of and demand

for foreign-currency denominated assets.

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Expectations
2. Soundness of a nation’s economic policies

a nation’s currency tends to strengthen with

sound economic policies.

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Expectations
3. Expectations and central bank behavior
exchange rates are also influenced by
expectations of central bank behavior.

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Expectations
D. Central bank reputations and currency
values:

1. Central bank
the nation’s official monetary authority.

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Expectations
2. Price stability and central bank independence
when the bank limits its focus to price
stability, it is more likely to succeed in its goal.

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Expectations
3. Currency board
‒ exists where there is no central bank
‒ instead the board issues notes
‒ has no discretionary monetary policy.

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The Fundamentals of
Central Bank Interventions
2.3 HOW REAL EXCHANGE RATES AFFECT
RELATIVE COMPETITIVENESS

A. Appreciation:
– Domestic prices increase
relative to foreign prices.

– Exports: less competitive.

Imports: more attractive.

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The Fundamentals of Central Bank
Interventions
B. Currency depreciation:

domestic prices fall relative to foreign prices.

– Exports: more price competitive.

– Imports: less attractive.

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The Fundamentals of Central Bank
Interventions
C. Foreign exchange market intervention

Mechanics of intervention
Sterilized vs unsterilized intervention

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The Fundamentals of Central Bank
Interventions
D. The effects of foreign exchange market
intervention:

1. Definition: the official purchases and sales of

currencies through the central bank to
influence the home exchange rate.

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The Equilibrium Approach
2.4 THE EQUILIBRIUM APPROACH TO
EXCHANGE RATES

A. Disequilibrium theory and exchange rate

overshooting:
1. Various economic frictions cause prices
to adjust slowly over time.
2. Leads to “overshooting”.

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The Equilibrium Approach
B. The equilibrium theory of exchange
rates and its implications:

1. Markets clear through price adjustments.

2. Repeated shocks in supply and
demand create a correlation between changes
in nominal and real exchange rates.

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