Exchange Rate Theories
Exchange rate theories are frameworks used to explain the determinants of exchange rates between currencies. They include the purchasing power parity theory, the interest rate parity theory, and the balance of payments theory. These theories help businesses understand and predict currency movements, which is crucial for international trade, investment, and financial decision-making.
7 Key excerpts on "Exchange Rate Theories"
eBook - ePub- Sukumar Nandi(Author)
- 2017(Publication Date)
- Routledge India(Publisher)
...10 Modern Theory of Exchange Rate Determination and International Parity Relationship 10.1 Introduction When we discuss the determination of exchange rate of a currency, we mean the equilibrium exchange rate. The latter becomes meaningful as it should bring equilibrium in the balance of payments of the country as well as be consistent with other desirable parameters of the economy. There has been a tremendous growth of literature on the exchange rate in the past two decades. The success or failure of an open economy depends crucially on the management of its exchange rate. Given this importance, it is no wonder that exchange rate is one of the most heavily researched areas in the economics literature. In the case of an open economy, the exchange rate of the domestic currency is the crucial link between the domestic economy and the world. When a country has a flexible exchange rate regime, the domestic economy is expected to adjust whenever exchange rate changes. This makes the exchange rate change very important. The literature gives several theories that explain the movement of the exchange rate both in the short-run and in the long-run. The exchange rate reflects the bilateral quantitative relation between two sovereign currencies, which themselves are the numeraire in their domestic markets for the determination of the nominal prices of the commodities. This aspect brings the exchange rate into the central place of the open economy macroeconomics. Further, since it reflects the external price of the sovereign currency, the authorities attach importance to the stability of this rate. Thus, many governments give prestige to the stability of the exchange rate. Moreover, the stability of the exchange rate is important to safeguard the economic interest of the country, and this aspect will be made clearer a little later. The exchange rate as defined here is the indirect quotation of the same in the foreign exchange market (popularly known as forex market)...
eBook - ePub- Anthony J. Makin(Author)
- 2016(Publication Date)
- Routledge(Publisher)
...These days, however, national governments can choose from a number of alternative exchange rate arrangements ranging from independently floating to fixed. 3. The debate about fixed versus floating exchange rates covers such issues as whether currency speculation is stabilising or destabilising and whether central banks possess superior economic knowledge. 4. The decision to float exchange rates and abolish exchange controls was a consequence of increased trade and capital market integration. 5. The flow approach to the exchange rate explains short-run exchange rate variation based on the supply and demand for currencies arising from imports, exports and foreign capital inflows and outflows. 6. Over longer periods, the most fundamental theory of exchange rate determination is PPP, which links relative price levels and inflation rates to movements in the nominal exchange rate. Countries with higher inflation rates tend to have depreciating currencies relative to countries with low inflation rates. 7. As a long-run equilibrium condition, PPP can be used to judge whether nominal exchange rates at any time are overvalued or undervalued....
eBook - ePub- W. Charles Sawyer, Richard L. Sprinkle(Authors)
- 2020(Publication Date)
- Routledge(Publisher)
...CHAPTER 14 Exchange rates and their determination A basic model The exchange rate is determined from day to day by supply and demand of home currency in terms of foreign currency. Each transaction is two-sided, and sales are equal to purchases. Any change in the conditions of demand or of supply reflects itself in a change in the exchange rate, and at the ruling rate the balance of payments balances from day to day, or from moment to moment. Joan Robinson INTRODUCTION T he international value of a country’s currency has become an inescapable part of the daily flow of economic information. Most of us are aware that a country’s exchange rate is important, but many of us do not have a clear idea of why the exchange rate matters or what causes it to change. As the chapter’s opening quote indicates, the familiar tools of supply and demand analysis can be used to determine a country’s exchange rate. In this chapter, you will learn why the supply and demand model works in analyzing exchange rates—in the same manner, in fact, that it works in analyzing the price of gasoline or pizza, for one dollar or one yen or one gallon of gasoline is indistinguishable from another. By the end of this chapter you should have a good grasp of why exchange rates are important and what factors cause them to change over the long run. Finally, it is obvious to even a casual observer that exchange rates change frequently. These changes, or volatility, are a source of aggravation for individuals, businesses, and governments. The chapter explains what economists know about the effects of exchange rate volatility on international trade and how changes in exchange rates affect the prices of the goods and services we purchase. The final part of the chapter deals with the underlying value of a currency. While the exchange rate we observe in the market often differs from that value, it is very useful to know what that value is. EXCHANGE RATES Suppose that a U.S. importer is purchasing British Jaguars...
eBook - ePubDevelopment Economics
Theory and Practice
- Alain de Janvry, Elisabeth Sadoulet(Authors)
- 2021(Publication Date)
- Routledge(Publisher)
...If domestic inflation exceeds inflation abroad, then, other things being equal, there will be increasing demand for cheaper foreign goods and the exchange rate e should increase. The PPP theory asserts that this effect should be the main explanation for exchange rate movements. Correspondingly, one can define the PPP equilibrium exchange rate in any year in relation to a base-year equilibrium exchange rate as e * (P P P) = e 0 * P d / P 0 d P $ / P 0 $, where P 0 d, P 0 $, e 0 * are, respectively, the domestic price index, the foreign price index, and the equilibrium exchange rate in the base year. By choosing a base year in which the official nominal exchange rate e0 was at an equilibrium level, this expression can be used to compute a time series of equilibrium exchange rates. The choice of the base year is, however, the tricky part of this approach. One usually chooses a year in which the balance of payments was roughly in equilibrium or at an acceptable long-term disequilibrium value, and for which this equilibrium was not obtained by exceptional constraints imposed on imports, exports, or capital movements. All necessary data on exchange rate and price indices are available in the IMF’s International Financial Statistics (2020). The Real Exchange Rate and Its Effect on Real Balances Tradables, Non-Tradables, and the Real Exchange Rate The nominal exchange rate represents the relative price of the currencies of two countries, and hence the correspondence between domestic and foreign prices of the goods that are exchanged through imports or exports. It however does not account for the price of the many other goods and commodities that are not exchanged on the international market. In contrast, the real exchange rate (RER) measures in a given country the relative price of goods and services that are imported or exported with those that are not exchanged on the international market...
- Ashima Goyal(Author)
- 2016(Publication Date)
- Routledge India(Publisher)
...5 Purchasing power parity and the exchange rate Water finds its own level. 5.1 Introduction In Chapter 4, we took the expected nominal exchange rate to be given exogenously. In this chapter, we begin to examine more carefully what determines equilibrium real, and therefore expected nominal exchange rates. Trade arbitrage between any two countries should lead to a nominal exchange rate that is proportional to the relative price levels of the two countries. This is known as the purchasing power parity (PPP) nominal exchange rate. PPP, thus, links the nominal exchange rate to relative price levels. It implies the bilateral exchange rate between two countries is the ratio of their price levels. The concept has been known for centuries, although it was given its modern name by Gustav Cassel in 1918. 1 Although there is little empirical support for PPP, it serves as a benchmark and is a major component especially of the monetary theories of the exchange rate. In this chapter, we explain absolute and relative PPP and the underlying law of one price (LOOP). Then, we survey some of the empirical tests of these theories, before turning to reasons why they may fail to hold. The remainder of the chapter is structured as follows: Section 5.2 derives PPP and its variants from trade arbitrage. Section 5.3 reports on tests of trade arbitrage and Section 5.4 on why PPP is difficult to establish empirically, before Section 5.5 concludes with a summary of the chapter contents. Appendix 5.A.1 has a formal derivation of the Balassa-Samuelson (BS) result on why the real exchange rate is more appreciated in richer countries. 5.2 Trade arbitrage Just as arbitrage determines equilibrium under UIP, trade arbitrage affects the real equilibrium value of a currency. PPP exchange rate between two currencies is the rate, which would equate the two relevant national price levels if they were expressed in a common currency...
eBook - ePubForeign Exchange
A Practical Guide to the FX Markets
- Tim Weithers(Author)
- 2011(Publication Date)
- Wiley(Publisher)
...Much of the rationale for a floating exchange rate regime hinges on the belief that an unregulated global economy will serve to advance the interests of all countries collectively (even if it is not the case that every single individual benefits from that flexibility). Milton Friedman tells us that if foreign exchange rates are determined in a free market, they will settle at whatever level will clear that market. His classic treatise, “The Case for Flexible Exchange Rates,” produced in the early 1950s, in the middle of the Bretton Woods fixed exchange rate regime, was a spectacularly unorthodox defense of the power of competitive world markets. 7 “What about the argument that we must defend the dollar, that we must keep it from falling in value in terms of other currencies—the Japanese yen, the German mark, or the Swiss franc?. . . The price of the dollar, if determined freely, serves the same function as all other prices. It transmits information and provides an incentive to act on that information because it affects the incomes that participants in the market receive.” 8 If, to a U.S. consumer, Japanese automobiles are attractive relative to the alternatives, then why should the U.S. government either induce (possibly via tariffs) that consumer to buy the more expensive U.S. product or spend the consumer’s tax Dollars to artificially maintain a strong Yen = weak Dollar? It may sound somewhat less dramatic today, but the Friedmans report that the U.S. government lost around USD 2,000,000,000 between 1973 and early 1979 defending the U.S. Dollar. IMPLICATIONS OF MONETARY POLICY Economists have investigated, developed theories, and modelled the effects of monetary and fiscal policy under different exchange rate regimes...
eBook - ePubEconomics for Investment Decision Makers
Micro, Macro, and International Economics
- Christopher D. Piros, Jerald E. Pinto(Authors)
- 2013(Publication Date)
- Wiley(Publisher)
...Because each country reports its data in its own currency, each country’s data must be converted into a common currency, usually the U.S. dollar. One can convert the GDP data into dollars using either current market exchange rates or the exchange rates implied bypurchasing power parity (PPP). Purchasing power parity is the idea that exchange rates move to equalize the purchasing power of different currencies. At the exchange rates implied by PPP, the cost of a typical basket of goods and services is the same across all countries. In other words, exchange rates should be at a level where you can buy the same goods and services with the equivalent amount of any country’s currency.EXHIBIT 11-1Divergent Real GDP Growth among CountriesSources:International Monetary Fund,World Economic Outlookdatabase for growth rates, and Conference Board Total Economy Database (September 2011).In general, the simple method of taking a country’s GDP measured in its own currency and then multiplying by the current exchange rate to express it in another currency is not appropriate. Using market exchange rates has two problems. First, market exchange rates are very volatile. Changes in the exchange rate could result in large swings in measured GDP even if there is little or no growth in the country’s economy. Second, market exchange rates are determined by financial flows and flows in tradable goods and services. This ignores the fact that much of global consumption is for nontradable goods and services. Prices of nontraded goods and services differ by country. In particular, nontraded goods are generally less expensive in developing countries than in developed countries. For example, because labor is cheaper in Mexico City than in London, the prices of labor-intensive products, such as haircuts or taxi rides, are lower in Mexico City than in London...
