Factors influencing exchange rates Supply and Demand for

Factors influencing exchange rates: Supply and Demand for a Currency Short – run … financial transactions n Market fundamentals Current account balances n Real interest rates n n Market expectations News about future market fundamentals n Speculative opinion about future exchange rates n

Factors influencing exchange rates Medium – run n Real income … business cycle Monetary policy and fiscal policy Product availability Long – run n n Inflation rates Consumer preferences for domestic or foreign products Productivity changes affecting production costs … and prices Profitability and riskiness of investments Government trade policy

Impact of interest rate differentials: drop in US interest rate $ depreciation S 1 Dollars per Yen S 0 B. 0080 . 0075 A D 1 D 0

Impact of real income differentials: increase in US income $ depreciation S 0 Dollars per Pound B 1. 60 1. 50 A D 1 D 0

Purchasing power parity (PPP): The Law of One Price n n A good should cost the same in all countries (aside from tariffs or transportation costs) Exchange rates should make prices equal across countries P = ER x P* ($/bourbon) = ($/£) x (£ /scotch) = ($/scotch) n n If two countries have different inflation rates, exchange rates will move keep prices the same The currency of the high inflation country will depreciate (P/P*) ER ($/£)

Impact of inflation rate differentials: high US inflation $ depreciation S 1 Dollars per Pound S 0 B 1. 70 1. 50 A D 1 D 0

Market expectations As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates n Future expectations can be selffulfilling; speculative bubbles can start without any real information but can become self sustaining for a while n

Impact of expectations: expectation of $ depreciation S 1 Dollars per Pound S 0 B 1. 70 1. 50 A D 1 D 0

Alternative approaches to exchange rates Monetary approach Focus on exchange rates as the result of supply and demand for money at home and abroad n Demand depends on real income, prices, interest rates n Supply is controlled by central banks n Ms $ depreciates n Real income Md $ appreciates n Interest rate Md $ depreciates ? ? !? n