Topic 8 - Factors That Influence the Exchange Rate (Part 2)

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This article is a topic within the subject Capital Markets and Institutions.

Contents

Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 546-571.

Foreign Exchange Markets And An Equilibrium Exchange Rate

[1] To purchase Australian goods, services & assets foreigners must purchase (or demand) AUD. Demand is downward sloping as a depreciation is equivalent to the reduction in the price of everything in Australia (lower price higher demand). Supply is upward sloping. This means the quantity supplied increases as the AUD appreciates since the price of foreign currency falls making foreign goods, services & assets cheaper for Australians (who need to convert to foreign currency to purchase foreign goods, services or assets)). The Equilibrium Exchange Rate is the rate at which quantity supplied equals quantity demanded. It is the unique exchange rate at which both D&S will be satisfied.

Factors That Influence Exchange Rate Movements

[2] In this section we look at the factors that influence the value of currencies and go through a few clear examples.[3][4]

  • Relative Inflation Rates (PPP Theory) - E.g. if US inflation rises in comparison to AUS CPI, than:
    • AUS residents: spend less on more expensive US G&S causing reduced supply of AUD
    • US residents: may switch to Australian G&S as their prices aren’t rising as fast, causing increased AUD demand
    • Effect on Australians + Effect of Americans = Appreciation (to offset the inflation differential incentives)
    • Purchasing Power Parity (PPP) theory states that exchange rate movements ensure the cost of identical G&S is the same across countries
  • Relative National Income Growth RatesE.g. if Australian income growth rates rise in comparison to the US, than:
    • AUS residents: demand for US exports increases, increasing supply of AUD, causing a depreciation
    • Secondary Effect: Foreigners (US Citizens) may increase investment, increasing demand for AUD, causing an appreciation
  • Relative Interest RatesE.g. if Australian interest rates rise relative to the US, than:
    • AUS citizens: keep investments in Australia decreasing supply
    • US citizens: redirect investments into Australian interest bearing assets, increasing demand for AUD
    • Effect on Australians + Effect of Americans = Appreciation
    • Interest rate analysis cannot ignore expectations of the currency’s future price movements (see diagram below)
    • Appreciation depends on whether an increase in real interest rate or the inflations expectation premium
      • The nominal interest rate =~ real rate of return + inflation expectation premium
        • If an interest rate rise is due to an increase in real rate of return there will be more inflows & less outflows = appreciation
        • If an interest rate rise is due to an increase in the inflationary expectation premium the currency may not appreciate but depreciate
          • May depreciate – due to higher inflation (PPP theory), avoid investment in high inflation areas

FINS1612L.jpg

  • Exchange Rate Expectations
    • Significant activity is from exchange rate expectations based on relative inflation rates, income growth & interest rates
    • E.g. If the AUD is expected to depreciate, than:
      • AUS residents: buy foreign currency, increase supply of AUD
      • Foreign residents: defer AUD purchases, reduced demand
      • Depreciation
  • Government or Central Bank Intervention
    • Policies by foreign & domestic government may affect relative inflation, income growth & interest rates
      • Influences market expectations, policies to slow CPI, expectations reflect relevant future variable levels
    • Intervene in international trade flows
      • Subsidies to exporters increases demand for AUS exports & increase AUD demand
      • Tariffs, quotas & embargoes reduce import demand & reduce AUD supply
    • Intervene in foreign investment flows
      • Prohibit outflows (penalising offshore income)
      • Increase/Decrease inflows (FIRB)
    • Intervene directly in the FX market by dirtying the float (buying/selling currency) to ‘smooth’ volatility caused by speculators to bring about stability ONLY (don’t aim to change AUD value) or to push the equilibrium exchange rate to some level (exchange rate targeting)

End

This is the end of this topic. Click here to go back to the main subject page for Capital Markets and Institutions.

References

Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.

  1. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 548-551
  2. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 551-561
  3. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  4. Natalie Oh, Lecture Notes, ASB, UNSW
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