Saudi Arabia’s Currency and the U.S. Dollar

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INTERNATIONAL ECONOMICS SEVENTEENTH EDITION

ROBERT J. CARBAUGH

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Chapter 12 Exchange Rate Determination

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Chapter Outline

What Determines Exchange Rates?

Determining Long-Run Exchange Rates

Inflation Rates, Purchasing Power Parity, and Long-Run Exchange Rates

Determining Short-Run Exchange Rates: The Asset-Market Approach

Exchange-Rate Overshooting

Forecasting Foreign-Exchange Rates

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What Determines Exchange Rates? (1 of 3)

Factors that cause the supply-and-demand schedules of currencies to change

Market fundamentals (economic variables)

Productivity, inflation rates, real-interest rates, consumer preferences, and government trade policy

Market expectations

News about future market fundamentals

Traders’ opinions about future exchange rates

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What Determines Exchange Rates? (2 of 3)

Factors affecting exchange rates

Short run: transfers of assets

Differences in real-interest rates and shifting expectations of future exchange rates

Medium run: cyclical factors

Fluctuations in economic activity

Long run: flows of goods, services, and investment capital

Inflation rates, investment profitability, consumer tastes, productivity, and government trade policy

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What Determines Exchange Rates? (3 of 3)

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Determining Long-Run Exchange Rates (1 of 5)

Exchange rate changes

Reactions of traders in foreign-exchange market to changes in four key factors:

Relative price levels

Relative productivity levels

Preferences for domestic or foreign goods

Trade barriers

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Determining Long-Run Exchange Rates (2 of 5)

TABLE 12.1 Determinants of the Dollar’s Exchange Rate in the Long Run

Factor*	Change	Effect on the Dollar’s Exchange Rate
U.S. price level	Increase Decrease	Depreciation Appreciation
U.S. productivity	Increase Decrease	Appreciation Depreciation
U.S. preferences	Increase Decrease	Depreciation Appreciation
U.S. trade barriers	Increase Decrease	Appreciation Depreciation

*Relative to other countries. The analysis for a change in one determinant assumes that the other determinants are unchanged.

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Determining Long-Run Exchange Rates (3 of 5)

Relative Productivity Levels

Increase in U.S. price level leads to increase in demand for foreign currency, decrease in supply of foreign currency, and depreciation of dollar

Decrease in U.S. price level leads to decrease in demand for foreign currency, increase in supply of foreign currency, and appreciation of dollar

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Determining Long-Run Exchange Rates (4 of 5)

Preferences for Domestic or Foreign Goods

Increased demand for U.S. exports and appreciation of dollar

Increased demand for U.S. imports and depreciation of dollar

U.S. imposes trade barriers

Appreciation of dollar

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Determining Long-Run Exchange Rates (5 of 5)

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (1 of 13)

Law of One Price

Identical goods should be sold everywhere at same price when converted to common currency, assuming it is costless to ship goods between nations, there are no barriers to trade, and markets are competitive

Prevailing market-exchange rate is the true equilibrium rate

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (2 of 13)

Burgeromics: The Big Mac Index and the Law of One Price

Attempt to measure the true equilibrium value of a currency based on one product, the Big Mac

Can be used to determine extent to which market-exchange rate differs from true equilibrium-exchange rate

Big Mac prices show law of one price does not hold across countries

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (3 of 13)

TABLE 12.2 Big Mac Index, 2017

Country/Currency	Price of Big Mac in Local Currency	Price of Big Mac in U.S. Dollars*	Local Currency Overvaluation (+) Undervaluation (−) (percent)
United States (dollar)	$5.06	$5.06	—
Switzerland (franc)	6.50	6.35	25.5
Norway (krone)	49.0	5.67	12.1
Sweden (krona)	48.0	5.26	4.0
Canada (dollar)	5.98	4.51	−10.9
Euro Area (euro)	3.88	4.06	−19.7
China (yuan)	19.6	2.83	−44.1
Mexico (peso)	49.0	2.23	−55.9

*At market exchange rate, January 12, 2017. The price in each country is based on the average of four cities.

Source: From “Big Mac Currencies,” The Economist, available at http://www.economist.com.

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (4 of 13)

Purchasing Power Parity

Theory that exchange rates adjust to make goods and services cost same everywhere

Application of law of one price

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (5 of 13)

Purchasing Power Parity

If the rate of inflation is much higher in one country

Its money has lost purchasing power over domestic goods

Currency should depreciate to restore parity with prices of goods abroad

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (6 of 13)

TABLE 12.3 The Law of One Price Applied to a Single Product—Steel

According to the law of one price, if the yen price of steel increases by 10 percent and the dollar price of steel remains constant, the yen will depreciate by 10 percent against the dollar to ensure that price is the same in both countries.

Yen Price of a Ton of Steel	Dollar Price of a Ton of Steel	Exchange Rate: Yen per Dollar
50,000 yen	500	100
55,000	500	110

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (7 of 13)

Purchasing Power Parity(cont’d)

Trade flows are mechanism that makes a currency depreciate or appreciate

Changes in relative national price levels determine changes in exchange rates over long term

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (8 of 13)

Purchasing Power Parity (cont’d)

Foreign-exchange value of currency tends to appreciate or depreciate at rate equal to difference between foreign and domestic inflation

Changes in relative national price levels

Determine changes in exchange rates, long term

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (9 of 13)

Purchasing Power Parity (cont’d)

A currency is expected to depreciate by amount equal to the excess of domestic inflation over foreign inflation

A currency is expected to appreciate by amount equal to excess of foreign inflation over domestic inflation

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (10 of 13)

Purchasing Power Parity (cont’d.)

Used to predict long-term exchange rates

P - price indexes of U.S. and Switzerland

0 - base period

1 - period 1

S0 - equilibrium exchange rate in base period

S1 - estimated target at which actual rate should be in the future

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (11 of 13)

Purchasing Power Parity (cont’d.)

Exchange-rate movements may be influenced by investment flows

Problems

Choosing appropriate price index to be used in price calculations

Determining equilibrium period to use as base

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (12 of 13)

Purchasing Power Parity (cont’d.)

Government policy may interfere with operation of theory

Forecasting exchange rates appropriate in long run; poor forecasters in short run

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Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (13 of 13)

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Determining Short-Run Exchange Rates: The Asset-Market Approach (1 of 9)

Foreign-exchange market activity

Dominated by investors in assets

Treasury securities, corporate bonds, bank accounts, stocks, and real property

Asset-market approach

Investors decide between domestic and foreign investments based on

Relative levels of interest rates

Expected changes in exchange rate itself over term of investment

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Determining Short-Run Exchange Rates: The Asset-Market Approach (2 of 9)

TABLE 12.4 Determinants of the Dollar’s Exchange Rate against the Pound in the Short Run

Change in Determinant*	Repositioning of International Financial Investment	Effect on Dollar’s Exchange Rate
U.S. Interest Rate
Increase	Toward dollar-denominated assets	Appreciates
Decrease	Toward pound-denominated assets	Depreciates
British Interest Rate
Increase	Toward pound-denominated assets	Depreciates
Decrease	Toward dollar-denominated assets	Appreciates
Expected Future Change in the Dollar’s Exchange Rate
Appreciate	Toward dollar-denominated assets	Appreciates
Depreciate	Toward pound-denominated assets	Depreciates

*The analysis for a change in one determinant assumes that the other determinants are unchanged.

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Determining Short-Run Exchange Rates: The Asset-Market Approach (3 of 9)

Relative Levels of Interest Rates

Level of nominal interest rate is first approximation of rate of return on assets that can be earned in a particular country

Differences in level of nominal interest rates between economies

Likely to affect international investment flows as investors seek highest rate of return

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Determining Short-Run Exchange Rates: The Asset-Market Approach (4 of 9)

Relative Levels of Interest Rates (cont’d)

If interest rates in U.S. > rates abroad

Increase in demand for dollars

Dollar appreciation

If interest rates in U.S. < rates abroad

Decrease in demand for dollars

Dollar depreciation

Real-interest rate

Nominal-interest rate minus inflation rate

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Determining Short-Run Exchange Rates: The Asset-Market Approach (5 of 9)

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Determining Short-Run Exchange Rates: The Asset-Market Approach (6 of 9)

TABLE 12.5 Nominal and Real Interest Rates, April 2017

Country	Nominal Interest Rate* (percent)	Inflation Rate** (percent)	Real Interest Rate (percent)
Greece	6.7	0.8	5.9
Russia	8.1	4.5	3.6
South Africa	8.8	5.7	3.1
Indonesia	7.0	4.3	2.7
United States	2.2	2.4	−0.2
Canada	1.5	1.9	−0.4
Euro Area	0.2	1.6	−1.4
Venezuela	10.4	56.2	−45.8

*Rates are for 10-year government bonds.

**Measured by the Consumer Price Index for the latest three months.

Source: From The Economist, “Economic and Financial Indicators,” April 22, 2017. See also International Monetary Fund, International Financial Statistics, and World Bank, Data and Statistics, available at www.data.worldbank.org.

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Determining Short-Run Exchange Rates: The Asset-Market Approach (7 of 9)

Expected Change in the Exchange Rate

Future expectations of appreciation of dollar can be self-fulfilling for today’s value of the dollar

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Determining Short-Run Exchange Rates: The Asset-Market Approach (8 of 9)

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Determining Short-Run Exchange Rates: The Asset-Market Approach (9 of 9)

Diversification, Safe Havens, & Investment Flows

Relative levels of interest rates strongly impact investment flows

Other factors affecting investment flows among economies

Size of stock of assets denominated in a particular currency in investor portfolios may induce change in investor preferences for diversification purposes

Safe-haven effect: investors may be willing to sacrifice return for safe repository for their funds

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Exchange-Rate Overshooting (1 of 4)

Exchange-Rate Overshooting

Short-run response (depreciation or appreciation) to change in market fundamentals is greater than its long-run response

Changes in market fundamentals exert a disproportionately large short-run impact on exchange rates

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Exchange-Rate Overshooting (2 of 4)

Exchange-Rate Overshooting (cont’d)

Helps explain why exchange rates depreciate or appreciate so sharply from day to day

Volatility of exchange rates intensified by overshooting

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Exchange-Rate Overshooting (3 of 4)

Exchange-Rate Overshooting (cont’d)

Overshooting explained by:

Tendency of elasticities to be smaller in short run than in long run

Ex. (Figure 12.6): Increased demand for pounds leads to initial pound appreciation (dollar depreciation); with U.S. prices lower, quantity of pounds supplied increases over time, dampening the initial pound appreciation

Exchange rates tend to be more flexible than many other prices, which are often written into long-term contracts

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Exchange-Rate Overshooting (4 of 4)

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Forecasting Foreign- Exchange Rates (1 of 9)

Forecasting exchange rates

Very tricky, especially in short run

Necessary for exporters, importers, investors, bankers, and foreign-exchange dealers

Choosing currency in which to make deposits requires idea of what currency’s value will be

Decisions about foreign investment necessitate awareness of where exchange rates will move over time

Need for exchange rate forecasting resulted in emergence of consulting firms

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Forecasting Foreign- Exchange Rates (2 of 9)

Judgmental forecasts

Subjective or common sense models require

Wide array of political and economic data

Interpretation of these data in terms of timing, direction, and magnitude of exchange-rate changes

Projections based on thorough examination of individual nations

Based on economic indicators, political factors, technical factors, psychological factors

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Forecasting Foreign- Exchange Rates (3 of 9)

Technical forecasts

Involve use of historical exchange-rate data to estimate future values

Ignore economic and political determinants of exchange-rate movements

Founded on idea that “history repeats itself”

Used to analyze short-run movements of exchange rates

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Forecasting Foreign- Exchange Rates (4 of 9)

TABLE 12.7 Exchange Rate Forecasters

Forecasting Organization	Methodology	Horizon
Global Insights	Econometric	24 months
JPMorgan Chase	Judgmental Econometric	Under 12 months Over 12 months
Bank of America	Econometric Technical	Over 12 months Under 12 months
Goldman Sachs	Technical Econometric	Under 12 months Over 12 months
UBS Global Asset Management	Judgmental Econometric	8 months 12 months

Source: Data collected by author.

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Forecasting Foreign- Exchange Rates (5 of 9)

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Forecasting Foreign- Exchange Rates (6 of 9)

Fundamental Analysis

Opposite of technical analysis

Considers economic variables likely to affect supply and demand of a currency

Uses statistical estimations of economic theories

Attempts to incorporate fundamental variables that underlie exchange-rate movements

Interest rates, balance of trade, productivity, inflation rates

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Forecasting Foreign- Exchange Rates (7 of 9)

Limitations of econometric models used to forecast exchange rates

Rely on predictions of key economic variables for which reliable information may be hard to obtain

Some factors affecting exchange rates cannot easily be quantified

Precise timing of factor’s effect on currency’s exchange rate may be unclear

Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis

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Forecasting Foreign- Exchange Rates (8 of 9)

Econometric models best suited for forecasting long-run trends in the movement of an exchange rate

Models do not generally provide foreign currency traders precise price information regarding when to purchase or sell a particular currency

Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis

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Forecasting Foreign- Exchange Rates (9 of 9)

Exchange-Rate Misalignment

Deviation of exchange rate from fundamental value

Has implications for country’s trade position and job creation

Undervalued currency gives country trade advantage at expense of trading partners

Undervaluation widely considered unfair; however, there’s no sure way to estimate correct value of currency and thus determine extent of undervaluation

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