ch16

Chapter 16
Determinants of the
Foreign Exchange Value
of a Currency
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Learning Objectives
Explain how exchange rates are
determined
Describe the factors responsible for
movements in the exchange rate
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Chapter Organisation
16.1 Introduction
16.2 FX Market and the Equilibrium
Exchange Rate
16.3 Factors Influencing Exchange
Rate Movements
16.4 Sensitivity of the Exchange Rate
to Changes in Economic Variables
16.5 Purchasing Power Parity
16.6 Summary
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16.1 Introduction
The structure and operations of the FX
markets are considered in Chapter 15

Attention is now focused on the
factors that influence the value of a
currency (in a floating exchange rate
regime) in order to attempt to forecast
future exchange rates with some
reliability and accuracy
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16.1 Introduction (cont.)

A floating exchange rate regime is one
in which the value of the currency is

determined by demand and supply
conditions
A pegged exchange rate regime is
where a domestic currency is locked
into a multiple of another currency
such as the USD e.g. Hong Kong dollar
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16.1 Introduction
Exchange Rate
Rate Movements
16.6 Summary
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16.2 FX Market and the

Equilibrium Exchange Rate
Demand for a currency
To purchase Australian goods and services,
foreigners must buy AUD
Downward sloping demand curve occurs as
the devaluation of AUD results in a greater
demand by foreigners
For foreigners, a fall in the price of the AUD is
equivalent to a reduction in the price of
everything in Australia
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(cont.)
Supply of a currency
Upward sloping supply curve occurs as the
quantity of AUDs supplied to the FX market
increases as the price of the AUD increases
As the AUD appreciates, the price of foreign
currency falls, making foreign goods cheaper
for Australian residents
The demand for foreign currency increases
and, therefore, the supply of AUD
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(cont.)
Equilibrium exchange rate
The equilibrium exchange rate is the rate at
which the quantity of AUD supplied to the
market is equal to the demand for AUD
It shows the unique rate at which both the
demanders and suppliers of AUD will be
satisfied
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(cont.)
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16.1 Introduction
Exchange Rate
Rate Movements
16.6 Summary
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16.3 Factors Influencing

Exchange Rate Movements
Relative inflation rates
Relative national income growth rates
Relative interest rates
Exchange rate expectations
Government or central bank
intervention
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Relative inflation rates

Relative inflation rates influence the price
and, therefore, the demand for foreign

goods by residents
The change in demand for imported
goods, in turn, affects the demand for
foreign currency used to buy these goods
This view of the determination of the value of

a currency is called purchasing power parity
(PPP) and is discussed in detail later
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Relative inflation rates (cont.)

Example: increase in US rate of inflation
relative to Australia
Effect for Australian residents
Effect for foreign residents
US imports more expensive, decreasing

demand for these goods; therefore, reducing
the supply of AUD
Some US demand for goods and services, and
assets will switch to Australian items, increasing
demand for AUD to pay for these items
Net effect is an appreciation of the AUD
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Relative inflation rates (cont.)
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Relative national income growth

rates
Example: Australian income growth
rates rise relative to the USA

Australian demand for imports increases,
increasing the supply of AUD, causing the AUD
to depreciate
A secondary effect could be an increase in
foreign investment in Australia, increasing the
demand for AUD, causing the AUD to recover
some value
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Relative national income growth

rates (cont.)
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Example: if Australian interest rates
rise, relative to the USA
Effect for US residents
US residents and companies may redirect some

of their cash into Australian interest bearing
instruments, increasing the demand for the
AUD
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Relative interest rates (cont.)
Australian investors and businesses are more

likely to keep their surplus funds invested in
Australia, causing a decrease in the supply of
the AUD
Net effect
AUD will appreciate
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The role of interest rates on the
exchange rate ignores expectations

about the value of the currency during
the investment period
Table 16.1 illustrates the interaction of
interest rate differentials and
expected changes in the exchange
rate over the investment period on
currency value
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From Table 16.1 the following impact
on the value of the AUD would be

evident
Scenario
Scenario
Scenario
Scenario
1:
2:
3:
4:
AUD
AUD
AUD
AUD
would
would
would
would
depreciate
appreciate
not change
appreciate
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The analysis has ignored whether a
change in nominal interest rates is

due to a change in the real rate of
return or a change in the inflation
expectations premium
inom r pe
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Example: if nominal interest rates rise
due to an increase in the inflation

expectations premium
The currency may not appreciate, and

could depreciate due to
The effect of inflationary expectations (PPP

theory)
Businesses and individuals seeking to invest
cash holdings in overseas securities to avoid a
loss of value
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Example: if nominal interest rates rise
due to an increase in the real rate of

return
The currency may appreciate
Due to an inflow of funds from the rest of the

world
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Relatively little of the turnover in the
FX market is associated with

payments for imports and exports of
goods and services
Most turnover is motivated by
changes in exchange rate
expectations
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(cont.)
Exchange rate expectations are based
on expectations about future changes

in
Relative inflation
Relative income growth
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(cont.)
Example: AUD expected to depreciate
Effect for foreign residents
Seek to buy foreign currency before AUD falls

Increasing supply of AUD on FX markets
Defer purchases of AUD denominated items
Reduces demand for AUD
Net effect
AUD depreciates as expected
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(cont.)
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intervention
Policies by foreign and/or domestic
governments may affect the relative

rate of inflation, income growth or
interest rates between countries
Also, the market participants
expectations that the government will
alter its policy affecting these
variables in the future
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intervention (cont.)
A central bank may also influence the
currency by
Intervening in international trade flows

Intervening in foreign investment flows
Directly intervening in the FX market
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International trade flows
Intervention aimed at increasing exports
and/or reducing imports by the use of
Subsidies to exporters, making exports more

competitive
Thereby, increasing demand for Australian

exports and increasing demand for AUD
Tariffs, quotas and embargoes on imports
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Foreign investment flows
Governments alter the exchange rate by
altering the flow of investment funds
between countries by
Prohibitions on the outflow of funds from a

country
Imposing penalty taxes to residents who earn
income offshore
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Direct FX market intervention
Involves purchases or sales of currency
Two motivations for doing this
Smoothing
RBA tries to remove volatility in the currency

caused by speculators
Exchange rate targeting
RBA tries to push the equilibrium exchange rate

to some level
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16.1 Introduction
Exchange Rate
16.3 Factors Influencing Exchange Rate
Movements
16.4 Sensitivity of the Exchange Rate to
Changes in Economic Variables
16.6 Summary
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16.4 Sensitivity of the

Exchange Rate to Changes in
Economic Variables
Regression analysis can be used to
assess how changes in economic

variables affect the exchange rate
It is a statistical technique that

determines the relationship between a
dependent variable (the exchange rate)
and independent variables (relative
growth, inflation and interest rates etc.)
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16.1 Introduction
Exchange Rate
Rate Movements
16.6 Summary
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(PPP)
Purchasing power parity (PPP) suggest
that exchange rates will adjust to

ensure prices on the same goods are
equal between countries
i.e. a currency should have equal

purchasing power at home or in any
foreign country once the currency is
exchanged into foreign currency at the
current rate
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(PPP) (cont.)
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(PPP) (cont.)
PPP provides reasonably accurate results
over the long run
Poor short-term performance is attributed to

factors affecting the mechanism for adjustments in
the demand for goods and services between
countries with different rates of inflation, including
Existence of substitutes
Unknown quality and reliability of new supply
Delivery time from overseas
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(PPP) (cont.)
S%
(1 I )
f
1 I )
(16.1)
Where :
S percentage change in the exchange rate that should
offset the change in the inflation differenti al between
two countries
I home country inflation rate
h
foreign country inflation rate
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(PPP) (cont.)
Assume that the home country
experiences inflation of 10 per cent per

annum, while the foreign country has
inflation of 4 per cent per annum. If PPP
is maintained, then:
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(PPP) (cont.)
S%
(1 I )
f
1 I )
(1 4.00%)
1
1 10.00%)
1.04
1
1.10
5.4545%
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(PPP) (cont.)
That is, the home currency should depreciate
by 5.46 per cent in response to the higher

rate of inflation in the home country.
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16.1 Introduction
Exchange Rate
16.3 Factors Influencing Exchange Rate
Movements
16.6 Summary
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16.6 Summary
Demand and supply determine the value of a
currency in a floating exchange rate regime

Factors that influence the demand and/or
supply of a currency are
Relative inflation rates (PPP)

Relative national income growth rates
Central bank or government intervention
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Chapter 16

markets are considered in Chapter 15

16.1 Introduction (cont.)

in which the value of the currency is

16.2 FX Market and the

16.2 FX Market and the

16.2 FX Market and the

16.2 FX Market and the

16.3 Factors Influencing

Relative inflation rates

and, therefore, the demand for foreign

This view of the determination of the value of

Relative inflation rates (cont.)

Effect for Australian residents

Effect for foreign residents

US imports more expensive, decreasing

Net effect is an appreciation of the AUD

Relative inflation rates (cont.)

Relative national income growth

rates rise relative to the USA

Relative national income growth

Relative interest rates

rise, relative to the USA

Effect for US residents

US residents and companies may redirect some

Relative interest rates (cont.)

Effect for Australian residents

Australian investors and businesses are more

AUD will appreciate

Relative interest rates (cont.)

Relative interest rates (cont.)

exchange rate ignores expectations

Relative interest rates (cont.)

Relative interest rates (cont.)

on the value of the AUD would be

Relative interest rates (cont.)

change in nominal interest rates is

Relative interest rates (cont.)

due to an increase in the inflation

The currency may not appreciate, and

The effect of inflationary expectations (PPP

Relative interest rates (cont.)

due to an increase in the real rate of

The currency may appreciate

Due to an inflow of funds from the rest of the

Exchange rate expectations

FX market is associated with

Exchange rate expectations

on expectations about future changes

Exchange rate expectations

Effect for Australian residents

Effect for foreign residents

Seek to buy foreign currency before AUD falls

AUD depreciates as expected

Exchange rate expectations

Government or central bank

governments may affect the relative

Government or central bank

Intervening in international trade flows

Government or central bank

Subsidies to exporters, making exports more

Thereby, increasing demand for Australian

Tariffs, quotas and embargoes on imports