Determinants of an Exchange Rate - Essay Example

Determinants of an Exchange Rate Introduction Exchange rate is defined by Johann (2005: 5) as “prices for specific commodities, the currencies.” Just like in a goods market, exchanges rates in the financial markets are determined by forces of supply and demand. However, it all depends on the exchange rate regime being adopted by the particular country. The exchange rates have a strong effect on the economy as they affect production, real interest rates, domestic credit, terms of trade, employment and tourism (Levich, 2001). As such it is very important for policy makers to understand the determinants of exchange rate behaviour in the long-run and short-run so that they can make informed policy decisions. The exchange rates between countries are also essential in determining the balance of payments. According to Levich (2001) there is no general theory of exchange rate determination. Various economists apply different theories to come up with the short-run and long-run determinants of exchange rates. However, most of them agree that exchange rates are determined by parity conditions such as inflation, interest rates, and purchasing power. They are also determined by terms of trade, government expenditure and political risks (Dwivedi, 2010). The aim of this paper is to evaluate the main determinants of exchange rate behaviour in the short-run and long-run and explain why exchange rates tend to be volatile and notoriously hard to predict. To better understand the exchange rates, the paper will first discuss the foreign exchange market and then it will look at the exchange rate regimes. It will then discuss the exchange rate determination in foreign exchange market using combination of balance of payment and asset approach to determination of exchange rate. The IS-LM model developed by Hicks will be used to analyse the changes in the product and money market which have a bearing on exchange rates through balance of payments. The Foreign Exchange Market This is a market where currencies are traded or domestic currency is exchanged for foreign currency. The market is assumed to be efficient in that the price of the currency in the market is determined by forces of demand and supply (Carbaugh, 2011). The financial market like goods market obeys the laws of demand and supply; the demand for currency varies inversely with price (Williamson, 2009). If demand for a currency increases its price increases (appreciates) making it unattractive in the market. Buyers thus switch to buying products where value of currency is low leading to depreciation of the currency until equilibrium is reached. For example, in a market involving dollars and pounds whereby the dollar is the domestic currency and the pound is the foreign currency, an increase in demand for foreign currency (pound) results in depreciation of the domestic currency (dollar) while an increase in supply of foreign currency leads to appreciation of the dollar until equilibrium is reached (Sercu and Uppal, 1995). As shown in figure 1, Do represents the demand curve for pounds while So represents the supply curve. Equilibrium exchange rate is obtained at the point where demand curve intersects with supply curve (point E). At this point, the exchange rate of dollars per pound is stable hence the market is efficient (Carbaugh, 2011 p. 399). The demand curve in this case represents the desire of the Americans to purchase British goods, services and assets and by observing the law of demand; the US demand for pound varies inversely with price. If price increases, the demand for pounds decreases and if price decreases the demand for pound increases. This means that if the dollar price of pound increases, exports from Britain become more expensive and as a result the Americans will reduce their purchases leading to low demand for the pound. The supply curve represents the quantity of pounds in the market to buy the American dollar (Carbaugh, 2011: 399). As dollar price of the pound increases, the American goods become more attractive to for the British hence increased purchases and consequently increased supply of pounds in the foreign exchange market so as to buy the dollar (S0-S1). This means exports from the US become cheaper hence more imports by British and since foreign exchange is used to pay for imports, more pounds are offered in the market (Levich, 2001). The increased supply of pounds leads to a decline in dollar price of ponds hence appreciation of the dollar against the pound. However, these changes depend on the exchange rate regime. Fig. 1 Demand and Supply Conditions Foreign Exchange Market Equilibrium Increase in Demand Exchange Rate Regimes There are two exchange rate regimes; the floating exchange regime and the fixed exchange rate regime. Countries adopt either of the regimes but some of them like the US utilize both regimes. The floating exchange system according to Carbaugh (2011) is a system whereby the currency value is determined by the forces of demand and supply in the foreign exchange market. In such a situation the government has no control over the price of currency in the market. The demand for and supply of the home currency is determined by the equilibrium exchange rate where demand intersects with supply as in fig.1 above. The exchange rate in the floating regime is determined by relative interest rates, relative prices and relative income levels among nations (Fullerton, Hattori & Calderon 2001). This system is essential for nations especially the developed nations as it allows the nation to respond efficiently to the changes of demand and supply in the foreign exchange market (Williamson, 2009). It also eliminates the need to apply the monetary and fiscal policies to correct the imbalances in the economy thus allow them to be useful in other areas. Furthermore, the economy is cleared of any surpluses or deficits thus a balanced economy. However, leaving the currency rate to be determined by forces of demand and supply can lead to large fluctuations in the currency value (McDonald, Burton & Dowling, 2002). This leads to inflation and an effect on foreign trade and investments as well as tourism. The fixed exchange rate regime is whereby the government fixes the exchange rate instead of allowing the market forces to determine the value of currency (Williamson, 2009). According to Carbaugh (2011) it is mostly used by developing countries since they are prone to inflation. Fixed exchange system involves pegging a domestic currency against a key currency in the financial market. This currency must be stable and widely acknowledged as a means of exchange in the world market (Mankiw, 2010). For example, the dollar is used widely in the world market while the euro is used in European countries and also in the world market hence it can be set as a standard means of exchange. The benefit of using this system is that the government is able to prevent fluctuations in its currency. For example, the US uses a floating exchange rate but used fixed exchange to correct market failures hence it adopts a managed floating exchange rate. It also allows countries especially the developing ones to manage inflation thus create investor confidence and encourage foreign trade. Determinants of Exchange Rates The combined model of exchange rate determination enumerates five conditions: purchasing power parity, interest rate parity, fisher effect, international fisher effect and the forward rate (Johann, 2005; McDonald, Burton & Dowling, 2002). These conditions link the various determinants of exchange rates. According to Carbaugh (2011) the long-run determinants of exchange rate include relative price levels, relative productivity levels, consumer preferences for domestic or foreign goods and trade barriers (P. 400). Short-run determinants on the other hand, include relative interest rates and expectations of future exchange rates. Some other researchers include terms of trade, openness, political risk and domestic credit as determinants of exchange rates (Levich, 2001; Saeed, Awan, Sial & Sher, 2012). An IS-LM model shows the relationship between the product and the money market. It is essential to understand the transactions that go on in the two markets as they affect exchange rates. The product market depends on the money market and vice versa. The IS curve represents the product market while LM curve represents the money market (Baumol & Blinder, 2009; Gordon, 2009; Mankiw, 2010). In an open economy which includes foreign trade the product market is represented by the equation: C+ I+G+(X-M) =C+S+T but exports (X) are assumed to be constant and imports (M) is a function of national income Y. Since foreign trade does not directly affect money supply and money demand, the LM curve is represented by the equation M/P=L (i, Y) =L(r, Y) OR money supply (Ms) = money demand (Md). Where M is currency supply to public and P is price which is assumed to be fixed; i is real interest rate and r is nominal interest rate (Dwivedi, 2010; Gordon, 2009). The general equilibrium is reached when the product and money market are at equilibrium simultaneously through intersection of IS and LM curve. The model is used to study short-run changes when prices are fixed and no inflation. Fig. 2: The IS-LM Model Adapted from Dwivedi (2010):273 The relative interest rates connects forward rate to the spot rate and interests in domestic economy to those abroad (Levich, 2001). The forward rate is known and an unbiased predictor of future spot rates assuming that the inflation is known. The exchange rate is affected by interest rate difference between domestic and foreign country (i-ir) whereby i is the domestic interest and ir is foreign interest (Johann, 2005: 6). A rise in interest rate difference makes the domestic currency to appreciate thus attracting investors in assets (Mankiw, 2010). This leads to increased demand for domestic currency and reduced value for foreign currency and vice versa. The interest rate parity theorem indicates that rate of return to assets between countries will be equal to allow for expected exchange rate changes (McDonald et al. 2002 p. 112). As such, capital flows into the country are offset by appreciation in currency which discourages investors hence equilibrium is reached. This relative interest rate parity affects exchange rate in the short-run. The level of interest rates and level of income are determined by the general equilibrium of product and money markets (Baumol & Blinder, 2009). Using the balance of payment approach, balance of payment is the difference between exports and imports. Imports are withdrawals from the circular flow of income as they involve outflow of income while exports are injections since they bring income to the country in terms of foreign exchange (Mankiw, 2010). An increase in income from exports causes aggregate demand to rise causing rightward shift of IS curve while imports lead to downward shift of the curve. According to Gordon (2009) a rightward shift leads to increased investments, consumption and exports and decline spending on imports thus while a decrease in money supply shifts LM curve upwards leading to high interest rates and low income. This model is effective in short-run since prices are assumed to be fixed. In the long-run prices would go up leading to inflation thus devaluation of currency. The purchasing power parity assesses particular level of exchange rate or the adequacy of a particular exchange rate policy (Johann, 2005: 6). It states that over the long-run exchange rate between currencies adjusts to relative price levels. If price level in the domestic market increases and price level in foreign market remains constant, the consumers in the domestic market being rational will buy products from the foreign market since they are cheaper. This leads to outflow of cash or increased supply of domestic currency in foreign exchange market. However, the foreign country demand for currency is low since its products are expensive leading to fall in price of domestic currency and appreciation of the foreign currency. The productivity levels also determine exchange rates in the long-run (Carbaugh, 2011). For example, if UK manufacturers are more productive than the US manufacturers then it means UK manufactures can produce goods cheaply hence low prices. The low prices will attract buyers from the US thus increase in UK exports to US and consequently increased demand for the UK pound. This will lead to appreciation of the pound against dollar and in the long-run the market will adjust to reach equilibrium (Williamson, 2009). Conclusion The exchange rates are affected by various factors such as interest rates, expectations of future exchange rates, relative prices, productivity levels, and consumer preference. All these result from transactions in the product and the money market that in turn affect the income and interest rates. Interest rates determine the demand for money in the market and in turn money supply thus affecting exchange rates. If interest rates are high in the domestic market, foreign investors reduce investments hence decrease in money demand but if interests are low, investors demand more money for investments leading to appreciation of domestic currency. Volatility in exchange rates is as a result of short-term determinants such as exchange rate expectations. References Baumol, W.J. & Blinder, A.S. (2009). Economics: Principles and Policy. Mason, OH: South-Western Cengage. Carbaugh, R.J. (2011). Contemporary Economics: An Applications Approach. 6th ed. New York: M.E.Sharpe, Inc. Dwivedi, D.N. (2010). Macroeconomics: Theory and Policy. New Delhi: McGraw Hill. Fullerton, T. M., Hattori, M. & Calderon, C. (2001). Error Correction Exchange Rate Modeling Evidence for Mexico. 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