Shifts in Exchange Rates

Introduction

Key Concepts

Understanding Exchange Rates

An exchange rate is the price of one country's currency in terms of another's. It determines how much of one currency can be exchanged for another, facilitating international trade and investment. Exchange rates can be classified into two main types: floating and fixed.

In a floating exchange rate system, the value of the currency is determined by market forces of supply and demand relative to other currencies. Conversely, a fixed exchange rate system pegs the currency's value to that of another major currency or a basket of currencies, reducing the volatility associated with floating rates.

Factors Influencing Exchange Rates

Several factors can cause shifts in exchange rates, including:

• Interest Rates: Higher interest rates offer lenders a better return relative to other countries. Consequently, higher rates attract foreign capital, increasing demand for the currency and causing its value to rise.
• Inflation Rates: A country with a lower inflation rate will see an appreciation in its currency value, as its purchasing power increases relative to other currencies.
• Political Stability and Economic Performance: Countries that are politically stable and exhibit robust economic performance tend to attract foreign investment, increasing demand for their currency.
• Market Speculation: If investors believe that a currency will strengthen in the future, they will buy more of that currency now, leading to an appreciation.
• Government Intervention: Governments may intervene in the foreign exchange market to stabilize or increase the value of their currency by buying or selling their own currency.

The Balance of Payments and Exchange Rates

The balance of payments (BOP) is a comprehensive record of a country's economic transactions with the rest of the world. It consists of the current account, capital account, and financial account. The BOP influences exchange rates through its impact on the supply and demand for a country's currency.

A surplus in the current account, indicating that a country exports more than it imports, tends to appreciate the currency because there is higher demand for the country's goods and, by extension, its currency. Conversely, a deficit leads to depreciation as more of the country's currency is sold to purchase foreign goods and services.

Purchasing Power Parity (PPP)

Purchasing Power Parity is an economic theory that states that in the long run, exchange rates should adjust so that an identical good costs the same in different countries when priced in a common currency. PPP provides a method for comparing the economic productivity and standards of living between countries.

The formula for PPP is: $$ \text{Exchange Rate} = \frac{\text{Price Level in Domestic Country}}{\text{Price Level in Foreign Country}} $$ For example, if a basket of goods costs \$100 in the U.S. and £80 in the U.K., the PPP exchange rate would be: $$ \text{Exchange Rate} = \frac{100}{80} = 1.25 \text{ USD/GBP} $$ If the actual exchange rate deviates from the PPP rate, it suggests that one currency may be undervalued or overvalued relative to the other.

Interest Rate Parity (IRP)

Interest Rate Parity is a theory which posits that the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. IRP ensures that investors cannot achieve arbitrage profits by borrowing in a currency with a low-interest rate and investing in a currency with a high-interest rate.

The formula for Interest Rate Parity is: $$ \frac{F}{S} = \frac{1 + i_{\text{domestic}}}{1 + i_{\text{foreign}}} $$ Where:

• F = Forward exchange rate
• S = Spot exchange rate
• i_domestic = Domestic interest rate
• i_foreign = Foreign interest rate

Exchange Rate Determination Models

There are several models to determine exchange rates, each emphasizing different factors:

• Monetary Model: Focuses on the supply and demand for money in different countries, considering factors like money supply, income levels, and price levels.
• Asset Market Model: Considers currencies as assets and focuses on expectations, asset demand, and supply, including interest rates and risk perceptions.
• Behavioral Equilibrium Exchange Rate (BEER): Combines elements of different models to explain exchange rate movements based on economic fundamentals.

Each model provides unique insights, and often, exchange rates are influenced by a combination of factors rather than a single determinant.

Impact of Exchange Rate Shifts on the Economy

Exchange rate fluctuations can have significant effects on an economy:

• Exports and Imports: A depreciation of the domestic currency makes exports cheaper and imports more expensive, potentially improving the trade balance. Conversely, an appreciation makes exports more expensive and imports cheaper.
• Inflation: Depreciation can lead to higher inflation as imported goods become more expensive. Appreciation can help reduce inflationary pressures.
• Investment Flows: Exchange rate stability encourages foreign investment, while high volatility may deter investors due to increased risk.
• Economic Growth: Favorable exchange rate conditions can boost economic growth by enhancing export competitiveness and stimulating investment.

Speculative Attacks and Currency Crises

Speculative attacks occur when investors believe a currency will depreciate, leading them to sell off the currency en masse. If the central bank maintains a fixed exchange rate, it may need to use its foreign reserves to defend the currency, which can be costly and unsustainable in the long run. Prolonged speculative attacks can lead to a currency crisis, resulting in rapid devaluation and severe economic consequences.

Historical examples include the Asian Financial Crisis of 1997, where multiple currencies experienced sharp depreciations due to speculative attacks, leading to widespread economic turmoil.

Government Interventions in the Foreign Exchange Market

Governments and central banks may intervene in the foreign exchange market to influence their currency's value. Common interventions include:

• Direct Intervention: Buying or selling the domestic currency in exchange for foreign currencies to influence its value directly.
• Indirect Intervention: Implementing monetary or fiscal policies to affect the currency's value, such as changing interest rates or altering government spending.

While such interventions can temporarily stabilize exchange rates, persistent intervention may lead to imbalances and retaliatory measures from trading partners.

The Role of Expectations in Exchange Rate Movements

Expectations about future economic conditions, interest rates, and political stability significantly influence exchange rates. If investors anticipate that a country's economy will strengthen, they may buy more of its currency, causing it to appreciate. Conversely, negative expectations can lead to depreciation as investors divest from the currency.

Behavioral economics also highlights how cognitive biases and market sentiment can lead to exchange rate volatility, sometimes deviating from models like PPP and IRP in the short term.

Comparison Table

Summary and Key Takeaways