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# CHAPTER V! EXCHANGE RATES AND INTER .

ST RATES
Foreign-Exchange Markets

of one currency in terms of another currency is called the nominal exchange rate.

27 Nominal exchange rates set the value of a currency in terms of other currencies. They do not reflect the purchasing power, or the real exchange rate. For example,,a camera sells for \$1000; if the dollar is worth K800, the kyat price of the camera is K800,000rYhe purchasing power pf eLert kyat and the purchasing power of Icyzil are equal. qual. If the kyat price of the camera is K1,000,000, the purchasing power of a kyat is less than the purchasing power of a dollar. Real and nominal exchange rates are different concepts, but they can be compared in a single relationship. Suppose that a camera costs \$800 in America and K1,000,000 in Myanmar. If \$1 = K800 on foreign exchange market, the real exchange rate , or relative purchasing power by computing the costs of cameras in dollar terms. Let EX = nominal exchange in foreign currency per kyat (dollar per kyat) Pf = foreign-currency price of goods in the foreign country (\$ price of a camera in America) P = domestic-currency price of domestic goods (kyat price of a camera) EX r = real exchange rate (number of comparable goods that domestic consumers can get by trading a unit of domestic goods). The real exchange EXr, is given by the equation EX r = 47 taro EX xP K800 /\$ x EXr = = .1:11464 P1 K1,000,000

EXxP
f

4? Hence at the nominal exchange rate, \$806 buys one camera in the United States, but only 0.64? camera in Myanmar. The purchasing power of a camera - the real exchange rate - is 0.61. It is computed from price indexes. The consumer price index and the price deflator for thegross domestic product are two examples of price indexes. When a currency's real exchange rate rises (appreciate), the country can trade its goods for more units of foreign goods. When a currency's exchange falls (depreciate), the country obtains a smaller volume of foreign goods per unit of domestic goods. Percentage change of the real exchange can be calculated, by dividing the percentage change in EX x P by the percentage change in Pf. EXr AEX AP APf That is , = + EX EX P `71' Pr(4.. AP The percentage change in domestic prices is the domestic rate of inflation it and the percentage change in foreign prices AP Pf Thus
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## Determining Long-Ran Foreign-Exchange Rates

The simplest way to understand how long-run exchange rates are determined is by examining the law of one price. This law states that if two countries produce an identical good, profit opportunities should ensure that its price is the same around the world, no matter which country produces the good. Suppose that a yard of cloth produced in the United States sells for \$10 and that the same type of cloth produced by a Myanmar manufacturer costs K50 per yard. The law of one price says that the exchange rate between the U.S dollar and the Myanmar kyat must be K50 = \$10 or K5 per dollar. If, at going exchange rates, U.S. cloth is cheaper than. Myanmar cloth, the demand for dollars to buy the U. S. cloth would rise, pushing up the malve ra

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28 the dollar. But if, at going exchange rates. Myanmar cloth is cheaper than U.S. cloth, the demand for kyat to buy Myanmar cloth would rise, pushing up the mall.O -fthe kyat. If the exchange rate were K4 per dollar, in Myanmar U.S. cloth would sell for K40 which is cheaper than K50 charged by Myanmar manufacturers. In the U.S., Myanmar cloth would sell for \$12.50 per yard which is more expensive than U.S. produced cloth. As a result, there would be no demand for U.S. cloth and the demand for kyat to buy Myanmar cloth would rise, pushing up the value- of kyat. However, if the exchange rate were K6 per dollar, in Myanmar U.S. cloth would sell for K60 whereas in the U.S. Myanmar cloth would sell for \$8.33 and the demand for kyat would fall, pushing down valtre of kyat. As long as the dollar price of U.S. cloth and the kyat price of Myanmar cloth remain constant, the exchange rate must settle at \$5 per kyat. The law of one price holds when the international prices for an identical good are compared. If the concept of the law of one price is applied to a group of goods, it becomes the purchasing power parity theory of exchange rate determination. The purchasing power parity (PPP) theory is based on the assumption that real exchange rate between two currencies are constant. It states that changes in the nominal exchange rate between two currencies are accounted for by differences in the inflation rates of the two countries. The nominal exchange rate EX = EXr 13,

Because the law of one price holds that EXr is constant, increase or decreases in EX reflect changes in relative price levels between the two countries. In general, the PPP theory of exchange rate determination suggests that whenever a country's price level is expected to rise relative to another country's price level, its currency should depreciate relative to the other country's currency. Conversely, whenever a country's price level is expected to fall relative to another country's price level, its currency should appreciate._ In reality, the law of one price does not hold. Part of this failure is that most of the commodities are differentiated. Another measurement problem with the PPP theory is that not all goods and services are traded in international markets. Finally, the PPP theory's underlying assumption that the real exchange rate is constant is incorrect. Three factors are important in explaining changes in real exchange rate: (I) shifts in preferences for domestic or foreign goods, (2) differences in productivity, and (3) trade barriers. If inflation rates do not change, these factors also can explain shifts in nominal exchange rates.

## Determining Short Run Foreign Exchange Rates

-

In the short run, financial markets determine nominal exchange rates as investors compare expected rates of return on domestic and foreign assets. In particular, the nominal exchange rate represents the price of domestic financial assets dominated in domestic currency in terms of foreign financial assets dominated in foreign currency. Suppose a person wants to invest \$1000 for one year. The investor has the choice to invegt in a U.S. Treasury bill or a Japanese government bond. The U.S. instrument pays interest and principal in dollars with a nominal interest rate of 5% per year. The Japanese instrument pays interest and principal in yen and carries a nominal interest rate of 5% per year. If the risk, liquidity, and information characteristics of the two instruments are comparable, it is necessary to choose which one should buy. It depends on the return of the two instruments. To do so it needs to convert expected returns on both instruments into dollars. If investment of \$1000 is made in the U.S. Treasury bill, interest return of \$50 will be received, so that investment will worth \$1050. For the Japanese bond, dollar must convert into yen first. After a year, the principal and interest received in terms of yen has to be converted into dollar in order

29 to compare the return with that from the U.S. bond. Suppose that the current nominal exchange rate is 100/\$ and that the exchange rate is expected to appreciate by 5% during the coming year. The expected future exchange rate EX' is (f 100)(1.05)/\$ = Y 105/\$. At the current exchange rate, when \$1000 is converted into yen, l00,000 will be available for investment. After receiving a 5% interest return, investment is now worth y105,000 after a year. The expected exchange rate at that time is Y105/\$, so the expected &liar value investment will be -Y105,000/105 = \$1000. Hence, even though the Japanese bond pays the same stated rate of interest as the U.S. Treasury bill, it carries a lower expected return. In general, for each dollar investment in a U.S. Treasury bill will yield Earns \$1 Yielding (1+i). Investing \$1 in a Japanese bond will yield
interest Exchange for foreign currency

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- 117"1 Today's global economy requires significant international capital mobility, that is, the ability of investors to move funds among international markets easily. Hence investors can buy financial assets denominated in many different currencies at many places around the world. In the short run, nominal exchange rates are determined in financial markets as savers compare expected rates of return-on domestic and foreign assets. Foreign exchange market forces equalize expected returns on domestic and foreign assets. For U.S. assets, the expected rate of return R equals the U.S interest rate i. The expected rate of return on foreign assets in dollar taws Rf equals if AEX e /EX. Hence, for Japanese assets, the expected return R t equals the Japanese interest rate if less the expected appreciation of the dollar. Figure 6.1 shows the foreign-exchange market equilibrium. Figure 6.1 Foreign-Exchange Market
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30 A graph of R against the current yen/dollar exchange rate is simply a vertical line because the return on a U.S. asset in dollar terms is the same regardless of the exchange rate. It is paid in dollars. The diagram is based on a U.S. interest rate of 5%. To graph R r against the exchange rate it is necessary to specify the expected yen/dollar exchange rate. This assumption allows calculating the dollar's expected rate of appreciation a key component of Rf. Whenever the current yen/dollar exchange rate exceeds that expected future level, investors will believe that the dollar is usually strong and that it eventually will command fewer yen. That is they will expect the dollar to depreciate. Thus, for an expected level of the exchange rate, a graph of Rf against the current exchange rate slopes upward. As the yen/dollar exchange rate rises, the dollar's expected rate of appreciation falls, pushing up Rf. Suppose that the future yen/dollar exchange rate is expected to be 100, and that Japanese interest rates are 5%. If the current exchange rate also 100, no appreciation is expected, and Rt. equals the 5% Japanese interest rate. If the current exchange rate rises to Y1051\$1, the dollar is expected to depreciate. In this case, investors predict that a dollar will bring only Y 100 in the future. This expected 4.8% depreciation of the dollar increases Rt. to 9.8%. Alternately, if the yen/dollar exchange rate falls to 97, the dollar is expected to appreciate 3.1% and Rf falls to 1.9%. The equilibrium exchange rate is the rate that equates R and Rf. The intersection of R and Rf occurs at Y100/\$1, at which both R and Rr equal 5%. At any other current exchange rate, the expected appreciation or depreciation of the dollar causes Rf to differ from R. The market equilibrium condition is called the nominal interest rate parity condition.. Expected return on domestic asset = Expected return on foreign asset i = if 4EXe/EX This implies that R = R1
Exchange Rate Fluctuations

Exchange rates change in response to shifts in the determinants of domestic interest rate and foreign interest rates. Factors affecting the equilibrium exchange rate are: 1. Changes in domestic real interest rates 2. Changes in domestic expected inflation 3. Changes in foreign interest rates 4. Changes in the expected future exchange rate Effect of a Change in the Domestic Real Interest Rate The expected return on domestic bonds depends on the interest rate i on those instruments. That rate is the sum of expected real rate of interest and the expected rate of inflation. Holding expected inflation constant, an increase in the domestic interest rate increases the rate of return on domestic assets, shifting the R curve to the right from Ro to R I as shown in Figure 6.2(a). Because of the 'higher return on domestic assets, investors increase their demand for dollars to buy domestic assets, resulting in an increase in the exchange rate from EX to EX I . But as Figure 6.2(b) shows, a decrease in the domestic real interest rate causes the expected real rate of return tci shift to the left from R o to R1.

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Figure 6.2 Effect of a Change in the Domestic Real Interest Rate (b) (a)

## Expected Rate of Return

The lower return on domestic assets increases investors' demand for foreign assets and thus the foreign currency. The higher demand for foreign currency exerts downward pressure on the current exchange rate, which falls from Ex o to Ex,. To summarize, if nothing else changes, an increase in the domestic real interest rate causes the domestic currency to appreciate. A decrease in the domestic interest rate causes the domestic currency to depreciate.
Effect of an Increase in Domestic Expected Inflation A change in the domestic nominal interest rate also can be caused by a change in expected inflation for any real rate of interest. When domestic expected inflation changes, the expected change in the exchange rate likely is affected. Because an increase in domestic expected inflation erodes the currency's purchasing power, causing it to depreciate, or lose value against other currencies. Conversely, a decrease in domestic expected inflation raises the domestic currency's purchasing power, causing the domestic currency to appreciate. Figure 6.3 shows the two effects are at work when the domestic interest rate increases because of an increase in expected inflation. Figure 6.3 eeitt. of `Ay) Effect of an Increase in Domestic Expected Inflation do 047P

## Expected Rate of Return

For a constant domestic real interest rate, an increase in expected inflation raises the domestic nominal interest rate from R0 to RI. At the same time, the higher domestic expected inflation reduces the expected appreciation of the clodenaiirrency. The R curve shifts to the right from Rj to Rn . Most empirical studies show that the second effect dominates the first, so that the current exchange rate falls from EX to EX,. To summarize, an increase in the domestic interest rate in response to an increase in domestic expected inflation leads to depreciation of the domestic currency. A decrease in the domestic interest rate in response to a decrease in domestic expected inflation leads to appreciation of the domestic currency.

32

Effect of a Change in the Foreign Interesi Rate The expected rate of return for foreign assets depends on both the foreign interest rate and the expected change in the exchange rate. Figure 6.4 (a) shows that an increase in the foreign real interest rate shifts the foreign expected rate of return Rfo to the right to Rft because, at any exchange rate, the foreign rate of return increases. Figure 6.4 Effect of a Change in the Foreign Interest Rate (b) (a)
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## Expected Rate of Return

As a result the current exchange rate falls. Because the rate of return on foreign assets has gone up, investors buy more foreign currency to buy foreign assets. The availability of a higher expected rate of return on foreign assets increases the demand for those assets relative to domestic assets, increasing the demand for foreign currency and decreasing the demand for domestic currency. As a result, the domestic currency depreciates. If the foreign real interest rate declines instead, as Figure 6.4(b) shows, the expected rate of return on foreign assets declines. That shifts the expected rate of return RID to the left to Rn and increases the exchange rate leading to an appreciation of the domestic currency. Investors now buy more domestic currency to buy domestic assets because the rate of return on domestic assets has gone up. Effect of a Change in Exchange Rate Expectation If the expected future exchange rate increases, as Figure 6.5 (a) shows, expected appreciation of the domestic currency rises. Hence the expected rate of return on foreign assets falls, thereby shifting the expected rate of return from Rio to the left to Rn and increasing the exchange rate. Figure 6.5 Effect of a Change in Exchange Rate Expectation (a) (b) x w
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## Expect d Rate of Return

If instead the expected future exchange rate decreases, as Figure 6.5(b) shows, expected dollar appreciation declines, shifting the expected rate of return from RID to the right to R. Investors now expected a higher return from investing in foreign assets, because they will be able

33 to exchange foreign currency for more units of domestic currency. As foreign assets now have a higher expected rate of return, R tD shifts to the right in Figure 6.5(b), and the exchange rate falls. An increase or decrease in the expected future exchange rate reflects shifts in one or more of the underlying determinants of the exchange rate-differences in price levels, shifts in preferences for domestic or foreign goods, differences in productivity growth, and differences in trade barriers-as well as changes in expected future interest rates. Factors that increase the expected future exchange rate shift the foreign expected rate of return to the left and cause the domestic currency to appreciate. Factors that decrease the expected future exchange rate shift the foreign expected rate of return to the right and cause the domestic currency to depreciate.