Chapter 05 What Determines Exchange Rates?,Thinking in terms of supply and demand is a necessary first step toward understanding exchange rates. The next step is the one that has to be taken in any market analysis: finding out what underlying forces cause supply and demand to change. Since the general shift to floating exchange rates in the early 1970s, exchange rates between the U.S. dollar and other major currencies have been variable or volatile.,Figure 5.1 reminds us just how variable exchange rates have been. (Panel A),Panel B,The charts suggest three types of variability. First, there are long-term trends in which some currencies tend to appreciate against the dollar, and others tend to depreciate. Second, there are medium-term trends which are sometimes counter to the longer trends. Third, there is a substantial variability during the short run (from month to month, and indeed, from day to day, hour to hour, and even minute to minute).,Why do we see large changes in the values of floating exchange rates? How does short-run variability turn into long-run trends? Why are medium-run trends sometimes opposite to these longer trends?,5.1 Exchange Rates in the Short Run 5.2 The Long Run: Purchasing Power Parity (PPP) 5.3 The Long Run: The Monetary Approach 5.4 Exchange Rate Overshooting 5.5 How Well Can We Predict Exchange Rates,5.1 Exchange Rates in the Short Run,To analyze, we use the concept of uncovered interest parity from chapter 4. Recall that investors determine the expected overall return on an uncovered investment in a bond denominated in a foreign currency by using The basic return on the bond itself (the interest rate or yield), and The expected gain or loss on currency exchanges (the expected appreciation or depreciation of the foreign currency).,Uncovered interest parity links together four variables: the domestic interest rate, the foreign interest rate, the current spot exchange rate and the expected future spot exchange rate. Change in any one of these four variables implies that adjustments will occur in one or more of the other three.,The Role of Interest Rates,Suppose the domestic interest rate (i) increases, while the foreign interest rate (if) and the spot exchange rate expected at some appropriate time in the future (eex) remain constant, if the international investors want to shift toward domestic currency assets, they first need to buy domestic currency before they can buy the domestic-currency bonds. This increase in demand for domestic currency increases the current spot exchange rate value of domestic currency, so the foreign currency depreciates (the home currency appreciates). Given the speed with which financial investors can initiate shifts in their portfolios, the effect on the spot exchange rate can happen very quickly (instantaneously or within a few minutes).,For example, page 73. If the foreign interest rate increases, then the foreign currency appreciates. Then what happens if both interest rates change at the same time? The answer is that what really matters is the change in the interest differential if-i.,The Role of the Expected Future Spot Exchange Rate,Suppose that the interest rate differential is unchanged, the financial investors now expect the future spot exchange rate to be higher than they previously expected, if the investors want to shift toward foreign-currency assets, they first need to buy foreign currency. This increase in demand for foreign currency increases the current spot exchange rate e. (The foreign currency appreciates; the domestic currency depreciates.) For example, page 74.,As with a change in interest rates, the effect of a change in the expected future spot rate on the current spot exchange rate can happen very quickly (instantaneously or within a few minutes). Given the powerful effects what exchange-rate expectations can have on actual exchange rates, wed like to know what determines these expectations. Many different things can influence the value of the expected future exchange rate.,First, if expectations simply extrapolate recent trends, then a bandwagon is possible. Speculation then may be based on destabilizing expectations expectations formed without regard to the economic fundamentalsand (speculative) bubbles can occur. Second, if expectations are based on a belief that exchange rates eventually follow PPP, then they lead to stabilizing speculationspeculation that tend to move the exchange rate toward a value consistent with the economic fundamentals of national price levels. Third, expectations are affected by various kinds of news about economic and political circumstances. Overall, Figure 5.2 provides a road map by summarizing the effects.,Figure 5.2,5.2 The Long Run: Purchasing Power Parity (PPP),In the short run, floating exchange rates are often highly variable, and there are times when it is not easy to understand why the rates are changing as they are. In the long run, economic fundamentals become dominant, pro