ECN 500 Saudi Electronic University Exchange Rate Determination Paper

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While Saudi Arabia seeks to diversify its economy, the Saudi economy is dominated by the petroleum sector. In addition, the Saudi Arabian Riyal (SAR) is pegged to the U.S. Dollar.
In a critical essay, discuss the advantages and disadvantages of the pegged exchange rate. Indicate the main considerations Saudi Arabia faces from a currency perspective (e.g., currency values, interest rates, inflation, and trade issues) that ensue given two scenarios:
The first scenario is a dramatically declining world oil price.
The second scenario is a dramatically increasing world oil price.

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INTERNATIONAL
ECONOMICS
SEVENTEENTH EDITION
ROBERT J. CARBAUGH
© 2019 Cengage. All rights reserved.
1
Chapter 12
Exchange
Rate
Determination
© 2019 Cengage. All rights reserved.
2
Chapter Outline
What Determines Exchange Rates?
Determining Long-Run Exchange Rates
Inflation Rates, Purchasing Power Parity, and
Long-Run Exchange Rates
Determining Short-Run Exchange Rates: The
Asset-Market Approach
Exchange-Rate Overshooting
Forecasting Foreign-Exchange Rates
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3
What Determines Exchange
Rates? (1 of 3)
Factors that cause the supply-and-demand
schedules of currencies to change
• Market fundamentals (economic variables)
• Productivity, inflation rates, real-interest rates,
consumer preferences, and government trade
policy
• Market expectations
• News about future market fundamentals
• Traders’ opinions about future exchange rates
© 2019 Cengage. All rights reserved.
4
What Determines Exchange
Rates? (2 of 3)
• Factors affecting exchange rates
• Short run: transfers of assets
• Differences in real-interest rates and shifting
expectations of future exchange rates
• Medium run: cyclical factors
• Fluctuations in economic activity
• Long run: flows of goods, services, and
investment capital
• Inflation rates, investment profitability, consumer
tastes, productivity, and government trade policy
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5
What Determines Exchange
Rates? (3 of 3)
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6
Determining Long-Run Exchange
Rates (1 of 5)
Exchange rate changes
• Reactions of traders in foreign-exchange
market to changes in four key factors:
•
•
•
•
Relative price levels
Relative productivity levels
Preferences for domestic or foreign goods
Trade barriers
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7
Determining Long-Run Exchange
Rates (2 of 5)
TABLE 12.1 Determinants of the Dollar’s Exchange Rate in the Long Run
Factor*
Change
Effect on the Dollar’s
Exchange Rate
U.S. price level
Increase
Decrease
Depreciation
Appreciation
U.S. productivity
Increase
Decrease
Appreciation
Depreciation
U.S. preferences
Increase
Decrease
Depreciation
Appreciation
U.S. trade barriers
Increase
Decrease
Appreciation
Depreciation
*Relative to other countries. The analysis for a change in one determinant assumes that the other
determinants are unchanged.
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8
Determining Long-Run Exchange
Rates (3 of 5)
• Relative Productivity Levels
• Increase in U.S. price level leads to increase
in demand for foreign currency, decrease in
supply of foreign currency, and depreciation of
dollar
• Decrease in U.S. price level leads to
decrease in demand for foreign currency,
increase in supply of foreign currency, and
appreciation of dollar
© 2019 Cengage. All rights reserved.
9
Determining Long-Run Exchange
Rates (4 of 5)
• Preferences for Domestic or Foreign
Goods
• Increased demand for U.S. exports and
appreciation of dollar
• Increased demand for U.S. imports and
depreciation of dollar
• U.S. imposes trade barriers
• Appreciation of dollar
© 2019 Cengage. All rights reserved.
10
Determining Long-Run Exchange
Rates (5 of 5)
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11
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (1 of 13)
Law of One Price
• Identical goods should be sold everywhere at
same price when converted to common
currency, assuming it is costless to ship goods
between nations, there are no barriers to
trade, and markets are competitive
• Prevailing market-exchange rate is the true
equilibrium rate
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12
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (2 of 13)
• Burgeromics: The Big Mac Index and the
Law of One Price
• Attempt to measure the true equilibrium value
of a currency based on one product, the Big
Mac
• Can be used to determine extent to which
market-exchange rate differs from true
equilibrium-exchange rate
• Big Mac prices show law of one price does
not hold across countries
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13
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (3 of 13)
TABLE 12.2 Big Mac Index, 2017
Price of Big Mac
in Local Currency
Price of Big Mac
in U.S. Dollars*
Local Currency Overvaluation (+)
Undervaluation (?) (percent)
$5.06
$5.06
—
Switzerland (franc)
6.50
6.35
25.5
Norway (krone)
49.0
5.67
12.1
Sweden (krona)
48.0
5.26
4.0
Canada (dollar)
5.98
4.51
?10.9
Euro Area (euro)
3.88
4.06
?19.7
China (yuan)
19.6
2.83
?44.1
Mexico (peso)
49.0
2.23
?55.9
Country/Currency
United States (dollar)
*At market exchange rate, January 12, 2017. The price in each country is based on the average of four cities.
Source: From “Big Mac Currencies,” The Economist, available at http://www.economist.com.
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14
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (4 of 13)
• Purchasing Power Parity
• Theory that exchange rates adjust to make
goods and services cost same everywhere
• Application of law of one price
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15
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (5 of 13)
• Purchasing Power Parity
• If the rate of inflation is much higher in one
country
• Its money has lost purchasing power over
domestic goods
• Currency should depreciate to restore parity
with prices of goods abroad
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16
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (6 of 13)
TABLE 12.3 The Law of One Price Applied to a Single
Product—Steel
According to the law of one price, if the yen price of steel increases by
10 percent and the dollar price of steel remains constant, the yen will
depreciate by 10 percent against the dollar to ensure that price is the
same in both countries.
Dollar Price of a
Ton of Steel
Exchange Rate:
Yen per Dollar
50,000 yen
500
100
55,000
500
110
Yen Price of a Ton of Steel
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17
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (7 of 13)
• Purchasing Power Parity(cont’d)
• Trade flows are mechanism that makes a
currency depreciate or appreciate
• Changes in relative national price levels
determine changes in exchange rates over
long term
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18
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (8 of 13)
• Purchasing Power Parity (cont’d)
• Foreign-exchange value of currency tends to
appreciate or depreciate at rate equal to
difference between foreign and domestic
inflation
• Changes in relative national price levels
• Determine changes in exchange rates, long term
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19
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (9 of 13)
• Purchasing Power Parity (cont’d)
• A currency is expected to depreciate by
amount equal to the excess of domestic
inflation over foreign inflation
• A currency is expected to appreciate by
amount equal to excess of foreign inflation
over domestic inflation
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20
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (10 of 13)
• Purchasing Power Parity (cont’d.)
• Used to predict long-term exchange rates
• P – price indexes of U.S. and Switzerland
• 0 – base period
• 1 – period 1
• S0 – equilibrium exchange rate in base period
• S1 – estimated target at which actual rate should be
in the future
S1 = S0
PUS1 PUS0
PS1 PS0
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21
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (11 of 13)
• Purchasing Power Parity (cont’d.)
• Exchange-rate movements may be influenced by
investment flows
• Problems
• Choosing appropriate price index to be used in
price calculations
• Determining equilibrium period to use as base
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22
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (12 of 13)
• Purchasing Power Parity (cont’d.)
• Government policy may interfere with operation of
theory
• Forecasting exchange rates appropriate in long
run; poor forecasters in short run
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23
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (13 of 13)
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24
Determining Short-Run Exchange Rates:
The Asset-Market Approach (1 of 9)
Foreign-exchange market activity
• Dominated by investors in assets
• Treasury securities, corporate bonds, bank
accounts, stocks, and real property
Asset-market approach
• Investors decide between domestic and
foreign investments based on
• Relative levels of interest rates
• Expected changes in exchange rate itself over
term of investment
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25
Determining Short-Run Exchange Rates:
The Asset-Market Approach (2 of 9)
TABLE 12.4 Determinants of the Dollar’s Exchange Rate against the
Pound in the Short Run
Change in Determinant*
Repositioning of International
Financial Investment
Effect on Dollar’s
Exchange Rate
Increase
Toward dollar-denominated assets
Appreciates
Decrease
Toward pound-denominated assets
Depreciates
Increase
Toward pound-denominated assets
Depreciates
Decrease
Toward dollar-denominated assets
Appreciates
Appreciate
Toward dollar-denominated assets
Appreciates
Depreciate
Toward pound-denominated assets
Depreciates
U.S. Interest Rate
British Interest Rate
Expected Future Change in the
Dollar’s Exchange Rate
*The analysis for a change in one determinant assumes that the other determinants are unchanged.
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26
Determining Short-Run Exchange Rates:
The Asset-Market Approach (3 of 9)
• Relative Levels of Interest Rates
• Level of nominal interest rate is first
approximation of rate of return on assets that
can be earned in a particular country
• Differences in level of nominal interest rates
between economies
• Likely to affect international investment flows as
investors seek highest rate of return
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27
Determining Short-Run Exchange Rates:
The Asset-Market Approach (4 of 9)
• Relative Levels of Interest Rates (cont’d)
• If interest rates in U.S. > rates abroad
• Increase in demand for dollars
• Dollar appreciation
• If interest rates in U.S. < rates abroad • Decrease in demand for dollars • Dollar depreciation • Real-interest rate • Nominal-interest rate minus inflation rate © 2019 Cengage. All rights reserved. 28 Determining Short-Run Exchange Rates: The Asset-Market Approach (5 of 9) © 2019 Cengage. All rights reserved. 29 Determining Short-Run Exchange Rates: The Asset-Market Approach (6 of 9) TABLE 12.5 Nominal and Real Interest Rates, April 2017 Country Nominal Interest Rate* (percent) Inflation Rate** (percent) Real Interest Rate (percent) Greece 6.7 0.8 5.9 Russia 8.1 4.5 3.6 South Africa 8.8 5.7 3.1 Indonesia 7.0 4.3 2.7 United States 2.2 2.4 ?0.2 Canada 1.5 1.9 ?0.4 Euro Area 0.2 1.6 ?1.4 Venezuela 10.4 56.2 ?45.8 *Rates are for 10-year government bonds. **Measured by the Consumer Price Index for the latest three months. Source: From The Economist, “Economic and Financial Indicators,” April 22, 2017. See also International Monetary Fund, International Financial Statistics, and World Bank, Data and Statistics, available at www.data.worldbank.org. © 2019 Cengage. All rights reserved. 30 Determining Short-Run Exchange Rates: The Asset-Market Approach (7 of 9) • Expected Change in the Exchange Rate • Future expectations of appreciation of dollar can be self-fulfilling for today’s value of the dollar © 2019 Cengage. All rights reserved. 31 Determining Short-Run Exchange Rates: The Asset-Market Approach (8 of 9) © 2019 Cengage. All rights reserved. 32 Determining Short-Run Exchange Rates: The Asset-Market Approach (9 of 9) • Diversification, Safe Havens, & Investment Flows • Relative levels of interest rates strongly impact investment flows • Other factors affecting investment flows among economies • Size of stock of assets denominated in a particular currency in investor portfolios may induce change in investor preferences for diversification purposes • Safe-haven effect: investors may be willing to sacrifice return for safe repository for their funds © 2019 Cengage. All rights reserved. 33 Exchange-Rate Overshooting (1 of 4) Exchange-Rate Overshooting • Short-run response (depreciation or appreciation) to change in market fundamentals is greater than its long-run response • Changes in market fundamentals exert a disproportionately large short-run impact on exchange rates © 2019 Cengage. All rights reserved. 34 Exchange-Rate Overshooting (2 of 4) • Exchange-Rate Overshooting (cont’d) • Helps explain why exchange rates depreciate or appreciate so sharply from day to day • Volatility of exchange rates intensified by overshooting © 2019 Cengage. All rights reserved. 35 Exchange-Rate Overshooting (3 of 4) • Exchange-Rate Overshooting (cont’d) • Overshooting explained by: • Tendency of elasticities to be smaller in short run than in long run • Ex. (Figure 12.6): Increased demand for pounds leads to initial pound appreciation (dollar depreciation); with U.S. prices lower, quantity of pounds supplied increases over time, dampening the initial pound appreciation • Exchange rates tend to be more flexible than many other prices, which are often written into long-term contracts © 2019 Cengage. All rights reserved. 36 Exchange-Rate Overshooting (4 of 4) © 2019 Cengage. All rights reserved. 37 Forecasting ForeignExchange Rates (1 of 9) Forecasting exchange rates • Very tricky, especially in short run • Necessary for exporters, importers, investors, bankers, and foreign-exchange dealers • Choosing currency in which to make deposits requires idea of what currency’s value will be • Decisions about foreign investment necessitate awareness of where exchange rates will move over time • Need for exchange rate forecasting resulted in emergence of consulting firms © 2019 Cengage. All rights reserved. 38 Forecasting ForeignExchange Rates (2 of 9) • Judgmental forecasts • Subjective or common sense models require • Wide array of political and economic data • Interpretation of these data in terms of timing, direction, and magnitude of exchange-rate changes • Projections based on thorough examination of individual nations • Based on economic indicators, political factors, technical factors, psychological factors © 2019 Cengage. All rights reserved. 39 Forecasting ForeignExchange Rates (3 of 9) • Technical forecasts • Involve use of historical exchange-rate data to estimate future values • Ignore economic and political determinants of exchange-rate movements • Founded on idea that “history repeats itself” • Used to analyze short-run movements of exchange rates © 2019 Cengage. All rights reserved. 40 Forecasting ForeignExchange Rates (4 of 9) TABLE 12.7 Exchange Rate Forecasters Forecasting Organization Methodology Horizon Global Insights Econometric 24 months JPMorgan Chase Judgmental Under 12 months Econometric Over 12 months Econometric Over 12 months Technical Under 12 months Technical Under 12 months Econometric Over 12 months Judgmental 8 months Econometric 12 months Bank of America Goldman Sachs UBS Global Asset Management Source: Data collected by author. © 2019 Cengage. All rights reserved. 41 Forecasting ForeignExchange Rates (5 of 9) © 2019 Cengage. All rights reserved. 42 Forecasting ForeignExchange Rates (6 of 9) • Fundamental Analysis • Opposite of technical analysis • Considers economic variables likely to affect supply and demand of a currency • Uses statistical estimations of economic theories • Attempts to incorporate fundamental variables that underlie exchange-rate movements • Interest rates, balance of trade, productivity, inflation rates © 2019 Cengage. All rights reserved. 43 Forecasting ForeignExchange Rates (7 of 9) • Limitations of econometric models used to forecast exchange rates • Rely on predictions of key economic variables for which reliable information may be hard to obtain • Some factors affecting exchange rates cannot easily be quantified • Precise timing of factor’s effect on currency’s exchange rate may be unclear • Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis © 2019 Cengage. All rights reserved. 44 Forecasting ForeignExchange Rates (8 of 9) • Econometric models best suited for forecasting long-run trends in the movement of an exchange rate • Models do not generally provide foreign currency traders precise price information regarding when to purchase or sell a particular currency • Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis © 2019 Cengage. All rights reserved. 45 Forecasting ForeignExchange Rates (9 of 9) • Exchange-Rate Misalignment • Deviation of exchange rate from fundamental value • Has implications for country’s trade position and job creation • Undervalued currency gives country trade advantage at expense of trading partners • Undervaluation widely considered unfair; however, there’s no sure way to estimate correct value of currency and thus determine extent of undervaluation © 2019 Cengage. All rights reserved. 46 Purchase answer to see full attachment Explanation & Answer: 5 pages Tags: exchange rate Interest rates Oil price User generated content is uploaded by users for the purposes of learning and should be used following Studypool's honor code & terms of service.