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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.readings required:Hiro, I., & McCauley, R. (2019). A key currency view of global imbalances. Journal of International Money and Finance, 94, 97-115.Muhammad, A., & Iftikhar, A. (2019). Empirical investigation of foreign direct investment and current account balance in East Asian economies. Journal of Commerce & Social Sciences, 13(3), 779-795.Chapter 12 in International Economics PowerPoint attachedOfer, A., & Varon, E. (2019). Turkish currency crisis- spillover effects on European banks. Borsa Istanbul Review, 19(4), 372-378.
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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
© 2019 Cengage. All rights reserved.
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
© 2019 Cengage. All rights reserved.
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
© 2019 Cengage. All rights reserved.
7
Determining Long-Run Exchange
Rates (2 of 5)
TABLE 12.1 Determinants of the Dollars Exchange Rate in the Long Run
Factor*
Change
Effect on the Dollars
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)
© 2019 Cengage. All rights reserved.
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
© 2019 Cengage. All rights reserved.
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
© 2019 Cengage. All rights reserved.
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.
© 2019 Cengage. All rights reserved.
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
ProductSteel
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
© 2019 Cengage. All rights reserved.
17
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (7 of 13)
Purchasing Power Parity(contd)
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
© 2019 Cengage. All rights reserved.
18
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (8 of 13)
Purchasing Power Parity (contd)
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
© 2019 Cengage. All rights reserved.
19
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (9 of 13)
Purchasing Power Parity (contd)
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
© 2019 Cengage. All rights reserved.
20
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (10 of 13)
Purchasing Power Parity (contd.)
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 (contd.)
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 (contd.)
Government policy may interfere with operation of
theory
Forecasting exchange rates appropriate in long
run; poor forecasters in short run
© 2019 Cengage. All rights reserved.
23
Inflation Rates, Purchasing Power Parity,
& Long-Run Exchange Rates (13 of 13)
© 2019 Cengage. All rights reserved.
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
© 2019 Cengage. All rights reserved.
25
Determining Short-Run Exchange Rates:
The Asset-Market Approach (2 of 9)
TABLE 12.4 Determinants of the Dollars Exchange Rate against the
Pound in the Short Run
Change in Determinant*
Repositioning of International
Financial Investment
Effect on Dollars
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
Dollars Exchange Rate
*The analysis for a change in one determinant assumes that the other determinants are unchanged.
© 2019 Cengage. All rights reserved.
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
© 2019 Cengage. All rights reserved.
27
Determining Short-Run Exchange Rates:
The Asset-Market Approach (4 of 9)
Relative Levels of Interest Rates (contd)
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 todays 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 (contd)
Helps explain why exchange rates depreciate
or appreciate so sharply from day to day
Volatility of exchange rates intensified by
overshooting
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35
Exchange-Rate Overshooting
(3 of 4)
Exchange-Rate Overshooting (contd)
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 currencys 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 factors effect on currencys 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 countrys trade position
and job creation
Undervalued currency gives country trade
advantage at expense of trading partners
Undervaluation widely considered unfair; however,
theres no sure way to estimate correct value of
currency and thus determine extent of
undervaluation
© 2019 Cengage. All rights reserved.
46
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international economics
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pegged exchange rate
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