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Madura 4
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7/17/2019 Madura 4 DU
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Exchange Rate Determination4
Chapter
South-Western/Thomson Learning © 2003
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A4 - 2
Chapter Objectives
• To explain how exchange rate movements
are measured;
• To explain how the equilibrium exchange
rate is determined; and
• To examine the actors that aect theequilibrium exchange rate!
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"easuring
Exchange Rate "ovements• #n exchange rate measures the value o one
currenc$ in units o another currenc$!
• %hen a currenc$ declines in value& it is saidto depreciate! %hen it increases in value& it is
said to appreciate!
• On the da$s when some currencies
appreciate while others depreciate against
the dollar& the dollar is said to be 'mixed in
trading!(
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"easuring
Exchange Rate "ovements• The percentage change )* in the value
o a oreign currenc$ is computed as
+t , +t -.
+t -.
where St denotes the spot rate at time t .
• # positive * represents appreciation othe oreign currenc$& while a negative *
represents depreciation!
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Exchange Rate Equilibrium
• #n exchange rate represents the price o a
currenc$& which is determined b$ the
demand or that currenc$ relative to the
suppl$ or that currenc$!
D
+/.0T1
2uantit$ o oreignexchange
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Bangladesh inflation ↑
⇒ ↑ B’desh demand for US goods, and
hence demand for US $ increases.
3actors that nluence
Exchange RatesRelative Inflation Rates
⇒ ↓ US desire for B’desh goods, and hence
the supply of US $ decreases.
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Eect o inlation
• Price of US $1 in taka
D.
D5
+.
+5
67
89
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B’desh interest rates ↑⇒ B’desh demand for US ank deposits ↓,
and hence demand for US $ decreases.
3actors that nluence
Exchange RatesRelative Interest Rates
⇒ ↑ US desire for B’desh deposits, and
hence the supply of US $ increases.
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Eect o :igher nterest Rate
• Price of US $1 in taka
D5
D.
+5
+.
67
89
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Relative Interest Rates
3actors that nluence
Exchange Rates
• t is thus useul to consider real interestrates& which adjust the nominal interest
rates or inlation!
• # relativel$ high interest rate ma$ actuall$
relect expectations o relativel$ highinlation& which discourages oreign
investment!
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Relative Interest Rates
3actors that nluence
Exchange Rates
• This relationship is sometimes called the
Fisher effect !
• real nominal
interest ≈ interest , inlation rate rate rate
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B’desh income le!el ↑⇒ ↑ B’desh demand for US goods, and
hence demand for US$ increases.
3actors that nluence
Exchange RatesRelative Income Levels
⇒ "o e#pected change for the supply of US$.
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Eect o increased local national
income• rice o <+ /. in ta1a
D.
D5
+.
8=
89
2uantit$ ooreign exchange
.>
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Government Controls
• ?overnments ma$ inluence the equilibrium
exchange rate b$@ imposing foreign e#change arriers, imposing foreign trade arriers, inter!ening in the foreign e#change market,
and affecting macro !ariales such as inflation,
interest rates, and income le!els.
3actors that nluence
Exchange Rates
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?overnment Control@
.! tari • Eects o Tari
Price
%emand
Supply
&uantity
Pi
Pi'
&1 &( &) &* &+
P)
Pi'
Pi
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Eects o Tari on 3oreign Exchange
"ar1et• 'ariff reduces the demand for foreign e#change and so
the demand cur!e shifts left to increase the !alue ofdomestic currency. ffecti!eness, howe!er, depends on
the elasticity of the demand cur!e of the commoditymarket. %emand cur!es of our main import commoditiesare inelastic, firstly. Secondly, those e#perienceincreasing trend. -n that case the demand cur!e wouldrather shift right oth in the commodity market as well as
the foreign e#change market. owe!er, since the time oflierali/ation the current trend here is tariff reduction.'his results in rightward shifting of the demand forforeign e#change, and e#change rate increases.
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5! 2uota
• 2uota means quantitative restriction! #
quantitative restriction is imposed on import to
have the almost same eects o tari! Dierence
between tari and quota is that the government
revenue does not ta1e place in case o quota!
Eectiveness o quota depends on the strength
o commercial polic$! <norganiAed econom$
oten lac1s it!
• 3oreign exchange rate becomes avorable due to
the introduction o quota!
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>! nant ndustr$ #rgument@
• -f import duty or 0uota is used to protect local industry
then it is called infant industry argument. -mport may e
completely withheld. %omestic industry in!ol!es in
higher scale of production and gets the ad!antage of
large scale economy and learning effect. Supply cur!e
shifts right and go!ernment withdraws the protection
gradually. 'hus, it is e#pected that such protection is
not needed in the long term. Unlike emerging tigers,most countries e#perience a failure of infant industry
arguments as it encourages inefficiency in production.
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4! +ubsidies
• # subsid$ is a government pa$ment to domestic
producers to increase the competitiveness in the
export mar1et! t ta1es the orm o cash grant& low
interest loans& tax brea1s& and other indirect
incentives to the irm b$ the government! This is
commonl$ called as dumping! ncreased export leads
to a rightward shit o suppl$ curve! Domestic
currenc$ becomes stronger!
• +ubsid$ is also used to substitute import b$ ma1ing
the domestic production cheaper through subsid$!
This is t$picall$ the issue o agricultural subsid$
which was responsible behind the ailure o ?#TT!
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Others methods o government control
• 9! Boluntar$ Export Restrains@ BER is a quota ontrade imposed b$ the exporting countr$& t$picall$ at
the request o the importing countr$s government!
Domestic currenc$ becomes wea1er!
• 8! ocal Content Requirement@ t is a requirementthat some speciic raction o a good be produced
domesticall$! This also reduces import! 3oreign
exchange rate becomes avorable!
• 6! #dministrative olicies@ mport procedure can be
made length$ b$ means o complicated
administrative policies to discourage import!
3oreign exchange rate becomes avorable!
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Expectations
• 3oreign exchange mar1ets react to an$
news that ma$ have a uture eect!
• nstitutional investors oten ta1e currenc$
positions based on anticipated interest rate
movements in various countries!• ecause o speculative transactions&
oreign exchange rates can be ver$ volatile!
3actors that nluence
Exchange Rates
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Interaction of Factors
3actors that nluence
Exchange Rates
• The sensitivit$ o the exchange rate to
these actors is dependent on the volumeo international transactions between the
two countries!
• Over a particular period& dierent actors
ma$ place opposing pressures on thevalue o a oreign currenc$!
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