Exchange Rate Determination and Forecasting

Question 1

Insert the words missing:

Understanding why exchange rates change over time requires an understanding of the concept of ______ ______ ______as well as the factors that drive it.

Answer 1

Understanding why exchange rates change over time requires an understanding of the concept of equilibrium exchange rates as well as the factors that drive the equilibrium rate.

Question 2

What does the term equilibrium refer to?

Answer 2

The term equilibrium refers to the demand for and supply of a currency. If supply equals demand, the exchange rate is said to be in equilibrium.

Moreover, a currency should trade at a price which balances demand and supply at any point in time.

Question 3

Can equilibrium of the exchange rates change?

Answer 3

Over time, supply and demand will change in response to various factors, and this will lead to changes in (equilibrium) exchange rates.

Question 4

How does the demand curve look like?

And why?

What is one the axes?

Answer 4

For a GBP and USD market:

The demand curve shows the quantity of dollars that would be demanded by UK consumers and corporations at various exchange rates.

The demand curve slopes down because

• a lower GBP/USD rate means that UK corporations and consumers find it cheap to buy US goods, invest in the US, ….
• Conversely, a higher GBP/USD rate means that UK corporations and consumers find it expensive to buy US goods, invest in the US, ….

Question 5

How does the supply curve look like?

And why?

What is one the axes?

Answer 5

The supply curve shows the quantity of dollars supplied by U.S. consumers and corporations at various exchange rates.

The supply curve slopes up because

• a lower GBP/USD rate means that a dollar buys fewer pounds so UK goods are expensive for US consumers and the supply of USD is low
• a higher GBP/USD rate means that the pound is cheap so US consumers will buy more UK goods and the supply of USD is high.

Question 6

what is it called:

If supply > demand

and

If demand > supply

Answer 6

If supply > demand: Surplus of dollars

If demand > supply: Shortage of dollars

Question 7

How and why can relative inflation rates affect the equilibrium exchange rates?

Answer 7

Changes in relative inflation rates can affect international trade flows, which in turn affect the demand and supply of currencies.

SO: change in relative inflation rates –> international trade –> demand and supply.

_______________________________________________

1. UK inflation rises above US inflation –> UK goods become relatively more expensive
2. UK: More demand for US goods (=higher USD demand)
3. UK: Less demand for UK goods (=less USD supply)

Equilibrium Exchange Rate (EER) has to rise

REMEMBER: When UK goods become more expensive (inflation up), GBP has to appreciate to offset the change

Question 8

How and why can relative interest rates affect the equilibrium exchange rates?

Answer 8

Changes in relative interest rates affect the demand for international securities which can affect the demand and supply of currencies.

SO: change in relative interest rates –> demand for international securities –> demand and supply of currencies

__________________________________________

1. UK interest rates unexpectedly rise relative to US interest rates.
2. UK: Less demand for US bonds (less demand for USD)
3. UK: More demand for UK bonds (more USD supply)

EER has to fall to equate demand and supply.

Question 9

How and why can relative income levels affect the equilibrium exchange rates?

Answer 9

Changes in income levels affect the overall demand for goods. Hence they can impact trade flows and exchange rates.

______________________________________________

1. US income level falls unexpectedly whereas UK income is unchanged.
2. UK: no change
3. US: less demand for UK goods (–> less USD supply)

EER has to rise to equate demand and supply.

Question 10

What does PPP stand for?

Answer 10

Purchasing Power Parity

Question 11

How is exchange rates connected to PPP?

Answer 11

Goods market arbitrage will ensure that exchange rates will not deviate too much from the so-called PPP rate.

Question 12

Explain PPP

Answer 12

The PPP rate is the (hypothetical) exchange rate that equates purchasing power between two countries and is computed as:

Question 13

What can be said about this example?

Answer 13

Sterling is overvalued relative to the dollar.

Question 14

Is it really as simpel as that PPP equals the exchange rate?

Answer 14

• No. Empirically, PPP only holds approximately in the short run:
  
  • Tariffs and quotas
  • Transaction costs
  • Non-tradable goods
  • Measurement errors (price indices are based on baskets of goods)
• However, the PPP rate serves as a useful tool for evaluating exchange rate valuations and generating exchange rate forecasts over long periods.

Question 15

What is said to be the natural complement to the PPP rate?

Answer 15

A natural complement to the PPP rate is the so-called Real Exchange Rate (RER) which is is a measure of how far actual market exchange rates differ from the PPP rate: