Park University Exchange Rate Determination Discussion

Please respond to the 2 students 150 words or more

Student 1

Good Morning Class,

Explain in detail the 3 major theoretical approaches to exchange rate determination and how/when each approach is used.

“There are basically three views of the exchange rate. The first takes the exchange rate as the relative price of monies (the monetary approach); the second, as the relative price of goods (the purchasing-power-parity approach); and the third, the relative price of bonds (Moffett 2018).” What is important to note is that these approaches are not competing theories, but rather complementary theories, that when combined in a fashion, offers the ability to capture the complexity of the global market for securities.

Parity Conditions Approach: This is said to be some variant of the PPP theory of the exchange rate. Ultimately, this theory is made up of a number of different theories; Law of One Price, Absolute Purchasing Power Parity, Relative Purchasing Power Parity, and Interest Rate Parity (Moffett 2018).” However, the parity conditions approach is most widely accepted through the Purchasing Power Parity, which states “that the long-run equilibrium exchange rate is determined by the ratio of domestic prices relative to foreign prices (Moffett 2018).” While the PPP Theory is at the core of the parity conditions approach, the other 3 previously listed are more accurate at what drives the changes in exchange rates over time, as the PPP theory has short and medium term limitations to forecasting exchange rates. In the PPP Theory, exchange rate changes are induced by changes in relative price levels between two countries. The basis for PPP is the ‘law of one price’, where there will always be an equilibrium between countries. The interest rate parity is satisfied when the foreign exchange market is in equilibrium, or when the supply of currency is equal to the demand.

Balance of Payments Approach: Following the interest rate parity approach, the balance of payments approach involves the supply and demand for currencies in the foreign exchange market. This theory is also referred to as ‘demand-supply theory of exchange.’ Ultimately, this theory stresses that the exchange rate relates to the position of the balance of payments within the country concerned. A favorable balance of payments leads to an appreciation in the external value of the country’s currency, while an unfavorable balance of payments causes the opposite. The balance of payments approach illustrates that the “equilibrium exchange rate is found when the net inflow (or outflow) of foreign exchange arising from current account activities matches that of the net outflow (or inflow) of foreign exchange arising from financial account activities (Moffett 2018).” It follows that the external value of a country’s currency will also depend on the demand for and supply of the currency. This theory assumes perfect competition and non-intervention of the government. Another limitation to this theory is that it does not explain the internal value of a currency, which is where the PPP theory is used.

Monetary Approach and/or Asset Market Approach: This approach is composed of two variations on the same themes; that “the exchange rate is determined by the supply and demand for money (monetary approach) or the supply and demand for financial assets (asset market approach) (Moffett 2018).” The monetary approach focuses on the supply and demand for national stocks, as well as the changes therein as a determinant of inflation. Inflation rates will have immediate impact on exchange rates through the PPP effect. However, one large drawback of the monetary approach is that it focuses more heavily on the demand for money, while PPP has shown to be a poor measure of short and medium term of exchange rates, as well as the interdependency of monetary supply with economic activity. The Asset Market approach focuses on the shifts in the supply and demand for financial assets, which include the changes in monetary and fiscal policies. All of which, will alter expected returns which influence exchange rate changes.

Matt

References:

CFI (2021). What is the Interest Rate Parity (IRP)? Article posted to corporatefinanceinstitute.com. Retrieved on 8 July 2021 from https://corporatefinanceinstitute.com/resources/knowledge/finance/interest-rate-parity-irp/ (Links to an external site.)

Moffett, M. H., Stonehill, A. I., Eiteman, D. K. (2018). Fundamentals of Multinational Finance. [6th Ed.]. Pearson Education. New York, NY.

Student 2

1. Detail how and why direct and indirect foreign exchange market intervention is conducted by central bank.

Central banks often deem it necessary to intervene in the foreign exchange market to protect the value of their national currency. Central banks can achieve this by buying or selling foreign exchange reserves or simply by mentioning that a particular currency is under or over-valued, allowing participants of the forex market to do the rest. This article looks at the different types of central bank interventions and important facts to keep in mind before trading.Central banks generally agree that intervention is necessary to stimulate the economy or maintain a desired foreign exchange rate. Central banks will often buy foreign currency and sell local currency if the local currency appreciates to a level that renders domestic exports more expensive to foreign nations. Therefore, central banks purposely alter the exchange rate to benefit the local economy.

• Sterilized intervention

Sterilized intervention is a policy that attempts to influence the exchange rate without changing the monetary base. The procedure is a combination of two transactions. First, the central bank conducts a non-sterilized intervention by buying (selling) foreign currency bonds using domestic currency that it issues. Then the central bank “sterilizes” the effects on the monetary base by selling (buying) a corresponding quantity of domestic-currency-denominated bonds to soak up the initial increase (decrease) of the domestic currency. The net effect of the two operations is the same as a swap (Links to an external site.) of domestic-currency bonds for foreign-currency bonds with no change in the money supply With sterilization, any purchase of foreign exchange is accompanied by an equal-valued sale of domestic bonds.

For example, desiring to decrease the exchange rate, expressed as the price of domestic currency, without changing the monetary base, the monetary authority purchases foreign-currency bonds, the same action as in the last section. After this action, in order to keep the monetary base unchanged, the monetary authority conducts a new transaction, selling an equal amount of domestic-currency bonds, so that the total money supply is back to the original level.

• Non-sterilized intervention

Non-sterilized intervention is a policy that alters the monetary base. Specifically, authorities affect the exchange rate through purchasing or selling foreign money or bonds with domestic currency.

For example, aiming at decreasing the exchange rate/price of the domestic currency, authorities could purchase foreign currency bonds. During this transaction, extra supply of domestic currency will drag down domestic currency price, and extra demand of foreign currency will push up foreign currency price. As a result, the exchange rate drops.

Indirect intervention

Indirect currency intervention is a policy that influences the exchange rate indirectly. Some examples are capitol controls (taxes or restrictions on international transactions in assets), and exchange controls (the restriction of trade in currencies). Those policies sometimes lead to inefficiencies or reduce market confidence, or in the case of exchange controls may lead to the creation of a black market, but can be used as an emergency damage control.