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chapter 8:
[macroeconomic policy - exchange rate policy], (2.3) causes of…
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(2.3) causes of changes in exchange rate
(factors that change DD/SS of a currency)
- relative interest rates
- relative income changes
- relative changes in price level (inflation)
- trade performance
- foreign direct investment (FDI)
- changes in taste / preferences
- speculation
relative interest rates
- affect short term financial flows
- ↑ IR of £ (short term)
- attracts inflow of 'hot money' from overseas (since foreigners shift their funds into £ to earn higher interest)
- ↑ demand for £ (appreciation)
- ↑ exchange rate
interest rate arbitrage
- firms borrow currency with lower IR
- then transfer to currencies with higher IR
(hence making profit off the difference)
relative income changes
- ↑ income
- ↑ demand for domestic & foreign goods
- ↑ demand for imports
(hence ↑ demand for foreign currency, cp)
- ↑ price of foreign currency (ie. depreciation)
this means that if a country's income growth is faster than other countries, the currency is likely to depreciate
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relative changes in price level
(relative inflation rate)
- affects ER in the long run
- country with a higher inflation rate than others will see its currency depreciate
(due to Purchasing Power Parity theory)
purchasing power parity
- same basket of goods cost US$100 & £200
(hence PPP is US$1 = £2)
- US lower inflation rate than UK (10% vs 20%)
- hence new cost is US$110 & £240
(ie. PPP is US$1 = £2.18)
- hence US$ appreciated against £
limitations of PPP theory
- does not take into account trade restrictions
- not all goods are internationally traded
- differences in quality
does not take into account trade restrictions (example)
- UK prices increase faster than SG prices
- but tariffs imposed to keep SG goods out of UK market
- hence £ may not have to depreciate relative to S$
not all goods are internationally traded
- basket of goods used to determine domestic price level may be different from what is traded
(hence domestic inflation rate may not influence ER)
differences in quality
- theory assumes basket of goods are the same, but there are differences (eg. fruit from US vs fruit from Japan)
trade performance
- large trade deficit → surplus of currency in forex market (since country is paying other countries more than they are receiving)
- countries with persistent deficits are likely to see depreciation of their ER
foreign direct investment (FDI)
- affects ER in the long run
- FDI is influenced by long term expectations of a country's profit opportunities (ie. prospective yield)
- eg. strong profit potential in US, ↑ demand for US$
change in taste & preferences
- change in preference → change in DD/SS of currency
(hence change in ER)
speculation (expectations)
- expect ER of US$ to fall, sell US$ now to avoid future losses (and hence buy another currency)
- this causes an immediate fall in US$ ER, while ER of other currency will rise
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