6.2 Exchange rate determination

Exchange Rate Determination

Factors in Exchange Rate Movements

Exchange rates move in response to different forces depending on the time horizon. Short-run movements tend to be driven by capital flows and market sentiment, while long-run trends reflect deeper structural differences between economies.

Short-run factors:

• Interest rate differentials — Higher interest rates attract capital inflows, increasing demand for the currency and causing appreciation. When the Federal Reserve raises rates, for instance, global investors shift funds into dollar-denominated assets, pushing the dollar up.
• Inflation rate differentials — Higher inflation erodes purchasing power, making a country's goods less competitive and its currency less attractive. Venezuela's bolivar collapsed in value as hyperinflation took hold.
• Current account balance — A trade surplus means foreigners need to buy your currency to pay for your exports, pushing it up. China's large trade surpluses put upward pressure on the yuan. Conversely, persistent trade deficits tend to weaken a currency because the country is selling its currency to buy foreign goods.
• Political and economic stability — Stable countries attract capital inflows, strengthening their currencies. The Swiss franc is a classic safe-haven currency for this reason. Instability drives capital out, as seen when the Turkish lira depreciated sharply during periods of political turmoil.

Long-run factors:

• Purchasing power parity (PPP) — Over time, exchange rates tend to adjust so that the same basket of goods costs roughly the same across countries. The Big Mac Index is a simplified version of this idea, comparing burger prices worldwide.
• Productivity differentials — Countries with faster productivity growth become more competitive, and their currencies tend to appreciate. The Japanese yen strengthened considerably during Japan's post-war economic boom.
• Economic growth prospects — Stronger growth attracts foreign investment, increasing demand for the currency. The Australian dollar, for example, tends to rise when commodity prices surge because commodity exports drive Australia's growth outlook.

Purchasing Power Parity Theory

PPP is one of the oldest theories of exchange rate determination. The core idea is that exchange rates should adjust so that identical goods cost the same in different countries when converted to a common currency. This is sometimes called the law of one price applied to the whole economy.

Absolute PPP

The exchange rate between two currencies should equal the ratio of their price levels:

$E = \frac{P_d}{P_f}$

• $E$ = exchange rate (domestic currency per unit of foreign currency)
• $P_d$ = domestic price level
• $P_f$ = foreign price level

Example: If a basket of goods costs $100 in the US and £80 in the UK, the PPP exchange rate is $\frac{100}{80} = 1.25$ dollars per pound.

Relative PPP

Rather than comparing price levels, relative PPP says the change in the exchange rate should reflect the difference in inflation rates:

$\frac{E_1}{E_0} = \frac{1 + \pi_d}{1 + \pi_f}$

• $E_1$ = exchange rate at time 1
• $E_0$ = exchange rate at time 0
• $\pi_d$ = domestic inflation rate
• $\pi_f$ = foreign inflation rate

Example: If US inflation is 2% and UK inflation is 4%, relative PPP predicts the dollar should appreciate by roughly 2% against the pound. The country with higher inflation sees its currency weaken.

Limitations of PPP

• Assumes free trade with no barriers, tariffs, or transportation costs, which is unrealistic.
• Ignores non-traded goods and services like haircuts, housing, and local services that aren't exposed to international competition. These can differ widely in price across countries without triggering any arbitrage.
• Prices are sticky in the short run. Wages and contracts don't adjust instantly, so PPP works better as a long-run anchor than a short-run predictor.

Interest Rate Parity Theory

Interest rate parity (IRP) connects exchange rates to interest rate differentials between countries. The basic logic: if one country offers higher interest rates, its currency should be expected to depreciate by enough to offset that advantage. Otherwise, investors could earn risk-free profits.

Covered Interest Rate Parity (CIRP)

This is a no-arbitrage condition linking spot rates, forward rates, and interest rates. If CIRP holds, you can't profit by borrowing in one currency, converting, investing in another, and locking in the return with a forward contract.

$\frac{F}{S} = \frac{1 + i_d}{1 + i_f}$

• $F$ = forward exchange rate
• $S$ = spot exchange rate
• $i_d$ = domestic interest rate
• $i_f$ = foreign interest rate

Example: If the spot rate is $1.20/€ and the 1-year forward rate is $1.30/€, the forward premium on the euro is about 8.33%. For CIRP to hold, the US interest rate must exceed the eurozone rate by that same margin.

CIRP holds very well in practice because deviations are quickly eliminated by arbitrage in liquid currency markets.

Uncovered Interest Rate Parity (UIRP)

UIRP replaces the forward rate with the expected future spot rate. It says the expected depreciation of a currency should offset its interest rate advantage:

$\frac{E_1^e}{E_0} = \frac{1 + i_d}{1 + i_f}$

• $E_1^e$ = expected exchange rate at time 1

Example: If US interest rates are 2% and eurozone rates are 1%, UIRP predicts the dollar should depreciate by about 1% against the euro. The higher US yield gets offset by the expected weakening of the dollar.

Implications of IRP

• In the short run, higher interest rates attract capital inflows and cause appreciation. This is the basis of carry trades, where investors borrow in low-interest-rate currencies and invest in high-interest-rate ones.
• UIRP holds less reliably than CIRP in practice, partly because investors demand a risk premium for bearing exchange rate uncertainty, and partly because expectations aren't always rational.

Market Expectations and Risk

Market expectations play a large role in short-run exchange rate movements. Currency markets are forward-looking, so rates respond to anticipated changes in fundamentals, not just current conditions. A central bank signaling future rate hikes can move a currency before any policy change actually happens. Major geopolitical events like Brexit or trade wars can shift expectations rapidly.

Risk factors that affect currency values:

• Exchange rate risk — Uncertainty about future rates makes international trade and investment harder to plan. Exporters and importers both prefer more predictable rates.
• Country risk — Political instability, weak institutions, or the possibility of sovereign default (as Argentina has experienced multiple times) make investors demand higher returns, and can trigger sudden capital outflows.
• Liquidity risk — Some currencies, especially exotic or emerging-market ones, are thinly traded. Large transactions can move the price significantly, making it costly to enter or exit positions.

Risk management techniques:

• Hedging uses financial instruments to reduce exchange rate exposure:
  1. Forward contracts lock in a specific exchange rate for a future date, eliminating uncertainty.
  2. Options give you the right (but not the obligation) to buy or sell currency at a predetermined rate, providing protection while preserving the ability to benefit from favorable moves.
• Diversification spreads risk by holding assets denominated in multiple currencies, so that losses in one are offset by gains in another.