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Chapter 4 - Exchange rate determination. The objectives of this chapter are: to present some stylised facts about the observed behaviour of exchange rates, to identify the factors that lead to changes in the supply of and demand for foreign exchange and, consequently, the exchange rate, | Chapter 4 Exchange Rate Determination Objectives To identify the factors causing changes in the exchange rate. To describe purchasing power parity and the monetary model of exchange rates. To explain how the bid-offer spread and the forward spread are determined. To examine the factors affecting the AUD exchange rate. 4- Some stylised facts The exchange rate follows approximately a random walk with little or no drift. The spot and forward rates tend to move in the same direction and by approximately the same amount. There is no correspondence between exchange rates and prices. (cont.) 4- Some stylised facts (cont.) The relation between the exchange rate and the current account is not strong . Rapid monetary expansion leads to rapid currency depreciation. (cont.) 4- Some stylised facts (cont.) The behaviour of exchange rates is often described as “bubbles followed by crashes”. Volatility clustering. Periods of calm are followed by periods of calm, and periods of turbulence are followed by periods of turbulence. Exchange rates move in cycles with significant random variation. 4- The equilibrium exchange rate S(d/f) Sf Df Q f 4- Factors affecting the supply of and demand for FX Relative inflation rates: A country that has a higher inflation rate than its trading partners will experience a depreciating currency. (cont.) 4- The effect of a higher domestic inflation rate S(d/f) Sf Df Q f 4- Factors affecting the supply of and demand for FX (cont.) Relative interest rates: Higher interest rates lead to currency appreciation. Distinction must be made between nominal and real exchange rates. 4- The effect of a higher domestic interest rate S(d/f) Sf Df Q f 4- Factors affecting the supply of and demand for FX (cont.) Relative growth rates: The effect of growth is ambiguous since it affects the current account and financial account in different directions. (cont.) 4- Factors affecting the supply of and demand for FX (cont.) The role of | Chapter 4 Exchange Rate Determination Objectives To identify the factors causing changes in the exchange rate. To describe purchasing power parity and the monetary model of exchange rates. To explain how the bid-offer spread and the forward spread are determined. To examine the factors affecting the AUD exchange rate. 4- Some stylised facts The exchange rate follows approximately a random walk with little or no drift. The spot and forward rates tend to move in the same direction and by approximately the same amount. There is no correspondence between exchange rates and prices. (cont.) 4- Some stylised facts (cont.) The relation between the exchange rate and the current account is not strong . Rapid monetary expansion leads to rapid currency depreciation. (cont.) 4- Some stylised facts (cont.) The behaviour of exchange rates is often described as “bubbles followed by crashes”. Volatility clustering. Periods of calm are followed by periods of calm, and periods of turbulence
