Lecture 15 Foreign Exchange Market Factors influencing exchange

Lecture 15 – Foreign Exchange Market Factors influencing exchange rates

Factors affecting exchange rates • There are mainly five factors that influence exchange rates. They are: – Domestic prices – Trade barriers – Import demand – Export demand – productivity

Domestic Prices • In the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate • and a fall in the country’s relative price level causes its currency to appreciate.

Trade Barriers In international trade some barriers to free trade exist – such as tariffs (taxes on imported goods) – And quotas (restrictions on the quantity of foreign goods that can be imported) • When trade barriers increase, they increase demand for local goods local currency tends to appreciate because local goods will still sell well even with a higher value of the local currency.

Preferences for Domestic Versus Foreign Goods. • Increased demand for a country’s exports causes its currency to appreciate in the long run; • conversely, increased demand for imports causes the domestic currency to depreciate • EXAMPE: If the Japanese develop an appetite for American goods , the increased demand for American goods (exports) tends to appreciate the dollar, because the American goods will continue to sell well even at a higher value for the dollar.

Productivity • If a country becomes more productive, businesses in that country can lower the prices of goods relative to foreign goods and still earn a profit. • As a result, the demand for domestic goods rises, and the domestic currency tends to appreciate.

Central bank intervention in exchange market • More often, foreign exchange market is not a free market • Central bank of the country manages the exchange rate by buying and selling currencies • With these interventions, money supply is also influenced

Unsterilized foreign exchange intervention • Suppose SBP decides to sell $500 million of its foreign exchange reserves in exchange for pakistani currency, this transaction will have two impacts: – It will reduce the SBP foreign exchange reserves by $500 million – Currency in circulation will fall by the same amount

• When the central bank activity in the foregin exchange market results in change in the monetary supply, it is called unsterilized foregin exchange intervention • A foreign exchange intervention with an offsetting open market operation that leaves the monetary supply unchanged is called sterilized foregin exchange intervention

Exchange rate regimes • Exchange rate regimes in the international financial system are of two basic types: • Fixed and floating • In a fixed exchange rate regime, the value of currency are kept pegged relative to one currency called the anchor currency so that exchange rates are fixed • In a floating exchange rate regime, the value of currencies are allowed to fluctuate against one another

• However, countries often attempt to influence their exchange rates by buying an selling currencies, so in this case the regime is refffered to as a managed float regime

Fixed rate regime • When the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result it loses international reserves • With the domestic currency undervalued, the central bank must sell currecny to keep the exchange rate fixed, but as a result it gains international reserves