Seven Reasons Exchange Rates Move - Part One

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From the course by University of California, Irvine

Strategic Business Management - Macroeconomics

14 ratings

University of California, Irvine

Strategic Business Management - Macroeconomics

14 ratings

This course weds business strategy with the principles of macroeconomics. It offers valuable a powerful toolbox together with cases and lessons across all major functions of business, management, from finance, operations management, and marketing to human resource management, organizational behavior, statistics, and, of course, business strategy.

From the lesson

Exchange Rates, The Balance of Payments, and Trade Deficits

Introduction4:01

Some Balance Payments Accounting - The Current Account7:11

More Balance of Payments Accounting - The Capital Account6:01

Exchange Rates Defined6:59

Seven Reasons Exchange Rates Move - Part One8:51

Seven Reasons Exchange Rates Move - Part Two8:13

Floating Versus Fixed Exchange Rates & David Hume's Gold Specie Flow Adjustment Mechanism9:46

Hume's Theory and the Gold Standard of the Real World6:19

The Dollar Standard and Its Collapse6:12

Today's Hybrid Exchange Rate System, Currency Blocs, and Fixed Pegs9:09

The Global Spillover Effects of Fiscal and Monetary Policy8:24

Meet the Instructors

Dr. Peter Navarro
Professor
Paul Merage School of Business

Okay, so far we've learned that exchange rates are always quoted in pairs,

and that exchange rates can strengthen or weaken over time.

So, our next question must be,

what factors actually make exchange rates move?

Why don't you think about this for a minute,

and jot down some ideas before we move on.

So why do you think the value of currencies change relative to one another?

In fact, there are at least seven main reasons why

currencies appreciate or depreciate over time.

These reasons include, differing rates of GDP growth between countries,

differing rates of inflation,

a change in relative interest rates,

current account deficits and trade imbalances,

a change in the terms of trade,

currency speculation, and movements associated with political instability,

geopolitical risk & exogenous shocks,

like droughts and earthquakes.

Yes, that is quite a long list.

So let's take these reasons one at a time now.

So here's a question for you.

If one country's gross domestic product or GDP grows relatively faster than another's,

will that country's exchange rate strengthen or weaken,

holding other things constant?

Please go ahead and jot down some ideas before moving to the answer.

In fact, the faster growing nation is likely to see its currency depreciate.

Just why is this so?

Well, faster GDP growth in a country like,

say, Taiwan, relative to another country like,

say, Vietnam, will typically lead to faster income growth in Taiwan relative to Vietnam.

This faster income growth in turn means that

Taiwanese consumers will increase their purchases of Vietnamese imports,

relative to Vietnamese demand for Taiwanese products.

This will increase the demand for Vietnamese currency called, the Dong,

and thereby weaken the Taiwan New Dollar,

Relative to the Vietnamese Dong.

Now, what about differing rates of inflation?

And here's the general question.

If one country's inflation rate is rising faster than another,

will its currency strengthen or weaken?

Relative to the currency of the other country,

holding other things constant.

Take a minute now to jot down your answer and

reasoning before moving on.

Okay, let's think this one through now with a specific example.

Suppose then, that the rate of inflation in Canada is rising faster than in Europe.

Will the Canadian dollar appreciate or depreciate relative to the euro?

Well, in this case,

the Canadian dollar will depreciate relative to the euro.

This is because of a key concept known in economics,

as The Law of One Price.

The Law of One Price states that the price of any given asset,

commodity, good, or security,

must have the same price in all countries,

when exchange rates and other factors like transportation costs are taken into account.

Let me repeat that. The Law of One Price states

that the price of any given asset, commodity, good,

or security, must have the same price in all countries,

when exchange rates are taken into account.

As to why the law of one price must hold,

this has to do with a really interesting concept in economics known as, arbitrage.

To understand the concept of arbitrage,

suppose that you are a speculator,

and you see the exact same good,

let's say an automobile,

sells in country one at a higher price,

than it sells for in country two,

when exchange rates are taken into consideration.

What will you, as a speculator do to make a profit here?

Think about that now for a minute,

try to come up with an answer before moving on.

In this case, where the same good sells in country one at a higher price,

than it sells for in country two,

you as an arbitrageur,

can buy the good for the cheaper price in country two,

then sell it for the more expensive price in country one.

And through this process of arbitrage,

which exploits price differentials in markets,

you can indeed, make a profit.

But here's the thing,

over time such arbitrage behavior,

must eliminate the price differential.

This is because the increased demand from speculators,

such as yourself, will drive the cheap price up in country two.

As speculators flood country one with more supply of the good,

this will drive down the price in country one.

So eventually, the two prices in the two countries,

as reflected in the exchange rate, must be equal,

and that's exactly why the law of one price holds.

Now, here's the key point.

It is exactly because of the law of

one price that an increase in the inflation rate in a country like Canada,

relative to that, of say, Europe,

must lead to a depreciation in the Canadian dollar,

as reflected in a weaker exchange rate.

Okay, here's the hypothetical case.

Suppose the Japanese Central Bank raises

interest rates but the bank of China takes no action,

how will this relative rise in interest rates affect

exchange rates for the Japanese Yen versus the Chinese Yuan?

In particular, will the Yen strengthen or weaken relative to the Yuan?

And why is this so? Please jot down your answers before moving on.

So why does the Japanese Yen rise

or fall relative to the Chinese Yuan,

with a relative increase in Japanese interest rates?

To answer this question,

we first must observe that with this rise in relative interest rates,

at least some Chinese investors will shift their investment funds from China to Japan,

to take advantage of a high return.

But here's the catch,

in order for Chinese investors to buy,

for example Japanese government bonds,

and earn the higher interest rate,

these investors will have to first exchange their Chinese Yuan for Japanese Yen.

Of course, this increase in the demand for Japanese Yen must

drive up the price of the yen relative to the yuan.

In other words, the yen appreciates.

Okay, so far we've gotten through three of

the seven main reasons why exchange rates move.

This is pretty intense stuff,

so let's take a break now if you need to,

and when you're ready, let's move on to the next module.

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