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INTERNATIONAL ECONOMICS SEVENTEENTH EDITION ROBERT J. CARBAUGH © 2019 Cengage. All rights reserved. 1 Chapter 12 Exchange Rate Determination © 2019 Cengage. All rights reserved. 2 Chapter Outline What Determines Exchange Rates? Determining Long-Run Exchange Rates Inflation Rates, Purchasing Power Parity, and Long-Run Exchange Rates Determining Short-Run Exchange Rates: The Asset-Market Approach Exchange-Rate Overshooting Forecasting Foreign-Exchange Rates © 2019 Cengage. All rights reserved. 3 What Determines Exchange Rates? (1 of 3) Factors that cause the supply-and-demand schedules of currencies to change • Market fundamentals (economic variables) • Productivity, inflation rates, real-interest rates, consumer preferences, and government trade policy • Market expectations • News about future market fundamentals • Traders’ opinions about future exchange rates © 2019 Cengage. All rights reserved. 4 What Determines Exchange Rates? (2 of 3) • Factors affecting exchange rates • Short run: transfers of assets • Differences in real-interest rates and shifting expectations of future exchange rates • Medium run: cyclical factors • Fluctuations in economic activity • Long run: flows of goods, services, and investment capital • Inflation rates, investment profitability, consumer tastes, productivity, and government trade policy © 2019 Cengage. All rights reserved. 5 What Determines Exchange Rates? (3 of 3) © 2019 Cengage. All rights reserved. 6 Determining Long-Run Exchange Rates (1 of 5) Exchange rate changes • Reactions of traders in foreign-exchange market to changes in four key factors: • Relative price levels • Relative productivity levels • Preferences for domestic or foreign goods • Trade barriers © 2019 Cengage. All rights reserved. 7 Determining Long-Run Exchange Rates (2 of 5) TABLE 12.1 Determinants of the Dollar’s Exchange Rate in the Long Run Factor* Change Effect on the Dollar’s Exchange Rate U.S. price level Increase Decrease Depreciation Appreciation U.S. productivity Increase Decrease Appreciation Depreciation U.S. preferences Increase Decrease Depreciation Appreciation U.S. trade barriers Increase Decrease Appreciation Depreciation *Relative to other countries. The analysis for a change in one determinant assumes that the other determinants are unchanged. © 2019 Cengage. All rights reserved. 8 Determining Long-Run Exchange Rates (3 of 5) • Relative Productivity Levels • Increase in U.S. price level leads to increase in demand for foreign currency, decrease in supply of foreign currency, and depreciation of dollar • Decrease in U.S. price level leads to decrease in demand for foreign currency, increase in supply of foreign currency, and appreciation of dollar © 2019 Cengage. All rights reserved. 9 Determining Long-Run Exchange Rates (4 of 5) • Preferences for Domestic or Foreign Goods • Increased demand for U.S. exports and appreciation of dollar • Increased demand for U.S. imports and depreciation of dollar • U.S. imposes trade barriers • Appreciation of dollar © 2019 Cengage. All rights reserved. 10 Determining Long-Run Exchange Rates (5 of 5) © 2019 Cengage. All rights reserved. 11 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (1 of 13) Law of One Price • Identical goods should be sold everywhere at same price when converted to common currency, assuming it is costless to ship goods between nations, there are no barriers to trade, and markets are competitive • Prevailing market-exchange rate is the true equilibrium rate © 2019 Cengage. All rights reserved. 12 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (2 of 13) • Burgeromics: The Big Mac Index and the Law of One Price • Attempt to measure the true equilibrium value of a currency based on one product, the Big Mac • Can be used to determine extent to which market-exchange rate differs from true equilibrium-exchange rate • Big Mac prices show law of one price does not hold across countries © 2019 Cengage. All rights reserved. 13 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (3 of 13) TABLE 12.2 Big Mac Index, 2017 Country/Currency Price of Big Mac in Local Currency Price of Big Mac in U.S. Dollars* Local Currency Overvaluation (+) Undervaluation (−) (percent) United States (dollar) $5.06 $5.06 — Switzerland (franc) 6.50 6.35 25.5 Norway (krone) 49.0 5.67 12.1 Sweden (krona) 48.0 5.26 4.0 Canada (dollar) 5.98 4.51 −10.9 Euro Area (euro) 3.88 4.06 −19.7 China (yuan) 19.6 2.83 −44.1 Mexico (peso) 49.0 2.23 −55.9 *At market exchange rate, January 12, 2017. The price in each country is based on the average of four cities. Source: From “Big Mac Currencies,” The Economist, available at http://www.economist.com. © 2019 Cengage. All rights reserved. 14 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (4 of 13) • Purchasing Power Parity • Theory that exchange rates adjust to make goods and services cost same everywhere • Application of law of one price © 2019 Cengage. All rights reserved. 15 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (5 of 13) • Purchasing Power Parity • If the rate of inflation is much higher in one country • Its money has lost purchasing power over domestic goods • Currency should depreciate to restore parity with prices of goods abroad © 2019 Cengage. All rights reserved. 16 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (6 of 13) TABLE 12.3 The Law of One Price Applied to a Single Product—Steel According to the law of one price, if the yen price of steel increases by 10 percent and the dollar price of steel remains constant, the yen will depreciate by 10 percent against the dollar to ensure that price is the same in both countries. Yen Price of a Ton of Steel 50,000 yen 55,000 Dollar Price of a Ton of Steel Exchange Rate: Yen per Dollar 500 100 500 110 © 2019 Cengage. All rights reserved. 17 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (7 of 13) • Purchasing Power Parity(cont’d) • Trade flows are mechanism that makes a currency depreciate or appreciate • Changes in relative national price levels determine changes in exchange rates over long term © 2019 Cengage. All rights reserved. 18 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (8 of 13) • Purchasing Power Parity (cont’d) • Foreign-exchange value of currency tends to appreciate or depreciate at rate equal to difference between foreign and domestic inflation • Changes in relative national price levels • Determine changes in exchange rates, long term © 2019 Cengage. All rights reserved. 19 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (9 of 13) • Purchasing Power Parity (cont’d) • A currency is expected to depreciate by amount equal to the excess of domestic inflation over foreign inflation • A currency is expected to appreciate by amount equal to excess of foreign inflation over domestic inflation © 2019 Cengage. All rights reserved. 20 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (10 of 13) • Purchasing Power Parity (cont’d.) • Used to predict long-term exchange rates • P - price indexes of U.S. and Switzerland • 0 - base period • 1 - period 1 • S0 - equilibrium exchange rate in base period • S1 - estimated target at which actual rate should be in the future S1 S0 PUS1 PUS0 PS1 PS0 © 2019 Cengage. All rights reserved. 21 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (11 of 13) • Purchasing Power Parity (cont’d.) • Exchange-rate movements may be influenced by investment flows • Problems • Choosing appropriate price index to be used in price calculations • Determining equilibrium period to use as base © 2019 Cengage. All rights reserved. 22 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (12 of 13) • Purchasing Power Parity (cont’d.) • Government policy may interfere with operation of theory • Forecasting exchange rates appropriate in long run; poor forecasters in short run © 2019 Cengage. All rights reserved. 23 Inflation Rates, Purchasing Power Parity, & Long-Run Exchange Rates (13 of 13) © 2019 Cengage. All rights reserved. 24 Determining Short-Run Exchange Rates: The Asset-Market Approach (1 of 9) Foreign-exchange market activity • Dominated by investors in assets • Treasury securities, corporate bonds, bank accounts, stocks, and real property Asset-market approach • Investors decide between domestic and foreign investments based on • Relative levels of interest rates • Expected changes in exchange rate itself over term of investment © 2019 Cengage. All rights reserved. 25 Determining Short-Run Exchange Rates: The Asset-Market Approach (2 of 9) TABLE 12.4 Determinants of the Dollar’s Exchange Rate against the Pound in the Short Run Change in Determinant* Repositioning of International Financial Investment Effect on Dollar’s Exchange Rate Increase Toward dollar-denominated assets Appreciates Decrease Toward pound-denominated assets Depreciates Increase Toward pound-denominated assets Depreciates Decrease Toward dollar-denominated assets Appreciates Appreciate Toward dollar-denominated assets Appreciates Depreciate Toward pound-denominated assets Depreciates U.S. Interest Rate British Interest Rate Expected Future Change in the Dollar’s Exchange Rate *The analysis for a change in one determinant assumes that the other determinants are unchanged. © 2019 Cengage. All rights reserved. 26 Determining Short-Run Exchange Rates: The Asset-Market Approach (3 of 9) • Relative Levels of Interest Rates • Level of nominal interest rate is first approximation of rate of return on assets that can be earned in a particular country • Differences in level of nominal interest rates between economies • Likely to affect international investment flows as investors seek highest rate of return © 2019 Cengage. All rights reserved. 27 Determining Short-Run Exchange Rates: The Asset-Market Approach (4 of 9) • Relative Levels of Interest Rates (cont’d) • If interest rates in U.S. > rates abroad • Increase in demand for dollars • Dollar appreciation • If interest rates in U.S. < rates abroad • Decrease in demand for dollars • Dollar depreciation • Real-interest rate • Nominal-interest rate minus inflation rate © 2019 Cengage. All rights reserved. 28 Determining Short-Run Exchange Rates: The Asset-Market Approach (5 of 9) © 2019 Cengage. All rights reserved. 29 Determining Short-Run Exchange Rates: The Asset-Market Approach (6 of 9) TABLE 12.5 Nominal and Real Interest Rates, April 2017 Country Nominal Interest Rate* (percent) Inflation Rate** (percent) Real Interest Rate (percent) Greece 6.7 0.8 5.9 Russia 8.1 4.5 3.6 South Africa 8.8 5.7 3.1 Indonesia 7.0 4.3 2.7 United States 2.2 2.4 −0.2 Canada 1.5 1.9 −0.4 Euro Area 0.2 1.6 −1.4 Venezuela 10.4 56.2 −45.8 *Rates are for 10-year government bonds. **Measured by the Consumer Price Index for the latest three months. Source: From The Economist, “Economic and Financial Indicators,” April 22, 2017. See also International Monetary Fund, International Financial Statistics, and World Bank, Data and Statistics, available at www.data.worldbank.org. © 2019 Cengage. All rights reserved. 30 Determining Short-Run Exchange Rates: The Asset-Market Approach (7 of 9) • Expected Change in the Exchange Rate • Future expectations of appreciation of dollar can be self-fulfilling for today’s value of the dollar © 2019 Cengage. All rights reserved. 31 Determining Short-Run Exchange Rates: The Asset-Market Approach (8 of 9) © 2019 Cengage. All rights reserved. 32 Determining Short-Run Exchange Rates: The Asset-Market Approach (9 of 9) • Diversification, Safe Havens, & Investment Flows • Relative levels of interest rates strongly impact investment flows • Other factors affecting investment flows among economies • Size of stock of assets denominated in a particular currency in investor portfolios may induce change in investor preferences for diversification purposes • Safe-haven effect: investors may be willing to sacrifice return for safe repository for their funds © 2019 Cengage. All rights reserved. 33 Exchange-Rate Overshooting (1 of 4) Exchange-Rate Overshooting • Short-run response (depreciation or appreciation) to change in market fundamentals is greater than its long-run response • Changes in market fundamentals exert a disproportionately large short-run impact on exchange rates © 2019 Cengage. All rights reserved. 34 Exchange-Rate Overshooting (2 of 4) • Exchange-Rate Overshooting (cont’d) • Helps explain why exchange rates depreciate or appreciate so sharply from day to day • Volatility of exchange rates intensified by overshooting © 2019 Cengage. All rights reserved. 35 Exchange-Rate Overshooting (3 of 4) • Exchange-Rate Overshooting (cont’d) • Overshooting explained by: • Tendency of elasticities to be smaller in short run than in long run • Ex. (Figure 12.6): Increased demand for pounds leads to initial pound appreciation (dollar depreciation); with U.S. prices lower, quantity of pounds supplied increases over time, dampening the initial pound appreciation • Exchange rates tend to be more flexible than many other prices, which are often written into long-term contracts © 2019 Cengage. All rights reserved. 36 Exchange-Rate Overshooting (4 of 4) © 2019 Cengage. All rights reserved. 37 Forecasting ForeignExchange Rates (1 of 9) Forecasting exchange rates • Very tricky, especially in short run • Necessary for exporters, importers, investors, bankers, and foreign-exchange dealers • Choosing currency in which to make deposits requires idea of what currency’s value will be • Decisions about foreign investment necessitate awareness of where exchange rates will move over time • Need for exchange rate forecasting resulted in emergence of consulting firms © 2019 Cengage. All rights reserved. 38 Forecasting ForeignExchange Rates (2 of 9) • Judgmental forecasts • Subjective or common sense models require • Wide array of political and economic data • Interpretation of these data in terms of timing, direction, and magnitude of exchange-rate changes • Projections based on thorough examination of individual nations • Based on economic indicators, political factors, technical factors, psychological factors © 2019 Cengage. All rights reserved. 39 Forecasting ForeignExchange Rates (3 of 9) • Technical forecasts • Involve use of historical exchange-rate data to estimate future values • Ignore economic and political determinants of exchange-rate movements • Founded on idea that “history repeats itself” • Used to analyze short-run movements of exchange rates © 2019 Cengage. All rights reserved. 40 Forecasting ForeignExchange Rates (4 of 9) TABLE 12.7 Exchange Rate Forecasters Forecasting Organization Methodology Horizon Global Insights Econometric 24 months JPMorgan Chase Judgmental Econometric Under 12 months Over 12 months Bank of America Econometric Technical Over 12 months Under 12 months Goldman Sachs Technical Econometric Under 12 months Over 12 months UBS Global Asset Management Judgmental Econometric 8 months 12 months Source: Data collected by author. © 2019 Cengage. All rights reserved. 41 Forecasting ForeignExchange Rates (5 of 9) © 2019 Cengage. All rights reserved. 42 Forecasting ForeignExchange Rates (6 of 9) • Fundamental Analysis • Opposite of technical analysis • Considers economic variables likely to affect supply and demand of a currency • Uses statistical estimations of economic theories • Attempts to incorporate fundamental variables that underlie exchange-rate movements • Interest rates, balance of trade, productivity, inflation rates © 2019 Cengage. All rights reserved. 43 Forecasting ForeignExchange Rates (7 of 9) • Limitations of econometric models used to forecast exchange rates • Rely on predictions of key economic variables for which reliable information may be hard to obtain • Some factors affecting exchange rates cannot easily be quantified • Precise timing of factor’s effect on currency’s exchange rate may be unclear • Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis © 2019 Cengage. All rights reserved. 44 Forecasting ForeignExchange Rates (8 of 9) • Econometric models best suited for forecasting long-run trends in the movement of an exchange rate • Models do not generally provide foreign currency traders precise price information regarding when to purchase or sell a particular currency • Currency traders generally prefer technical to fundamental analysis; most forecasters use combination of fundamental, technical, judgmental analysis © 2019 Cengage. All rights reserved. 45 Forecasting ForeignExchange Rates (9 of 9) • Exchange-Rate Misalignment • Deviation of exchange rate from fundamental value • Has implications for country’s trade position and job creation • Undervalued currency gives country trade advantage at expense of trading partners • Undervaluation widely considered unfair; however, there’s no sure way to estimate correct value of currency and thus determine extent of undervaluation © 2019 Cengage. All rights reserved. 46 Module 09: Critical Thinking Assignment Saudi Arabian Riyal and the U.S. Dollar (100 Points) While Saudi Arabia seeks to diversify its economy, the Saudi economy is dominated by the petroleum sector. In addition, the Saudi Arabian Riyal (SAR) is pegged to the U.S. Dollar. For this week's discussion, please answer the following questions: What are the advantages and disadvantages of the pegged exchange rate? • Analyze the effect on the economy of Saudi Arabia (GDP, interest rates, inflation, and trade balance) given two scenarios when there is a dramatically declining world oil price or a dramatically increasing world oil price. Directions: Your essay is required to be four to five pages in length, which does not include the title page and reference pages, which are never a part of the content minimum requirements. Support your submission with course material concepts, principles, and theories from the textbook and at least three scholarly, peer-reviewed journal articles. Use the Saudi Digital Library to find your resources. Use Saudi Electronic University academic writing standards and follow APA style guidelines. It is strongly encouraged that you submit all assignments into Turnitin prior to submitting them to your instructor for grading. If you are unsure how to submit an assignment into the Originality Check tool, review the Turnitin - Student Guide for step-by-step instructions. Review the grading rubric to see how you will be graded for this assignment. CT Rubric A+TOPIC Question designers need to avoid specific wording problems. For example, they should avoid leading questions or double-barreled questions. What do you think about it? Elaborate with sample questions and the possible answers. (Refer Chapter-11/ Module-7,9) Embed course material concepts, principles, and theories (which require supporting citations), along with two scholarly peer-reviewed references in support of your answer. Keep in mind that these scholarly references can be found in the Saudi Digital Library by conducting an advanced search specific to scholarly references. Be sure to support your statements with logic and argument, citing all sources referenced. Post your initial response early and check back often to continue the discussion. Be sure to respond to your peers' posts as well. Answer all questions posted by your fellow students as well as your professor. These post replies need to be substantial and constructive in nature. They should add to the content of the post and evaluate/analyze that post's answer. THREADS (0)High rate. Important to have general discussion, for example, if the prices for oil increases, what happens to the GDP, is the GDP, inflation, trade balance, interest rate, increases or decreases, explain why? Describe some events, for example in 2015, there was a high price of oil, General discussion is very important for high rate, rds English (United States) Accessibility: Investigate Focus
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Essay: Saudi Arabian Riyal and the US Dollar
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Essay: Saudi Arabian Riyal and the US Dollar
Courtesy of the underlying interlinkages and connections by nations in the modern world,
the progress of modern-world economies partly depends on activities in other countries. In
essence, the growth and development of modern nations depend on their resources and
capabilities and bilateral and multilateral relationships with other entities in the world (Nambisan
et al., 2019). For instance, modern economies usually engage in foreign exchange and trade to
access and dispose of their resources with other countries. In a nutshell, the current status of
modern economies could be associated with continuing globalization and foreign trade trends.
This essay mainly examines and analyzes the impact of foreign exchange activities between
Saudi Arabia and the United States, primarily through the lenses of their currency exchange
rates. The first section outlines the underlying advantages and disadvantages of the pegged
exchange rate predominant in Saudi Arabia. The essay also presents several viable discussions
that analyze the effects and impacts on the Saudi Arabian economy by examining situations
when world oil prices rise or decline. The essay renders these discussions through the lenses of
gross domestic product (GDP), inflation, trade balance, and interest rates.
Advantages and Disadvantages of the Pegged Exchange Rate
The Kingdom utilizes a pegged exchange rate to reduce foreign exchange risk between
Saudi Arabia and other world economies (Aloui et al., 2018). The authors reveal that the Saudi
Arabian Riyal is pegged with the solid and stable US dollar. The pegged exchange rate is also
emulated in other nations in the Middle East, including United Arab Emirates (UAE), Qatar,
Oman, Lebanon, Jordan, and Bahrain. The pegged exchange rate ensures that the performance of
the Saudi Arabian Riyal relies on the general performance of the US dollar. This section explores
the advantages and disadvantages of utilizing the pegged exchange rate in Saudi Arabia.

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As aforementioned, the primary intention of pegging a currency is to alleviate foreign
exchange risks that may occur due to irrepressible fluctuations in the currency market.
Considering that Saudi Arabia's economy mainly depends on oil, the value of the Riyal may be
primarily impacted by the dynamics in the global oil markets. Therefore, nations deem it prudent
and plausible to peg their currencies with more stable currencies to address and combat possible
price fluctuations in the foreign exchange market. According to, countries that utilize the pegged
exchange rate systems gain comparative trading advantages because they protect their economic
interests (Moin et al. 2020). The pegged currency enables the ...


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