Determinant of Exchange Rate (Short Run & Long Run) by Noor Amalina and Nur Farah

Determinant of Exchange Rate (Short Run & Long Run)

by Noor Amalina and Nur Farah]

Introduction

Exchange rates are prices that are determined by supply and demand.  For some countries the exchange rate is the single most important price in the economy because it determines the international balance of payments.  (Levich, 2001)  There is no general theory of exchange rate determination, but Eiteman et al (2001) divide the potential exchange rate determinants into five areas: parity conditions, infrastructure, speculation, cross-border foreign direct investment and portfolio investment, and political risks.  Although no model has been consistent in predicting short-term foreign exchange rate behavior, there are several major concepts that play a role in determining the long-term behavior of foreign exchange rates.  The first concept is based on the idea that the current price of an asset reflects all available information; and therefore, only unexpected events cause exchange rates to fluctuate. (Levich, 2001)

What Determines Exchange Rates In the Short Run?

1) Relative Levels of Interest Rates

The level of the nominal (money) interest rate is a first approximation of the rate of return on assets that can be earned in a particular country. Thus, differences in the level of nominal interest rates between economies are likely to affect international investment flows, as investors seek the highest rate of return. When interest rates in the United States are significantly higher than interest rates abroad, the foreign demand for U.S. securities and bank accounts will increase, which increases the demand for the dollars needed to buy those assets, thus causing the dollar to appreciate relative to foreign currencies. In contrast, if interest rates in the United States are on average lower than interest rates abroad, the demand for foreign securities and bank accounts strengthens and the demand for U.S. securities and bank accounts weakens. This weakness will cause the demand for foreign currencies needed to buy foreign assets to increase and the demand for the dollar to decrease, resulting in a depreciation of the dollar relative to foreign currencies.

To illustrate the effects of relative interest rates as a determinant of exchange rates, refer to Figure 2.1. It shows the demand and supply schedules for pounds. Initially, the equilibrium exchange rate is $1.50 per pound. Referring to Figure 2.1 (a), assume that an expansionary monetary policy of the U.S. Federal Reserve results in a fall in interest rates to three percent, while interest rates in the United Kingdom are at six percent. American investors will be attracted to the relatively high interest rates in the United Kingdom and will demand more pounds to buy UK Treasury bills. The demand for pounds thus rises to D1 in the figure. Concurrently, the UK investors will find investing in the United States less attractive than before, so fewer pounds will be offered to buy dollars for purchases of U.S. securities. The supply of pounds thus decreases to S1 in the figure. The combined effect of these two shifts is to cause the dollar to depreciate to $1.60 per pound. Alternatively, if interest rates werelower in the United Kingdom than in the United States, the dollar would appreciate against the pound as Americans made fewer investments in the United Kingdom and the UK investors made more investments in the United States. Things may not always be so simple, though, concerning the relation between interest rates, investment flows, and exchange rates. It is important to distinguish between the nominal interest rate and the real interest rate (the nominal interest rate minus the inflation rate).

Figure 2.1 (a) Relative Interest Rate

2) Expected Change in the Exchange Rate

Differences in interest rates may not be all investors need to know to guide their decisions. They must also consider that the return actually realized from an investment is paid out over some future period. This time frame means that the realized value of that future payment can be altered by changes in the exchange rate itself over the term of the investment. Simply put, investors must think about possible gains or losses on foreign currency transactions in addition to interest rates on assets. Expectations about the future path of the exchange rate itself will figure prominently in the investor’s calculation of what he or she will actually earn from an investment denominated in another currency. Even a high interest rate would not be attractive if one expects the denominating currency to depreciate at a similar or greater rate and erase all economic gain. Conversely, if the denominating currency is expected to appreciate, the realized gain would be greater than what the interest rate alone would suggest, and the asset appears more lucrative.

Figure 2.1 (b) illustrates the effects of investor expectations of changes in exchange rates over the term of an investment. Assume that the equilibrium exchange rate is initially $1.50 per pound. Suppose that UK investors expect that in three months the exchange value of the dollar will appreciate against the pound. Thus, by investing in three-month U.S. Treasury bills, UK investors can anticipate a foreign currency gain: today, selling pounds for dollars when dollars are relatively cheap, and, in three months, purchasing pounds with dollars when dollars are more valuable (pounds are cheap). The expectation of foreign currency gain will make U.S. Treasury bills seem more attractive, and the UK investors will purchase more of them. In the figure, the supply of pounds in the foreign-exchange market shifts rightward from S0 to S1 and the dollar appreciates to $1.45 per pound today. In this way, future expectations of an appreciation of the dollar can be self-fulfilling for today’s value of the dollar

Figure 2.1 (b) Expected Change in Exchange Rate

What Determines Exchange Rates In the Long Run?

Factor in the long run-value of the exchange rate are due to reactions of traders in the foreign-exchange markets to changes in four key determinants : relative price level, relative product productivity levels, consumer preferences for domestic and foreign goods and thus changes in the demand for exports and imports.

1) Price level

The domestic price level increase significantly in Singapore and remains constant in Malaysia.  This causes Singapore consumer to desire relatively low-priced in Malaysia goods. The demand for ringgit will increase. Conversely, as the Malaysia consumers will purchase less relatively high-priced Singapore goods, the supply of ringgit will decrease. The increase in the demand for ringgit and the decrease in the supply of ringgit result in depreciation of dollars to RM 2.9 per dollar. This analysis suggest that the increase in the Singapore price level relative to price levels in other countries causes the dollar to depreciation in the long run. According to Ong Kai Kiat (2015), many Singaporeans might be showing great pleasure over the weak of MYR because they can shopping trips neighbor Johor are now significantly cheap.  However a weak Malaysian economy is worst news for Singapore as our largest trading partner. They will demand more ringgit and will lead dollar to depreciation.

2) Productivity Levels

Productivity growth measures the increase in a country’s output for given level of input. If one country able to produce more the output and become more productivity than other countries, it can produce goods cheaper than its foreign competitors can. Productivity gains are vital to the economy because they allow us to accomplish more with less. Capital and labor are both scarce resources, so maximizing their impact is always a core concern of modern business. Productivity enhancements come from technology advances, such as computers and the internet, supply chain and logistics improvements, and increased skill levels within the workforce. Suppose Malaysia productivity growth faster than that of Singapore. As Malaysia good become relatively less expensive, Singapore demands more Malaysia goods, which result in an increase in the supply of dollar. Malaysia demand fewer Singapore good, which become relatively more expensive, causing the demand of dollar to decrease. Therefore, the ringgit appreciations.Simply, in the long run, as a country becomes more productive relative to other countries, its currency appreciations.

According to Minister of International Trade and Industry Malaysia, Dato Seri Mustapha Mohamed  “Malaysia recorded a productivity growth of 4.6% in tandem with the 5.1% Gross Domestic Products (GDP) growth and 0.6% increase in employment in 2011”.

3) Preferences for Domestic or Foreign Goods.

Suppose that Singapore consumers develop stronger preferences for Malaysia-manufactured goods such as foods and tourist attraction. The stronger demand for Malaysia good results in Singaporean’s demanding more ringgit to purchase these goods. As the demand for ringgit rises, the dollar depreciates to ringgit. Conversely, if Malaysia consumers demanded additional Singaporean computer software and machinery, the dollar will tend appreciate against the ringgit. We conclude that an increase demand for a country’s exports causes its currency to appreciate in the long run; conversely, increased demand for imports results in a depreciation in the domestic currency.

4) Trade barriers

Barriers to free trade also affect exchange rates. Suppose that Malaysia government imposes a tariffs on Singapore computer software , the tariffs discourages Malaysians from purchasing Singapore computer software. The tariff causes the demand for dollar to decrease with results in an appreciation of the ringgit per dollar. As a result, trade barriers such as tariffs and quotas causes a currency appreciation in the long run for the country imposing the barriers.