Exchange rates play a crucial role in international economics, influencing trade, investment, and economic policies. They're determined by various factors, including interest rates, inflation, and current account balances. Understanding these determinants helps explain currency fluctuations and their impact on global markets.

Macroeconomic policies, like monetary and fiscal measures, significantly affect exchange rates. For instance, lowering interest rates can lead to currency depreciation, boosting exports. Expectations and market psychology also play a key role, sometimes causing exchange rates to overshoot their long-term equilibrium levels.

Exchange Rates and Macroeconomic Policies

Determinants of exchange rates

• Short-run determinants
  • Interest rate differentials
    • Higher interest rates attract capital inflows increasing demand for the currency and causing appreciation (US Treasury bonds)
  • Inflation rate differentials
    • Higher inflation rates lead to currency depreciation as purchasing power decreases (Venezuela)
  • Current account balance
    • Trade surpluses increase demand for the currency leading to appreciation (China)
    • Trade deficits decrease demand for the currency leading to depreciation (United States)
  • Political and economic stability
    • Increased stability attracts capital inflows leading to currency appreciation (Switzerland)
• Long-run determinants
  • Purchasing Power Parity (PPP)
    • Exchange rates adjust to equalize the purchasing power of currencies
    • $S = P/P*$, where $S$ is the exchange rate, $P$ is the domestic price level, and $P*$ is the foreign price level (Big Mac Index)
  • Productivity differentials
    • Faster productivity growth in the tradable sector leads to currency appreciation (Japan in the 1980s)

Impact of policies on exchange rates

• Monetary policy
  • Expansionary monetary policy (lower interest rates)
    • Decreases demand for the currency leading to depreciation (Federal Reserve quantitative easing)
    • Stimulates exports and discourages imports improving the current account balance
  • Contractionary monetary policy (higher interest rates)
    • Increases demand for the currency leading to appreciation (Federal Reserve rate hikes)
    • Discourages exports and stimulates imports worsening the current account balance
• Fiscal policy
  • Expansionary fiscal policy (increased government spending or lower taxes)
    • Increases aggregate demand leading to higher interest rates and currency appreciation (Trump tax cuts)
    • May worsen the current account balance due to increased imports
  • Contractionary fiscal policy (decreased government spending or higher taxes)
    • Decreases aggregate demand leading to lower interest rates and currency depreciation (Austerity measures in Greece)
    • May improve the current account balance due to decreased imports

Expectations in exchange rate dynamics

• Expectations
  • Market participants form expectations about future exchange rates based on available information (forward rates)
  • Changes in expectations can lead to immediate adjustments in exchange rates (Brexit referendum)
• Overshooting (Dornbusch model)
  • Short-run overshooting occurs when exchange rates temporarily overshoot their long-run equilibrium level in response to changes in monetary policy
  • Process:
    1. Expansionary monetary policy leads to lower interest rates
    2. Capital outflows cause an immediate depreciation of the currency beyond its long-run equilibrium
    3. As prices adjust gradually, the currency appreciates back towards its long-run equilibrium (Plaza Accord)

Effectiveness of exchange rate policies

• Fixed exchange rate regimes
  • Advantages:
    • Provides stability and predictability for international trade and investment (Bretton Woods system)
    • Can help control inflation by anchoring expectations (Currency board in Hong Kong)
  • Disadvantages:
    • Requires sufficient foreign exchange reserves to maintain the peg (Argentine peso crisis)
    • Loss of monetary policy autonomy as policies must be aligned with maintaining the peg
• Floating exchange rate regimes
  • Advantages:
    • Allows for automatic adjustment to external shocks and imbalances (Canadian dollar)
    • Enables monetary policy autonomy to focus on domestic objectives (Bank of England inflation targeting)
  • Disadvantages:
    • Can lead to exchange rate volatility and uncertainty for international trade and investment (Japanese yen appreciation in the 1990s)
    • May be subject to speculative attacks and overshooting (George Soros and the British pound)
• Managed float or intermediate regimes
  • Combine elements of fixed and floating regimes
  • Authorities intervene in foreign exchange markets to influence the exchange rate without committing to a specific target or level (Singapore dollar)
  • Allows for some exchange rate flexibility while mitigating excessive volatility (Crawling peg in Chile)