L9_SRD2 - 1 1 Lecture 9 Spot rate determination 2 Today •...

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Unformatted text preview: 1 1 Lecture 9 Spot rate determination 2 Today • Stock (asset) approach to spot rate determination – Simple stock (asset) approach – Combine flow and stock approaches – General stock (asset) approach 2 Lecture 9 Spot rate determination 2 Stock versus Flow Approach • The flow approach focuses on the quantity changes in demand and supply of currency in each period of time. Currency is treated as a medium of exchange. • The stock or asset approach focuses on the total quantity of currency outstanding at a moment in time. Currency is treated as an asset, or store of value . 2 3 Lecture 9 Spot rate determination 2 Stock/Asset Approach to Spot Rates The asset approach gained favor in the late 1960s and early 1970s, because • Financial market transactions became more important as capital flow restrictions and currency convertibility rules were removed. • Linkage with other popular theories of financial asset pricing and market efficiency. 4 Lecture 9 Spot rate determination 2 Asset/Stock Approach to Spot Rates • More modern approach – Incorporates rational expectations • Key assumptions of model: – total stock of currency willingly held – investors are forward-looking – currency is an asset - investors care about the rate of return on FOREX holdings 3 5 Lecture 9 Spot rate determination 2 Simple Stock (Asset) Approach: Short Run $/€ Quantity of € Q: What does supply curve look like? 6 Lecture 9 Spot rate determination 2 $/€ Quantity of € Q: What does supply curve look like? A: Determined by monetary policy Supply Simple Stock (Asset) Approach: Short Run 4 7 Lecture 9 Spot rate determination 2 Simple Stock (Asset) Approach: Short Run $/€ Quantity of € Q: What does demand for € look like? Supply 8 Lecture 9 Spot rate determination 2 Simple Stock (Asset) Approach: Short Run $/€ Quantity of € Q: What does demand for € look like? A: Downward slope Supply Demand 5 9 Lecture 9 Spot rate determination 2 Simple Stock (Asset) Approach: Short Run $/€ Quantity of € Q: Suppose there is an increase in demand... Supply Demand 10 Lecture 9 Spot rate determination 2 Simple Stock (Asset) Approach: Short Run $/€ Quantity of € Q: Suppose there is an increase in demand... What will happen to $/€? Supply D D’ 6 11 Lecture 9 Spot rate determination 2 Simple Stock (Asset) Approach: Short Run $/€ Quantity of € Q: Suppose there is an increase in demand... What will happen to $/€? A: an appreciation of € Supply D D’ 12 Lecture 9 Spot rate determination 2 Simple Stock (Asset) Approach: Short Run $/€ Quantity of € Q: What about an increase in supply... Supply Demand 7 13 Lecture 9 Spot rate determination 2 Simple Stock (Asset) Approach: Short Run $/€ Quantity of € Q: What about an increase in supply......
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L9_SRD2 - 1 1 Lecture 9 Spot rate determination 2 Today •...

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