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IEU - Lecture 5 - What Determines ER

# IEU - Lecture 5 - What Determines ER - Izmir University of...

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Izmir University of Economics ECON 306 INTERNATIONAL ECONOMICS Lecture 5 What Determines Exchange Rates?

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Figure 1 – Selected Exchange Rates, 1970-2005 (Monthly) \$ depreciates \$ appreciates
Figure 1 – for Turkey TURKEY - EXCHANGE RATE (million US\$) 0,00 0,20 0,40 0,60 0,80 1,00 1,20 1,40 1,60 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

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Exchange Rate in the Short Run The  asset market approach  to exchange rates  emphasizes the role of portfolio repositioning by  international financial investors. Covered interest differential (CD) CD = (1 + i UK ) x f/e – (1 + i US ) = 0 (1 + i UK ) x f/e = (1 + i US ) Expected uncovered interest differential (EUD) EUD = (1 + i UK ) x e ex /e – (1 + i US ) = 0 (1 + i UK ) x e ex /e = (1 + i US )
Exchange Rate in the Short Run (1 + i UK ) x e ex /e = (1 + i US ) (1 + i UK ) x e ex  = (1 + i US ) x e Simplify the formula by deleting 1 from the equation.         i UK  x e ex  = i US  x e

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Figure 2 – Determinants of the Exchange Rate in the Short Run
Exchange Rate in the Short Run Examples i UK  = 0.10 i US  = 0.08 e = 2 e ex  = ? e ex  = (1 + i US ) x e / (1 + i UK ) e ex  = (1 + 0.08) x 2 / (1 + 0.10) e ex  = (1.08) x 2 / (1.10) e ex  = 2.16 / 1.10 = 1.964

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i UK  = 0.10 i US  = 0.08 e = 2 e ex  = 1.964 If i UK  goes down to 0.05 what would happen to e? e = (1 + i UK ) x e ex  / (1 + i US ) e = (1 + 0.05) x 1.964 / (1 + 0.08) e = (1.05) x 1.964 / (1.08) e = 2.0622 / (1.08) = 1.909 Exchange Rate in the Short Run Examples
i UK  = 0.10 i US  = 0.08 e = 2 e ex  = 1.964 If i US  goes up to 0.12 what would happen to e? e = (1 + i UK ) x e ex  / (1 + i US ) e = (1 + 0.10) x 1.964 / (1 + 0.12) e = (1.10) x 1.964 / (1.12) e = 2.1604 / 1.12 = 1.929 Exchange Rate in the Short Run Examples

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i UK  = 0.10 i US  = 0.08 e = 2 e ex  = 1.964 If e ex  goes up to 2.5 what would happen to e?
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