Continues a series of publications devoted to the study of fundamental analysis of the international currency market (FOREX).
In the previous issue of Forex Magazine, we have built a model describing the interaction of market borrowings and foreign exchange market. It was found that the demand for domestic currency is determined by the value of net exports, which depends on the real exchange rate. A proposal of the national currency is determined by the value of net foreign investment, which depends on the real interest rate, adjusted for market borrowing. Thus, in the foreign exchange market demand and supply of the currency brought into line with the equilibrium real exchange rate. But the relationship of real and nominal exchange rates, we brought in the Forex Magazine number 28 in the analysis of the theory of PPP. And its meaning is that the changes in the nominal exchange rate will stabilize the value of real exchange rate in the long run. That is, the growth of the real exchange rate should be accompanied by a rise in nominal and vice versa.
The model is generally quite simple, but, nevertheless, to understand, as a working mechanism of exchange rate changes on the currency market.
How to understand the changes in exchange rates on the foreign exchange market.
For visibility and ease of study to examine a few examples, starting with the easiest, and then complicated.
All examples will be analyzed in the three discussed in the previous publication of the graphs: Graph market borrowing, according to the schedule of net foreign investment from the real interest rate and the actual schedule of the foreign exchange market. In order not to overload the figures, take the following symbols:
r - real interest rate;
S - savings - the offer of loan funds;
I - investments (as the sum of domestic and net foreign investment) - the demand for borrowed funds;
NFI - net foreign investment - National sentence. currency;
NX - net exports - the demand for National. currency;
Er - the real exchange rate;
Qm - The number of national currencies.
Initial situation
The market borrowing established equilibrium real interest rate at the level of r1. In accordance with the prevailing level of interest rates have some value of net foreign investments, which are also the proposal of the currency in the foreign exchange market. Also have some correlation between the real exchange rate and net exports, which is both a demand for national currency in the foreign exchange market. The real exchange rate at the level of Er1 leads to the equilibrium exchange market. Er1 real exchange rate corresponds to a certain level of nominal exchange rate. The initial situation is depicted in the figure below.
Fig. 1. Initial situation
Scenario 1
Suppose, as a result of changes in consumer preferences have increased consumption of imported goods. Obviously, the value of net exports in this case reduced Constant ratio of internal and external prices. This change will affect our model only the schedule of foreign exchange market - will be shifting the curve of net exports to decrease, ie left.
As a result, the currency market, establishing a new balance in the equilibrium real exchange rate at the level of Er2.
Fig. 2. Scenario 1 - Changes in the ratio of imports and exports
And now remember the little theory of PPP. The relationship between real and nominal exchange rates is described by the following formula:
Er - the real exchange rate,
En - the nominal exchange rate
P - level of prices in the domestic market,
P * - the price level in the foreign market (denominated in foreign currency).
By a simple transformation turns out that the nominal exchange rate is equal to:
The graph the real exchange rate, we dropped that, accordingly, should be reflected in the reduction of the nominal exchange rate. Thus, we have received confirmation of already available to us rather intuitive level, believe that the decline in the trade balance must inevitably lead to a reduction in the national currency. That is true.
Situation 2
Assume that the Central Bank to raise interest rates on government obligations (quite often the situation). Here we will not consider what would happen to the market borrowing, we note only that such an event should definitely lead to higher real interest rates *, for example to the level of r2. As a result, the value of net foreign investment (and hence the proposal on the currency market) will decrease. As a result, the currency market, establishing a new equilibrium when the equilibrium real exchange rate at the level of Er2, which will be more original.
Fig. 3. Scenario 2 - impact of changes in interest rate CBR
* It is important not to be confused with the real rate of Central Bank interest rate. A real interest rate means the average difference between the current and future value of assets as a percentage, less the inflation rate.
The real exchange rate, we increased that, accordingly, should be reflected in the growth of the nominal exchange rate. So, now you can rightly conclude that the increase in interest rates by central banks should lead to an increase in the national currency.
Situation 3
(Now it is time to put in our analysis of the latest timetable - the market borrowing, which in the chain of our model in general, it is first.)
Let's say the country will improve the investment climate, which was caused by, for example, political events - the victory in the elections, the adoption of the new law, etc. The desire to invest in the domestic economy more funds should lead to increased demand for borrowed funds, ie at the same real rate of interest residents of the will to take more loans in the market borrowing. The curve of demand for borrowed funds shifted upward, ie, right. As a result, the equilibrium established in the real interest rate at the level of r2, which is higher than the previous level of r1. Continuing the chain of reasoning, just as we did in the previous example, we come to the fact that the nominal exchange rate, and in this case should grow.
Fig. 4. Situation 3 - Changes in investment climate
Conclude that improving the investment climate should lead to further foreign investment in the national economy (as the net foreign investment is decreasing), and, consequently, to an increase in the national currency.
In the next publication, we will continue to analyze the impact is already more complicated macro-economic processes to changes in exchange rates with the use of the same model.
In the previous issue of Forex Magazine, we have built a model describing the interaction of market borrowings and foreign exchange market. It was found that the demand for domestic currency is determined by the value of net exports, which depends on the real exchange rate. A proposal of the national currency is determined by the value of net foreign investment, which depends on the real interest rate, adjusted for market borrowing. Thus, in the foreign exchange market demand and supply of the currency brought into line with the equilibrium real exchange rate. But the relationship of real and nominal exchange rates, we brought in the Forex Magazine number 28 in the analysis of the theory of PPP. And its meaning is that the changes in the nominal exchange rate will stabilize the value of real exchange rate in the long run. That is, the growth of the real exchange rate should be accompanied by a rise in nominal and vice versa.
The model is generally quite simple, but, nevertheless, to understand, as a working mechanism of exchange rate changes on the currency market.
How to understand the changes in exchange rates on the foreign exchange market.
For visibility and ease of study to examine a few examples, starting with the easiest, and then complicated.
All examples will be analyzed in the three discussed in the previous publication of the graphs: Graph market borrowing, according to the schedule of net foreign investment from the real interest rate and the actual schedule of the foreign exchange market. In order not to overload the figures, take the following symbols:
r - real interest rate;
S - savings - the offer of loan funds;
I - investments (as the sum of domestic and net foreign investment) - the demand for borrowed funds;
NFI - net foreign investment - National sentence. currency;
NX - net exports - the demand for National. currency;
Er - the real exchange rate;
Qm - The number of national currencies.
Initial situation
The market borrowing established equilibrium real interest rate at the level of r1. In accordance with the prevailing level of interest rates have some value of net foreign investments, which are also the proposal of the currency in the foreign exchange market. Also have some correlation between the real exchange rate and net exports, which is both a demand for national currency in the foreign exchange market. The real exchange rate at the level of Er1 leads to the equilibrium exchange market. Er1 real exchange rate corresponds to a certain level of nominal exchange rate. The initial situation is depicted in the figure below.
Fig. 1. Initial situationScenario 1
Suppose, as a result of changes in consumer preferences have increased consumption of imported goods. Obviously, the value of net exports in this case reduced Constant ratio of internal and external prices. This change will affect our model only the schedule of foreign exchange market - will be shifting the curve of net exports to decrease, ie left.
As a result, the currency market, establishing a new balance in the equilibrium real exchange rate at the level of Er2.
Fig. 2. Scenario 1 - Changes in the ratio of imports and exportsAnd now remember the little theory of PPP. The relationship between real and nominal exchange rates is described by the following formula:
Er - the real exchange rate,
En - the nominal exchange rate
P - level of prices in the domestic market,
P * - the price level in the foreign market (denominated in foreign currency).
By a simple transformation turns out that the nominal exchange rate is equal to:
The graph the real exchange rate, we dropped that, accordingly, should be reflected in the reduction of the nominal exchange rate. Thus, we have received confirmation of already available to us rather intuitive level, believe that the decline in the trade balance must inevitably lead to a reduction in the national currency. That is true.Situation 2
Assume that the Central Bank to raise interest rates on government obligations (quite often the situation). Here we will not consider what would happen to the market borrowing, we note only that such an event should definitely lead to higher real interest rates *, for example to the level of r2. As a result, the value of net foreign investment (and hence the proposal on the currency market) will decrease. As a result, the currency market, establishing a new equilibrium when the equilibrium real exchange rate at the level of Er2, which will be more original.
Fig. 3. Scenario 2 - impact of changes in interest rate CBR* It is important not to be confused with the real rate of Central Bank interest rate. A real interest rate means the average difference between the current and future value of assets as a percentage, less the inflation rate.
The real exchange rate, we increased that, accordingly, should be reflected in the growth of the nominal exchange rate. So, now you can rightly conclude that the increase in interest rates by central banks should lead to an increase in the national currency.
Situation 3
(Now it is time to put in our analysis of the latest timetable - the market borrowing, which in the chain of our model in general, it is first.)
Let's say the country will improve the investment climate, which was caused by, for example, political events - the victory in the elections, the adoption of the new law, etc. The desire to invest in the domestic economy more funds should lead to increased demand for borrowed funds, ie at the same real rate of interest residents of the will to take more loans in the market borrowing. The curve of demand for borrowed funds shifted upward, ie, right. As a result, the equilibrium established in the real interest rate at the level of r2, which is higher than the previous level of r1. Continuing the chain of reasoning, just as we did in the previous example, we come to the fact that the nominal exchange rate, and in this case should grow.
Fig. 4. Situation 3 - Changes in investment climateConclude that improving the investment climate should lead to further foreign investment in the national economy (as the net foreign investment is decreasing), and, consequently, to an increase in the national currency.
In the next publication, we will continue to analyze the impact is already more complicated macro-economic processes to changes in exchange rates with the use of the same model.
Andrew Khamidullin
to Forex Magazine
fxtrade@tomsk.ru
to Forex Magazine
fxtrade@tomsk.ru
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