Question

Fully explain the effects of an increase in the expected future exchange rate on the spot exchange rate under both fixed and flexible exchange rate regimes (include the effects on the BOP, FX market, and domestic and foreign returns).

Answer 1

The asset market approach to exchange rates that focuses on debt securities and the relationships between the current spot exchange rate, interest rates, and the expected future spot exchange rate.If the expected future spot exchange rate value of the foreign currency increases, then the current spot exchange rate value of the foreign currency increases. Many different things can influence the expected future spot exchange rate.

• First, if expectations simply extrapolate recent trends, then a bandwagon is possible. Speculation then may be based on destabilizing expectationsexpectations formed without regard to the economic fundamentals-and (speculative) bubbles can occur.
• Second, if expectations are based on a belief that exchange rates eventually follow PPP, then they lead to stabilizing speculation-speculation that tend to move the exchange rate toward a value consistent with the economic fundamentals of national price levels.
• Third, expectations are affected by various kinds of news about economic and political circumstances.

Both the domestic interest rate and the expected future exchange rate can change at the same time. If the increase in the nominal domestic interest rate is caused by a higher expected rate of inflation, then it may also be accompanied by an expectation that the domestic currency will depreciate in the future. In this case, there is no simple prediction for the pressure on the current spot exchange rate. If instead the higher domestic interest rate is not accompanied by an expectation of higher future inflation, then there is no obvious reason to expect a depreciation of the country's currency. This increase in both the nominal and real interest rate results in pressure for the current spot exchange rate value of the country's currency to appreciate.