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Exchange Rates

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Exchange Rate: DefinitionExchange Rate: Definition The exchange rate is the price of a currency in terms of

another currency. Thud the exchange rate for the US dollar can be expressed in the amount of British pounds, EURO or Mexican pesos needed to but one dollar.

If $US1 = €0.82, then the exchange rate for EURO = (1/0.82) = $US 1.22

Q: The exchange rate for the US dollar is 7.5 Swedish Crowns (SEK), What is the exchange rate for the SEK?

A: 1 SEK = $ US 0.133

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Currencies are bought and sold on a foreign exchange market. The demand for a currency is a function of three main variables:1.The demand for other countries’ goods and services2.The demand for foreign direct investment and portfolio investment in another country3.Speculative demand

People and import/ export firms will buy currencies from banks and foreign exchange offices to conduct international transactions. Foreign exchange brokers will in turn be used by banks to supply needed currencies and to cash-in unneeded currencies. Finally the central banks of trading countries may intervene on the currency market by adding to the foreign reserves in order to adjust the exchange rate.

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The Supply curve for currencies is upward The Supply curve for currencies is upward sloping because a higher price of currency X sloping because a higher price of currency X would-ceteris paribus- would enable citizens of would-ceteris paribus- would enable citizens of that country (X) (to buy more goods of country Y. that country (X) (to buy more goods of country Y. In doing more currency X will be available in In doing more currency X will be available in country Y’s market.country Y’s market.

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EXPLANATION

When the value of the rupee increases in terms of dollars; rupee appreciates, you will be able to buy more from the same amount of rupees spent, therefore the supply of rupees will increase.

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DEMAND CURVE

The demand curve is downward sloping to The demand curve is downward sloping to indicate that citizens of country X will buy more indicate that citizens of country X will buy more currency Y when they get more of it – and more currency Y when they get more of it – and more goods- for their currency X.goods- for their currency X.

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EXPLANATION

When the rupee value falls in terms of other currencies ,say dollar, we would need more rupees to buy same amount of goods, demand for rupees would increase.

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The exchange rates for the Euro and the US dollar

P o

f €

in $

US

P o

f $U

S in

€

Q €(millions/day) Q $(millions/day)

Initial equilibrium:

$US 1 = € 0.82

And thus… €1 = $US 1.22

EURO

S$0

S$1

0.82

0.81

Q$0 Q$1Q€0 Q€1

D$

D€0

D€1

S€

1.22

1.23

US DOLLAR

Note: Do not confuse DD SS for money with foreign exchange marketsNote: Do not confuse DD SS for money with foreign exchange markets

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Fixed exchange ratesFixed exchange rates We know that exchange rates are established by market forces of demand and

supply. When a group of countries instead keep their exchange rate constant thus establishing a fixed exchange rate.

Such countries use the central government to intervene on the foreign exchange market in order to keep exchange rate within a narrow band-much like the mechanism used in a buffer stock mechanism.

The central government can affect the exchange rate in the short run by buying or selling its own currency on the foreign exchange market, and by adjusting the interest rate to influence investors’ demand for the currency.

In the long run, governments might intervene using fiscal policies, supply-side measures and protectionism to adjust national income in order to increase or decrease exports and citizens’ propensity to import.

Types of Fixed exchange ratesTypes of Fixed exchange rates The Gold Standard The Bretton Woods exchange rate system

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How a Fixed Exchange Rate WorksHow a Fixed Exchange Rate Works

Ceiling

LR equilibrium

Floor

Outside the band

Q1 Q2 Q3Q4

2.84

2.82

2.80

2.78

P o

f £

in U

S$

Q £(millions/day)

D£1D£0

B

D£2

A

C

D

S£1

S£0

When exchange rate rises above 2.82 the Bank of England will have to sell Q1Q3 (S£0 shifts to S£1) on the foreign exchange market to keep the pound within the band

Keeping the pound down

* (For ‘keeping the pound up’) refer pg 565 of textbook)

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Other tools affecting Exchange Rates Central banks are not limited to buying and selling their currencies in

order to influence the exchange rate. There are two alternatives in the short term:

1) The central bank can change the interest rate. If it wishes to increase the exchange rate, the interest rate could be raised. This would influence the demand for the home currency as foreign investors/ speculators would see a higher rate of return in holding the currency – demand for the home currency would rise.

2) The central bank could borrow from the International Monetary Fund. The IMF was created to aid countries having difficulty keeping a stable exchange rate. When a country’s currency falls, and the central bank runs out of foreign exchange to buy up the home currency, the central bank can borrow funds from the IMF to get over the crisis.

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Floating Exchange RatesFloating Exchange Rates When a currency’s value is totally determined by market forces – e.g. supply

and demand for the home currency – there is a floating exchange rate.

A currency ‘floats’ amongst the other currencies on the market and the price is set in accordance with the mechanisms of supply and demand outlined earlier.

The demand for a currency is derived from demand of goods, services and

investments in other countries. There is also speculation in currency – which is perhaps the main short run determinant of exchange rates – which is based on the predictions/ emotions of currency speculators ‘betting’ on changes in exchange rates

In a floating exchange rate system, perfect information is an important issue.

Central banks have a tendency to intervene to correct what is considered to be disequilibrium in a floating exchange rate. This is called managed float or dirty float. Dirty float implies that impure market forces (central bank interventions) are present.

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Managed Exchange RatesManaged Exchange Rates When currencies are allowed to fluctuate within a narrow band in the

short run, and allowed to be realigned in the long run, there is a managed exchange rate. The most common version is when a government pegs its currency to another.

Completely fixed rates cause a problem of inflexibility, since economies have different fundamentals such as growth rates and inflation rates.

In the long run it could be very costly for a country with a weakening currency to defend its links with other countries.

That is why we have managed exchanged rates

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An exampleAn example When the exchange rate exceeds the ceiling of When the exchange rate exceeds the ceiling of

$US 0.12082 per Yuan, points A in the diagram, $US 0.12082 per Yuan, points A in the diagram, the Chinese central bank sells Yuan (by buying the Chinese central bank sells Yuan (by buying foreign currencies) in order to increase the foreign currencies) in order to increase the supply and lower the exchange rate. supply and lower the exchange rate.

When the rate falls below the floor level of $US When the rate falls below the floor level of $US 0.12024 per Yuan, points B, the central bank 0.12024 per Yuan, points B, the central bank buys Yuan (with foreign currencies) which buys Yuan (with foreign currencies) which increases demand for Yuan and therefore the increases demand for Yuan and therefore the exchange rate for Yuan goes up.exchange rate for Yuan goes up.

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A managed exchange rateA managed exchange rate

Rev

alua

tion

Dev

alua

tion

Ceiling

CeilingCeiling A

A

A

B

B

B Floor

Floor

Floor

0.12024

0.12048

0.12082

1995 2004

t1 t2

P o

f Yua

n in

$U

S

time

• If there is fundamental upward movement in the Yuan i.e. the managed rate is below the long run rate the market sets, the Chinese central bank can realign the currency by revaluating the Yuan: time t1.

•Conversely, a fundamental overvaluation of the Yuan, shown at time t2, might cause massive purchasing of the Yuan and running down the foreign reserves.

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Appreciation and Appreciation and DepreciationDepreciation

When the exchange rate of a freely floating currency rises, the When the exchange rate of a freely floating currency rises, the currency has appreciated. currency has appreciated.

A fall in the value of a floating currency means the currency has A fall in the value of a floating currency means the currency has depreciated.depreciated.

Revaluation and devaluationRevaluation and devaluation

When the government re-pegs a fixed/ pegged currency, the currency has When the government re-pegs a fixed/ pegged currency, the currency has been revalued.been revalued.

When a fixed or pegged currency is realigned to a lower value, the currency When a fixed or pegged currency is realigned to a lower value, the currency has devalued.has devalued.

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Effects on exchange ratesEffects on exchange rates

Main determinants of the exchange rate

Two main assumptions:Two main assumptions: The currency in question (the US dollar) is The currency in question (the US dollar) is

not only floating but also freely floating-not only floating but also freely floating-there is no intervention by the US central there is no intervention by the US central bankbank

Each of the determinants mentioned later Each of the determinants mentioned later are operating under the ceteris paribus are operating under the ceteris paribus conditions-a change in interest rates is not conditions-a change in interest rates is not accompanied by a change in another accompanied by a change in another variablevariable

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Trade FlowTrade FlowWhen American exports increase, there will be an increased demand for the dollar as importers in other countries will need more dollars to buy the American goods. Increased exports will increase the demand for the dollar, causing the shift in the demand curve on slide 18 from D$0 to D$1 and subsequently an appreciation of the dollar from x 0 to x 1. (x = ex; delta = change).An increase in imports or an increase in American tourism abroad would imply increased trade of dollars for goods/ services causing an increase in supply of dollars on the market – S$’0 to S$’2 – and the dollar depreciates from x’ 0 to x’ 2 (slide 18)

=> US exports ↑demand for $US ↑x for $US↑ (and vice versa)=> US imports ↑supply of $US ↑ x for $US↓ (and vice versa)

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Capital Flows/ Interest rate changesCapital Flows/ Interest rate changes** Inflows of investment to the US demand for

the $ US ↑ x for the $US↑ (and vice versa) US investment abroad↑ supply of $US↑ x

for $US↓ (and vice versa)

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Variables affecting the exchange rate for the US dollarVariables affecting the exchange rate for the US dollar

D$2

D$1

D$0

S’$1

S’$0

S’$2

S$

D’$

US dollar US dollar

Q2 Q0 Q1 Q’1 Q’0 Q’2

P o

f $U

S (

TW

I)

P o

f $U

S (

TW

I)

Q$ (millions/day) Q$ (millions/day)

x 1

x 0

x 2

x ’1

x ’0

x ’2

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IncreaseIncrease in demand for the US in demand for the US dollar:dollar:

IncreaseIncrease in supply of the US in supply of the US dollar:dollar:

↑ US exports of goods/ services ↑ in foreign investment in US↑ in US interest rates↓ in US inflation rateSpeculative buying of US dollarUS central bank buys dollars (= decrease in foreign reserves)

↑ US imports of goods/ services↑ in US foreign investment abroad↑ in foreign interest rates↓ in foreign inflation ratesSpeculative selling of US dollarUS central bank sells dollars (= increase in foreign reserves)

Decrease in demand for the US Decrease in demand for the US dollar:dollar:

Decrease in supply of the US Decrease in supply of the US dollar:dollar:

↓ US exports of goods/ services↓ in foreign investment in US↓ in US interest rates↑ in US inflation rate

↓ US imports of goods/ services↓ in US foreign investment abroad↓ in foreign interest rates↑ in foreign inflation rate

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InflationInflation

Ceteris Paribus:

Relative inflation in US↑ demand for US exports & US demand for imports ↓ demand for US dollar ↓ & supply of US dollar↑ x for the $US ↓

Relative inflation in US↓ demand for US exports↑ & US demand for imports ↓ demand for US dollar ↑ & supply of US dollar↓ x for $US ↑

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SpeculationSpeculation

Speculative belief that the US dollar will depreciate US dollar is sold supply of the US dollar↑ x for $US↓

Speculative belief that the US dollar will appreciate US dollar is bought demand for the US dollar ↑ x for the $US↑

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Use of foreign exchange reservesUse of foreign exchange reserves Governments can intervene on the foreign currency market via the

foreign currency reserves held in the central bank

US dollar depreciates ‘too much’ US central bank intervenes by buying the US dollar demand for dollar ↑ x for the $US ↑ (decrease in US foreign reserves & inflow to US capital account)

US dollar appreciates ‘too much’ US central bank intervenes by selling the US dollar supply of the US dollar ↑ x for $US ↓ (decrease in the US foreign reserves & inflow to the US capital account)

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Fixed exchange ratesFixed exchange rates

Advantages: Predictability and certainty Exchange rate stability encourages trade Fiscal/ monetary discipline domestically Less risk of speculationDisadvantages: Loss of domestic monetary policy freedom Need of large foreign reserves Possibility of increased unemployment Possibility of imported inflation

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Floating exchange ratesFloating exchange rates

Advantages: The balance of payments automatically adjusts No large foreign reserves necessary Freedom in domestic/ monetary policies Reduced Speculation Less risk of imported inflationDisadvantages: Instability and lack of predictability Lack of monetary/ fiscal prudence Loss of competitiveness and efficiency

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Monetary Integration (single currencies)Information:In 1999 the EURO technically came into being and during 2001 (from all 15 members except UK, Denmark, Sweden and Greece) were ‘locked’ in place in exchange terms. A European central bank took over the task of setting and implementing monetary policies for all EMU countries. This project created one of the largest shifts in economic power in history.

In order for each country wishing to join to be eligible, they had to adjust domestic fiscal and monetary policies to fulfill the following criteria:Inflation could be no more than 1.5 percentage points above the average inflation of the three countries with the lowest inflationInterest rates had to be within 2 percentage points of the average of the three countries with the lowest interest ratesA maximum budget deficit of 3% of GDPExchange rates had to be kept within a narrow band for 2-3 yearsThe national debt had to be lower than 60% of GDP

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EMU: EMU: COSTSCOSTS AND AND BENEFITSBENEFITS

Benefits: Trade creation Increased efficiency due to increased competition Benefits of scale Lower transaction costs

Costs: Loss of domestic monetary policy Restrictions on domestic fiscal policy Regional unemployment

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Purchasing Power Parity*Purchasing Power Parity*

The theory of purchasing power parity The theory of purchasing power parity states that exchange rates will in the long states that exchange rates will in the long run adjust to different inflation rates in run adjust to different inflation rates in countries, leading to equilibrium where a countries, leading to equilibrium where a given amount of home currency traded for given amount of home currency traded for a foreign currency will buy an equally-sized a foreign currency will buy an equally-sized bundle of goods.bundle of goods.

*Refer to textbook for limitation of this theory

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Understand this situation – Understand this situation – Arbitrage and the law of one priceArbitrage and the law of one price

Assume two countries, X and Y, side-by-side which have no trade barriers; mo transaction costs; no transport costs; homogenous goods; identical expenditure taxes; and a floating exchange rate.

Country X can buy a kilo of flour for 2 ($X) domestically. Country Y can buy a kilo of flour for 3 ($Y) domestically The exchange rate is $X1 = $Y2; or $Y2 = $X0.5 The following two things will happen:(i) Citizens from X will cross over to Y to buy flour, seeing as how $X2 they pay

at home would get them $Y4 and then 1.33 kilos of flour;(ii) There would be arbitrage, as enterprising people in Y would buy flour

domestically and sell it in X for just under $X2 per kilo.The result: Increased demand for the Y dollar will cause the $Y to appreciate. Also, the traders from Y will exchange their X dollars for Y dollars, thereby

increasing supply of $X and causing a depreciation of the $X.

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Law of one price:Law of one price:Assuming that there are no Assuming that there are no imperfections, two homogenous imperfections, two homogenous goods must ultimately have the goods must ultimately have the same price on a marketsame price on a market

Demand for Y flour will cease and arbitrage activities will end when the exchange rate between the two countries is such that the price is the same for both countries.

i.e. 1 kilo flour in X = $X2 = $Y3= 1 kilo flour in Y

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The law of one price and the PPP theoryThe law of one price and the PPP theory Consider our previous situation. What if the inflation rates in X & Y

would differ, exchange rate remaining constant. Say for e.g. 10% inflation in Y and 0 in X. The answer: 1 kilo of flour would cost $Y3.3 in Y but still $X2 in X. If

the exchange rate remained unchanged, Y citizens would get more flour for their money in X and arbitrage would be conducted in the other direction – Y would import flour now. This would continue until a new exchange rate came in that gave both X & Y equal PPP.

2$X = 3.3$Y 1$X = 1.65$Y, or 1$Y = 0.60$X. The X dollar has appreciated by 10% and the Y dollar has depreciated

by 10%. This is essentially the PPP theory.