Introduction to Exchange Rates

(part 3)

Introduction to Exchange Rates:

3.) Change in Equilibrium – Appreciate vs Depreciate

1.) Classical Dichotomy - Nominal vs. Real

2.) Equilibrium - LoOP vs. PPP

4.) Change in Equilibrium – Reasons

5) Foreign Exchange regimes 制度

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

2.) Fixed Exchange Rates:

3.) Managed Exchange Rate:

Dirty Floating

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

- Price determined only by demand and supply of the currency.2.) Fixed Exchange Rates:

3.) Managed Exchange Rate:

Dirty Floating

These exchange rates float against each other.

These exchange rates float less against each other, one of them is more managed

This is NOT an example of floating rates against each

other

At first this one wasn’t floating, then it crashed,

and later it floats.

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

- Price determined only by demand and supply of the currency.

Reasons for it: Reasons against it:Vs.

- Not necessary for government control of foreign money to hold the prices stable.

Less need for currency reserves

One of these has to hold a lot of reserve currency to

maintain the rate.

This government ran out of money and couldn’t control the

rate any more and crashed.

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

- Price determined only by demand and supply of the currency.

Reasons for it: Reasons against it:Vs.

Less need for currency reserves

Semi-automatic correction for a trade deficit

- A current account deficit puts downward pressure on the exchange rate, increasing exports and decreasing imports.

If country A is experiencing bad economic times (recession) how could that lead to appreciation of it’s currency?

Appreciation in country's FOREX

Country hasEcon bad times

Country’s supply of currency

How could appreciation effect an economy?

Appreciation in country's' FOREX

Demand exports

Demand imports

*** It depends on which effect is higher and what caused the bad times

4.) Change in Equilibrium – Reasons

Due to “LoOP” a floating exchange will

“balance” itself.

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

- Price determined only by demand and supply of the currency.

Reasons for it: Reasons against it:Vs.

Less need for currency reserves

Semi-automatic correction for a trade deficit

Freedom (autonomy自治权)

for domestic monetary policy

- Freedom of government to use the money supply to adjust the macro economy.

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

- Price determined only by demand and supply of the currency.

Reasons for it: Reasons against it:Vs.

- Added risk of value changes in money makes profits hard to estimate.

Uncertainty discourages trade

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

- Price determined only by demand and supply of the currency.

Reasons for it: Reasons against it:Vs.

Uncertainty discourages trade

Inflation - Inflation sucks. Can mean imported material prices are higher.

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

- Price determined only by demand and supply of the currency.

Reasons for it: Reasons against it:Vs.

Uncertainty discourages trade

Inflation

Freedom (autonomy自治权)

for domestic monetary policy

- Freedom also means governments can get out of control and not be disciplined.

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

- Price determined only by demand and supply of the currency.

Reasons for it: Reasons against it:Vs.

- Less need for currency reserves

- Semi-automatic correction for a trade deficit

- Freedom (autonomy自治权) for domestic monetary policy

- Uncertainty discourages trade

- Inflation

- Freedom (autonomy自治权) for domestic monetary policy

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

2.) Fixed Exchange Rates:

3.) Managed Exchange Rate:

Dirty Floating

- The value of a currency fixed in relation to an anchor 锚的currency – not allowed to

fluctuate波动

China’s RMB is “pegged” to the US

dollar.

2.) Fixed Exchange Rates:

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

- The value of a currency fixed in relation to an anchor 锚的currency – not allowed to fluctuate波动

- Less risk promotes more trade, and less fear of swings in value destroying profit.

Stability

You know the future value so you can make long term contracts and not worry

about losing profit in a “volatile” floating exchange.

2.) Fixed Exchange Rates:

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

- The value of a currency fixed in relation to an anchor 锚的currency – not allowed to fluctuate波动

Stability

Disciplines on domestic producers

- Keep costs and prices down and may encourage attempts to raise productivity and focus on research and innovation. Can be certain of profits so can be freed up to use money in the best way with lowest opportunity costs.

2.) Fixed Exchange Rates:

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

- The value of a currency fixed in relation to an anchor 锚的currency – not allowed to fluctuate波动

- Can be very hard to do and if done wrong can destroy an economy. (South East Asia currency crisis of 1996 )

Need to hold a lot of foreign currency

{

This government ran out of money and couldn’t control the

rate any more and crashed.

2.) Fixed Exchange Rates:

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

- The value of a currency fixed in relation to an anchor 锚的currency – not allowed to fluctuate波动

Need to hold a lot of foreign currency

Inflation - Inflation sucks, very hard to control inflation and own monetary policy at the same at the same time as controlling the exchange rate.

2.) Fixed Exchange Rates:

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

- The value of a currency fixed in relation to an anchor 锚的currency – not allowed to fluctuate波动

- Stability

- Disciplines on domestic producers

- Need to hold a lot of foreign currency

- Inflation

1.) Floating Exchange Rates:

5.) Foreign Exchange regimes 制度

2.) Fixed Exchange Rates:

3.) Managed Exchange Rate:

Dirty Floating

- Rate influenced by government via central bank around a preferred rate. Tied to a basket of currencies.

2.) Managed Exchange Rates:

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

- Rate influenced by government via central bank around a preferred rate. Tied to a basket of currencies.

- All the reasons for a fixed rate apply but allows for a little bit of floating to take advantage of some of the benefits of a floating exchange.

Stable, but some flexibility permitted

Similar to fixed…

2.) Managed Exchange Rates:

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

- Rate influenced by government via central bank around a preferred rate. Tied to a basket of currencies.

Stable, but some flexibility permitted

Disciplines on domestic producers

- Keep costs and prices down and may encourage attempts to raise productivity and focus on research and innovation. Can be certain of profits so can be freed up to use money in the best way with lowest opportunity costs.

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

2.) Managed Exchange Rates: - Rate influenced by government via central bank around a preferred rate. Tied to a basket of currencies.

- Can be very hard to do and if done wrong can destroy an economy.

Need to hold a lot of foreign currency

Also similar to fixed…

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

Need to hold a lot of foreign currency

Inflation - Inflation sucks, very hard to control inflation and own monetary policy at the same at the same time as controlling the exchange rate.

2.) Managed Exchange Rates: - Rate influenced by government via central bank around a preferred rate. Tied to a basket of currencies.

5.) Foreign Exchange regimes 制度

Reasons for it: Reasons against it:Vs.

- Stability, but some flexibility permitted

- Disciplines on domestic producers

- Need to hold a lot of foreign currency

- Inflation

2.) Managed Exchange Rates: - Rate influenced by government via central bank around a preferred rate. Tied to a basket of currencies.

Graph me…The three again with graphs on them to see

So to summarize…

P

Q

S

D

This graph determines what the exchange rate is!

1.) Floating Exchange Rates:

P

Q

S

D

There really is no graph!!!

The exchange rate is just whatever the government says it is

2.) Fixed Exchange Rates:

P

Q

S

D

It is allowed to “float” but the government tries to make it stay between the dotted lines

Not too high,Not too low

3.) Managed Exchange Rates:

The End

Thank You!