Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and...

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 10

Exchange Rates and Exchange Rate Systems

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-2

Chapter Objectives

• Define exchange rate• Understand the relationship between domestic

and foreign exchange rates• Examine the many possible exchange rate

systems a country can adopt• Understand the interaction of an exchange rate

system, government policy, and the world economy


Introduction

• Economists tend to disagree on issues related to exchange rates and exchange rate systems more than on the issues examined thus far

• Countries have numerous choices among exchange rate systems on a continuum from fixed to completely flexible systems

• Each type of exchange rate system requires a different set of policies and responds differently to the pressures of the world economy


Exchange Rates and Currency Trading

• Exchange rate: the price of a currency stated in terms of another currency

– U.S. dollars per Mexican peso = 0.10 dollars

– Mexican pesos per U.S. dollar = 10 pesos

– Exchange rates are reported on a daily basis in the financial pages of major newspapers and in numerous Web sites


Exchange Rates and Currency Trading (cont.)

• Appreciation of a currency: the currency’s becoming more valuable (or able to buy more units of another currency)

• Depreciation of a currency: the currency’s becoming less valuable in relation to another currency


TABLE 10.1 Exchange Rates for Selected Countries, September 1, 2006


3 Reasons for Holding Foreign Currency

1. Trade and investment purposes

2. Interest rate arbitrage: taking advantage of interest rate differentials between countries; arbitrageurs buy money where interest rates are low and sell it where interest rates are high

3. Speculation: buying and selling of currency in anticipation of changes in the currency’s exchange rate; speculators sell overvalued currencies and buy undervalued currencies


Institutions

• Four main actors involved in foreign currency markets

– Retail customers: firms and individuals that hold foreign currency in order to trade, engage in arbitrage, or speculate

– Commercial banks: hold inventories of foreign currencies as part the services to customer

– Foreign exchange brokers: middlemen between buyers (banks) and sellers of foreign currency

– Central banks: a country’s bank of banks


Exchange Rate Risk

• Exchange rate risk stems from the fact that currencies are constantly changing in value

– Expected future payments in a foreign currency will likely be a different domestic currency amount from when the contract was signed

– Firms that do business in more than one country are thus subject to exchange rate risk


Two Ways to Deal with Exchange Rate Risk

• Forward exchange rate: the price of currency that will be delivered in the future; allows an exporter or importer to sign a currency contract that guarantees a set price for the foreign currency in either 30, 90, or 180 days into the future

• Forward market: market in which the buying and selling of currencies for future delivery takes place; important mechanism for exporters, importers, financial investors, and speculators


Dealing with Exchange Rate Risk

• Hedging: an interest rate arbitrageur’s insuring against exchange rate risk through buying a forward contract to sell foreign currency at the same time that the bonds or other financial assets owned by the arbitrageur mature

– Covered interest arbitrage: use of forward market by an interest rate arbitrageur against exchange rate risk


Foreign Exchange: Supply and Demand

• A currency’s value is determined by its supply and demand, regardless of which exchange rate system is adopted

– Under a flexible exchange rate system, an increase in the demand for the dollar will cause it to appreciate, while an increase in the supply of the dollar will cause it to depreciate

– Under a fixed exchange rate system, the central bank counteracts the demand and supply forces of the dollar, holding its value constant


FIGURE 10.1 The Demand Curve for Foreign Exchange


FIGURE 10.2 The Supply of Foreign Exchange


FIGURE 10.3 Supply and Demand in the Foreign Exchange Market


FIGURE 10.4 An Increase in Demand for British Pounds


FIGURE 10.5 An Increase in the Supply of British Pounds


TABLE 10.2 A Hypothetical Example of the Exchange Rate in the Long Run

• Purchasing power parity: the equilibrium value of an exchange rate is at the level that allows a given amount of money to buy the same quantity of goods abroad as it will buy at home


Exchange Rates: Medium Run

• Medium run forces affecting exchange rate

– The country’s economic growth: produces an increase in imports and an outward shift in the demand for foreign currency

– Growth abroad: results in an increase of exports from the home country and an increase in the supply of foreign currency


Exchange Rates: Short Run

• Short run (a year or less) effects on the exchange rate stem from financial capital flows

• These flows are determined by (1) interest rates and (2) expectations of future exchange rates

• Let’s analyze these forces more closely…


Short-Run Forces 1: Interest Rates

• Interest parity: the difference between any two countries’ interest rates is equal to the expected change in the exchange rate

– If i = i*, investors are indifferent

– If i > i*, investors prefer home to foreign


Short-Run Forces 2: Expectations of Future Rates

• The difference between forward exchange rate and spot rate reflects the expected appreciation or depreciation of the home currency

– F > R: home currency expected to depreciate, and home interest rates must exceed foreign rates by an equivalent percentage

– However, say, i < i* and F = R: no changes are expected in the exchange rate, and investors should invest in foreign


FIGURE 10.6 The Effects of an Increase in Home’s Interest Rate


TABLE 10.5 Major Determinants of an Appreciation or Depreciation


Real Exchange Rate

• Foreign prices ultimately determine the purchasing power of the domestic currency in terms of the foreign currency

– Real exchange rate: the market exchange rate (nominal exchange rate) adjusted for price differences between countries

– Real exchange rate = [(nominal exchange rate) (foreign prices)] / (domestic prices) = Rr = Rn(P*/ P)


Alternatives to Flexible Exchange Rates

• Fixed system: the value of a nation’s money is defined in terms of a fixed amount of a commodity (e.g., gold) or of another currency (e.g., U.S. dollar)

• Flexible (floating) system: the value of the currency is allowed to float up and down with market forces

• Bretton Woods exchange rate system: a type of gold standard in 1947–1971: U.S. dollar and British Pound were fixed to each other and to gold

• Purely fixed or floating systems are today rare


FIGURE 10.7 Fixed Exchange Rates and Changes in Demand


FIGURE 10.8 Selling Reserves of Pounds to Counter a Weakening Dollar


Pegged System

• Pegged exchange rate system: one currency is anchored to another currency instead of gold

• Crawling peg: fixed (pegged) exchange rates that are periodically adjusted– Allows for dealing with real depreciations or

appreciations better than a pegged system


Single Currency Areas

• In 1999, 11 of 15 European Union (EU) members adopted a common currency, the euro, which began circulating in 2002

• 4 reasons for countries to adopt common currency– Reduces currency conversions and transaction costs

– Eliminates of price fluctuations

– Increases in inter-state political trust

– Provides exchange rate greater credibility


Single Currency Areas (cont.)

• Optimal currency area: Robert Mundell’s criteria to determine whether two or more countries would be better off by sharing a currency

• For common currency to be viable, countries must share– synchronized business cycles– high degree of labor and capital mobility– regional policies to deal with economic imbalances– an integration effort that goes beyond mere free trade


TABLE 10.3 Composition of World Currency Trades, April 2004


TABLE 10.4 Currency Trading Centers


TABLE 10.6 Inflation in Argentina, 1985-1994

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and...

Documents

Transcript of Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and...