Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and...

Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Chapter 10

Exchange Rates and Exchange Rate Systems

Copyright © 2011 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: Fixed, Flexible, or In-Between?

• 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 in every newspaper with a business section and on numerous websites

Exchange Rates and Currency Trading (cont.)

• The three most frequently traded currencies are:

- European Union’s euro

- Japanese yen

- British pound

• All three are flexible exchange rates, meaning they are not fixed over time



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


Figure 10.1 Dollar Exchange Rates for Commonly Traded Currencies, 1999–2008


Reasons for Holding Foreign Currencies

1. Trade and investment: traders (importers and exporters) and investors routinely transact in foreign currencies

2. Interest rate arbitrage: taking advantage of interest rate differentials between countries; arbitrageurs borrow 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

• There are 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; most important of four participants

– 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 risks stem 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


Exchange Rate Risk (cont.)

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

• Spot market: Buying and selling of foreign currencies in the present


Exchange Rate Risk (cont.)

• 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: The use of forward market by an interest rate arbitrageur against exchange rate risk


The Supply and Demand for Foreign Exchange

• 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 10.2 The Demand Curve for

Foreign Exchange


FIGURE 10.3 The Supply of Foreign Exchange


FIGURE 10.4 Supply and Demand in the Foreign Exchange Market


FIGURE 10.5 An Increase in Demand for

British Pounds


FIGURE 10.6 An Increase in the Supply of

British Pounds


TABLE 10.1 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 in the Medium Run and Short 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 in the Medium Run and Short Run (cont.)

• 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…



• 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



• 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 10.7 The Effects of an Increase in

Home’s Interest Rate

Table 10.2 Composition of Currency Trades, April 2007


Table 10.3 Currency Trading Centers



TABLE 10.4 Major Determinants of an

Appreciation or Depreciation


The 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 exchange rate 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); the Gold standard exchange rate system

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

• Purely fixed or floating systems today are rare

Fixed Exchange Rate Systems

• Gold standards are a form of fixed exchange rates. Under a pure gold standard, nations keep gold as their international reserve.

• 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; a modified Gold standard exchange rate system



FIGURE 10.8 Fixed Exchange Rates and

Changes in Demand


FIGURE 10.9 Selling Reserves of Pounds to

Counter a Weakening Dollar

Table 10.5 Monetary Unions



Fixed Exchange Rate System (cont.)

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

• As of 2009, 16 of 27 EU members use the euro• Researchers have begun to analyze other regions

to see if they are suitable areas for a single currency

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


Single Currency Areas (cont.)

• 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

Conditions for Adopting A Single Currency

• For common currency to be viable, countries must share:

– Synchronized business cycles

– A high degree of labor and capital mobility

– Regional policies to deal with economic imbalances

– An integration effort that goes beyond mere free trade


Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and...

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