1. Chapter 10
Exchange Rates and Exchange Rate Systems

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
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3. 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
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4. 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
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5. 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
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6. 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
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7. Figure 10.1 Dollar Exchange Rates for Commonly Traded Currencies, 1999–2008
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8. Reasons for Holding Foreign Currencies
Trade and investment: traders (importers and exporters) and investors routinely transact in foreign currencies
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
Speculation: buying and selling of currency in anticipation of changes in the currency’s exchange rate; speculators sell overvalued currencies and buy undervalued currencies
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9. 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
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10. 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
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11. 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
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12. 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
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13. 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
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14. FIGURE 10.2 The Demand Curve for Foreign Exchange
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15. FIGURE 10.3 The Supply of Foreign Exchange
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16. FIGURE 10.4 Supply and Demand in the Foreign Exchange Market
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17. FIGURE 10.5 An Increase in Demand for British Pounds
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18. FIGURE 10.6 An Increase in the Supply of British Pounds
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19. 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
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20. 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
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21. 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…
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22. Exchange Rates in the Medium Run and Short Run (cont.)
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
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23. Exchange Rates in the Medium Run and Short Run (cont.)
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
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24. FIGURE 10.7 The Effects of an Increase in Home’s Interest Rate
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25. Table 10.2 Composition of Currency Trades, April 2007
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26. Table 10.3 Currency Trading Centers
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27. TABLE 10.4 Major Determinants of an Appreciation or Depreciation
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28. 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)
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29. 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
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30. 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
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31. FIGURE 10.8 Fixed Exchange Rates and Changes in Demand
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32. FIGURE 10.9 Selling Reserves of Pounds to Counter a Weakening Dollar
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33. Table 10.5 Monetary Unions
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34. 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
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35. 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
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36. 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
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37. 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
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