1 Exchange Rates References “Economics” Sloman, J – chapters 14, 22 “International Business” Hill, C W (6th edit., 2007), Chapter 10 “International Business”, Ball, D et. al. (11th edit.), Chapter 11

2 Exchange Rates Can be thought of as the price of one currency in terms of another i.e. $1.5/£1- from the UK perspective In a free floating system it is determined by the demand and supply of the currency on the Forex (foreign exchange market) The market will correct for any surpluses or deficits in the currency by either lowering the exchange rate or by increasing it

The Demand and Supply of a Currency Where does the demand and supply for a currency originate? As well as the obvious case of tourists travelling abroad, consumers and businesses also need to exchange currency E.g. when buying foreign goods or when investing in foreign banks 3

Businesses will need to convert currency in a number of circumstances a)Receiving foreign currency in exchange for exports b)Income from foreign investments c)To pay for imports or raw materials from abroad d)To invest in foreign banks e)Currency speculation 4

5 $ price of £ QSQS S by UK Q of £ D by USA QDQD ba Q Determination of the Exchange Rate

6 In the example above (Sloman, J chapter 14) the exchange rate of £1 for $1.80 means that there is excess supply of pounds a – b In order to achieve equilibrium (very quickly in exchange markets) banks will be forced to lower the exchange rate In the example below the exchange rate is too low and there is excess demand c – d for the £ This time banks will raise the exchange rate in order to reduce demand and again achieve equilibrium

7 QSQS QDQD d $ price of £ S by UK Q of £ c D by USA Q Determination of the Exchange Rate

Shifts in the Demand and Supply for a Currency The position of the demand and supply curves for £s can be affected by a number of factors Under a free floating currency regime the exchange rate is allowed to appreciate (rise) or depreciate (fall) depending on changes in these factors a)Interest Rates When interest rates in the UK rise relative to other countries the exchange rate will appreciate 8

The demand for the £ rises as investors now want to put more of their money into UK banks – the demand curve shifts to the RIGHT At the same time the supply for the £ falls as UK investors are less likely to want to deposit their money in foreign banks The supply curve shifts to the LEFT The new equilibrium is at a higher exchange rate than the old 9

10 O Exchange rate Quantity of £s S2S2 D2D2 er 2 er 1 S1S1 Appreciation D1D1 An Appreciation in the Exchange Rate

b)Inflation Rates If inflation is rising faster in the UK than abroad UK goods are becoming relatively expensive Imports rise and exports fall (X – M) The supply of £s increases and the demand for £s falls leading to a depreciation in the exchange rate c)Investment Opportunities If these improve in the UK the £ will appreciate 11

d)Increasing AD (Aggregate Demand) This increase may be caused by an increase in consumption, investment or government spending This causes an increase in imports which initially causes a fall in the exchange rate e)Speculation Occurs where investors believe that the value of the currency is either over priced or under priced – this can be in any direction (bandwagon effect) 12

Exchange Rates and Business International businesses are constantly exposed to fluctuations in exchange rates – this represents a risk to profits 1)Transaction Exposure Obligations on the purchase of goods in the future – exchange rate fluctuations may raise or lower the cost Loans made in foreign currencies i.e. from foreign banks 13

2)Translational Exposure Affects the value ‘on paper’ – i.e. this would give a false picture of the value of an asset such as a foreign subsidiary This may impact on future borrowing 3)Economic Exposure The effects on competitiveness, costs and profits Volatility creates uncertainty for investors 14

Reducing Risk to Exchange Rate Fluctuations When we are talking about exchange rates this is generally referring to the ‘spot rate’ – i.e. on any one particular day Since exchange rates change continually this poses a risk to a firm’s profitability One way of reducing this risk is to buy currency on a ‘forward rate’ fixed for some point in the future e.g. 30 days, 90 days or 180 days 15

E.g. a US company imports computers from Japan for ¥80,000 each and then sells them on at a price of $800 each in the USA The spot exchange rate is ¥120/$1 so each computer costs $ and the company should make a profit of $ on each BUT there is a time delay in ordering the computers and paying for them of 30 days – in this time the US dollar depreciates to ¥96/$1 Each computer now costs $ and the firm loses money on each sale i.e. $

The US company could insure this risk by agreeing to use the forward exchange rate of ¥108/$1 meaning that the cost of each of the Japanese computers is approximately $740 each The US firm should still make a profit of $60 on each computer as long as home demand conditions remain the same The forward exchange rate is usually different to the spot rate as it will reflect market sentiment on future exchange rates 17

Another way of reducing risk is to establish production facilities or retail outlets within another country e.g. many Japanese firms set up factories in the US and Europe to avoid tariffs AND to lessen exchange rate costs – at the time the value of the Yen was rising against many other countries making Japanese exports expensive Other measures include holding currency reserves in foreign subsidiaries – which would reduce transaction costs 18

Flexible sourcing – i.e. set up in a number of countries and keep spare capacity so that production can be increased or reduced in line with exchange rate variations Use forecasting to predict movements in exchange rates – i.e. by following movements in forward exchange rates or by setting up a forecasting unit Keep track of foreign currency exposure on paper – i.e. as part of financial reporting so as to hedge against risk 19

Fixed Exchange Rates Under a fixed exchange rate system the government intervenes in the currency markets to maintain an agreed rate between countries E.g. in 1990 the UK fixed the £ against the German DM at DM 2.95/£1 The UK was forced to leave the ERM in 1992 after speculation on a fall in the £ against the DM became to intense to maintain 20

UK Exchange Rate Systems : Fixed Exchange Rates Occasional devaluations against dollar (1948 and 1967) : Managed Floating : Shadowing the DM : Managed Floating (run up to ERM entry) : Semi-Fixed Exchange Rates 1992-present : Floating Exchange Rate 21

22 Correction under a Fixed Rate Regime Under a fixed exchange rate mechanism the government may be forced to intervene in the currency markets This occurs where then demand and supply for domestic currency are not equal at the FIXED rate For example – if there is a currency flow deficit the Bank of England will be forced to buy pounds by drawing on its foreign currency reserves

23 E.g. if UK interests rates are relatively high compared to other countries – money flows in from abroad to take advantage of the higher interest rates – the demand for £’s increases and shifts to the RIGHT At the same time UK residents are less likely to part with their £’s and supply shifts to the LEFT leading to a higher exchange rate In a floating regime this simply results in an appreciation of the exchange rate BUT in a FIXED regime the Bank is forced to intervene

24 Effects of a Correction under a Fixed Rate System One important effect in this case is on the money supply – if the Bank of England is forced to buy back pounds then the money supply will be affected The money supply will fall reducing aggregate demand and potentially leading to a lower level of national output If the government does not want the money supply to be affected in this way it must use open market operations or lower the reserve ratio to prevent this

25 Alternative Exchange Rate Regimes In practice most exchange rate systems have elements of both fixed and floating regimes Systems include : - –Adjustable peg –Dirty floating –Crawling peg –Joint float –Exchange rate band

26 Adjustable peg – exchange rates are fixed for a period of time (usually years) and central banks play the same role as they would in a totally fixed rate system E.g. if a current account deficit persists the central bank would be forced to pursue deflationary policies to shift demand and supply for the currency back towards the fixed rate Long term deficits or surpluses may then require revaluation or devaluation of the currency i.e. a change (or adjustment to the ‘peg’) in the fixed rate

27 Dirty floating is closer to free floating but the central bank may intervene in the currency market when required The central point here is that the central bank will allow adjustment but will try to avoid excessive volatility in the exchange rate This may include interest changes as well as buying/selling foreign reserves The crawling peg system operates in a similar manner but smaller adjustments are made more frequently e.g. once a month

28 A joint float occurs when a number of countries fix their currencies amongst themselves but float against other currencies E.g. the ERM (or Exchange Rate Mechanism) began in 1979 but the UK only joined in 1990 Exchange rate band – the government must intervene only when the currency fluctuates beyond the boundaries set i.e. above the ‘ceiling’ or below the ‘floor’

29 Exchange Rate Band Ceiling Floor parity Price of £s Time If the exchange rate rises to the ‘ceiling’ the UK government sells £s for $’s or may lowers interest rates and if the exchange rate falls to the ‘floor’ the government buys £’s for $’s with dollar reserves and gold reserves or may increase interest rates $1.75 $2.00 $1.50

30 Advantages/Disadvantages of Fixed/Floating Exchange Rates Advantages of fixed exchange rates –Certainty (for exports and imports) –less speculation (but devaluations?) –prevents 'irresponsible' government policies Disadvantages of fixed exchange rates –conflicts with other macro objectives –monetary policy is less effective –danger of competitive deflations –problems of international liquidity –difficulties in adjusting to shocks –speculation on how ‘fixed’ a rate actually is e.g. UK in the ERM 1992

31 Advantages of free-floating rates –automatic correction –no problem of international liquidity –insulation from external events –less constraint on domestic macro policy Disadvantages of free-floating rates –possibly unstable exchange rates –speculation –uncertainty for business offset by use of forward markets –lack of discipline on economy may lead to inflation