The Federal Reserve and Exchange Rates Personal Finance 1

Gold Standard 1876 – 1913 Values of currency set against precious metals  Each country set own conversion rate  Must maintain adequate reserves (Fort Knox) for redemption 2

Gold Standard Gold standard implied fixed XR Limited growth of money supply for any country  Need enough gold WWI limited free movement of gold 3

1920s and 1930s Some countries reverted to gold standard Some abandoned Some pegged to dollar or pound Period of instability  International trade declined 4

Bretton Woods Agreement International agreement in 1944 Fixed exchange rates  All currencies pegged to dollar  Dollar set at $35/ounce of gold  Intervention to prevent fluctuation of > 1% Lasted until

Floating Exchange Rates By 1971, dollar had depreciated Concerns about U.S. ability to convert dollars to gold March 1973  U.S. allows dollar to float  Other major currencies float as well 6

Countries with Floating XRs 7

Countries with Pegged XRs 8

Floating Exchange Rates Determined by supply and demand Factors affecting demand  Demand for nation’s product  Demand for nation’s stocks and bonds  Inflation expectations  Government stability 9

Floating Exchange Rates Supply is determined by monetary policy of central bank U.S. central bank is the Federal Reserve Too much supply – inflation Not enough supply - recession 10

Federal Reserve U.S. Central Bank  Established in 1913  12 federal reserve banks 11

Federal Reserve Board of Governors Seven members Appointed by President and confirmed by congress 14-year term Chairman’s term is four years 12

Federal Reserve FOMC  Chief policymaking committee All 7 governors President of NY fed bank Four other fed presidents – All fed presidents attend meetings  All votes are equal Chairman has much influence 13

Federal Reserve FOMC determines monetary policy  Supply of money Purchase or sell fixed income assets Influences short-term rates Impacts XR 14

Federal Reserve Mission  Maximum employment  Stable prices  Moderate long-term interest rates Goals may conflict  XR is not explicit goal 15

Foreign Exchange Market Spans the globe Operates 24 hours/day Major exchanges  Singapore, Hong Kong, Tokyo, Bahrain, London, New York, San Francisco, Sydney 16

Foreign Exchange Market 17 Tokyo opens Asia closing 10 AM In Tokyo Afternoon in America London closing 6 pm In NY Americas open Europe opening Lunch In Tokyo

Exchange Rates Spot Rate – the price of a currency in terms of another currency for trade today Forward Rate – The price of a currency in terms of another currency for a trade agreed upon today but to be executed at a specified date in the future (usually 30, 60,90, 180 or 360 days from today) 18

Exchange Rates Direct Quote – the number of dollars needed to buy one unit of the foreign currency. Dollar is in the numerator Indirect Quote – the number of units of a foreign currency needed to buy one dollar. Dollar is in the denominator Direct and Indirect Quotes are reciprocals of each other 19

Exchange Rates Which is a better deal – bananas being sold at 50 cents per pound, or two pounds of a dollar? 1.23 $/€ is the same as.813 €/$ Price of a dollar: €.813 Price of a euro: $1.23 Currency in the denominator is being priced 20

Exchange Rates Suppose you have $5.00 and want to convert to euros. You are both selling dollars and buying euros If XR is quoted at 1.23 $/€, do you multiply or divide? Suppose you have €30 and want dollars? 21

Exchange Rates There are always two exchange rates  The ask and the bid Ask > Bid The spread is the dealer’s profit The dealer buys at the bid and sells at the ask You are not the dealer, so you sell at the bid and buy at the ask 22

Exchange Rates Suppose you observe direct quotes of:  Ask:.0091 $/¥  Bid:.0090 $/¥ You have $150 you want to convert to yen. How many yen will you receive?  Which currency’s price is being quoted?  Are you buying or selling that currency?  Do you buy or sell at the bid, or the ask? 23

Exchange Rates – Cross Rates DollarEuroPoundSFrancPesoYenCdnDlr Canada Japan Mexico Switzerland U.K Euro U.S

Is the Dollar Rising or Falling? The dollar can only rise or fall in relation to another currency If the dollar increases in value (vs that currency), that other currency must be decreasing in value (vs the dollar) It is certainly possible for the dollar to rise in value vs one currency but fall in value vs a different currency 25

Is the Dollar Rising or Falling? Example: Yesterday, one euro was worth $1.12 Today, one euro is worth $1.10 Since a euro will buy fewer dollars, the euro dropped in value Since it takes fewer dollars to buy a euro, the dollar increased in value 26

Is the Dollar Rising or Falling? A strong dollar is good for importers because they can buy more foreign-made product with a dollar A weak dollar is good for exporters because their customers can buy more U.S.-made goods with their foreign currency 27

Is the Dollar Rising or Falling? A strong dollar is good for you if you plan to travel overseas because your dollar will buy more A weak dollar is good for U.S. businesses who cater to foreign travelers who come to the U.S. because their customers can purchase more 28