EXCHANGE RATES Chapter 8 Lecture 2

EXCHANGE RATES Defined as the number of units of one currency that have to be paid to acquire a unit of another currency There are different markets for currency –SPOT RATE –FORWARD RATE Most currency transactions are conducted by commercial banks, and the rest by foreign- exchange brokers

THE INTERNATIONAL MONETARY SYSTEM Efforts to provide economic stability to Allies led to Bretton Woods agreement to fix exchange rates based on gold and the U.S. dollar –Member currencies were denominated in gold and U.S. dollars (because of the dollar’s strength in the 1940s and 1950s) but the U.S. had 70% of gold reserves by 1947 and governments bought and sold dollars rather than gold assuming the U.S. government would pay gold for dollars.

Signators to International Monetary Fund in 1945 agreed to promote exchange stability, maintain orderly exchange relationships, provide a multilateral system of payments, create standby reserves Fixed exchange rates were altered in 1971 because: –The U.S. trade surplus began to shrink –U.S. dollar was devalued –It was no longer desirable to peg the world economy on the dollar

Three Exchange-Rate Approaches Pegged Rates –Exchange rate is fixed to one or several other currencies (according to a market basket of goods) Limited Flexibility –Flexibility is limited to 2.25% around the US dollar –Cooperative arrangements in EU More Flexible –Can freely float –Float on the basis of a set of indicators

WHAT AFFECTS EXCHANGE RATES? Government stability National or international “mood” or attitude toward the country Technical factors, e.g., economic statistics, seasonal demands Inflation In a freely floating system, the market decides

LOOK AT THE EFFECT OF INTERNAL INFLATION What is inflation? When overall demand grows faster than overall supply, the cost of a good is pushed up (but the value of the good is unchanged) If inflation cannot be stopped, then an inflationary spiral can occur where: –prices of goods rise –so you demand an increase in earnings to keep up –and the price of goods rises to cover the wages organizations have to pay

INFLATION AFFECTS EXCHANGE RATES This is the concept of Purchasing Power Parity: –A change in inflation has to affect exchange rates to keep prices in the two countries roughly equal.

PPP EXAMPLE – Two countries have an equal exchange of $1 to $1 –One economy experiences a 10% inflation rate; the other experiences a 5% inflation rate –Comparing dollar to dollar, the first dollar is worth 5% less than the second –So, you will only buy goods from the first country only if your dollar is 5% stronger –Hence, the new exchange rate is $1.05 of their money for $1 of your money

THE HAMBURGER INDEX U.S. Equivalent% over/under Norway France Japan U.S.2.19— U.K Hong Kong Hungary Based on 1988 data.

THE PPP EQUATION e=exchange rate i=rate of inflation h=home country f=foreign country o=the base period t=the end of a period

TO PRACTICE HOW EXCHANGE RATES OPERATE The Big Mac Index: 1995–8