1. The Foreign Exchange Market

2. Currency variability  Currencies vary widely in value over time.  The US dollar has shown weakness from time to time, but has so far maintained its position as the world reserve currency.  The dependence of countries on export-driven growth policies help the US dollar.  Investment into the US both supports the dollar and attests to world confidence in its future growth

3. The Exchange Rate  The exchange rate is the price of one currency in terms of another currency.  Example : US/€ measures how many US $ it takes to buy one Euro.  The value of the exchange rate may be fixed (like any fixed price), but in many countries it is determined by the demand and supply of currency

4. The market  “The worldwide network of markets and institutions that handle the exchange of foreign currencies is known as the foreign exchange market.  There are two main components to the market. –the spot market is where current transactions for immediate delivery of currency take place –the forward and futures markets are where transactions for future delivery of currency take place.

5. The Basic Foreign Exchange Market  Like any market, there is a demand side and a supply side to foreign exchange

6. Demand for Foreign Currency (3 types) 1. Demand for goods, services or immediate purchases, gifts –goods and services from another country –demand for currency to send a gift to another country –demand for currency to pay foreign factors pay investors pay international workers

7. Demand for Foreign Currency (foreign exchange) 2. Demand for financial assets –buy stocks from another country –buy bonds from another country –open a bank account in another country –buy a business in another country

8. Demand for Foreign Exchange (3 types) 3. Hedging and speculation –If you need to pay a foreign seller in the near future, you may buy foreign currency now if you are worried that its value will rise by the time the payment is due. (hedging) –If you want to make a profit off the change in value, you may buy the currency today to sell the currency tomorrow at a higher value (speculation)

9. The Demand for Foreign currency  The sum of the three demands constitute the demand for foreign currency  These demands correspond to debit items in the balance of payments

10. The Supply of Foreign currency  The sum of the three demands constitute the demand for foreign currency  These demands correspond to debit items in the balance of payments

11. Supply of Foreign Currency (3 types) 1. Sale of goods, services or immediate purchases, gifts –goods and services from OUR country –demand for OUR currency to send a gift to OUR country –supply of currency when foreign companies need to pay domestic factors pay investors pay workers working abroad

12. Supply of Foreign Currency (foreign exchange) 2. Purchases of OUR financial assets People from other countries –buy stocks from OUR country –buy bonds from OUR country –open a bank account in OUR country –buy a business in OUR country

13. Supply of Foreign Exchange 3. Hedging and speculation –If a foreign seller needs to pay in Canadian dollars in the near future, they may buy OUR currency now (selling theirs) if they are worried that its value will rise by the time the payment is due. (hedging) –If speculators want to make a profit off the change in value, they may buy OUR currency today (selling foreign currency) to sell OUR currency tomorrow at a higher value (speculation)

14. The market for Foreign Exchange  The foreign currency market defines demand an supply of a foreign currency.  Therefore, when the demand for foreign currency increases, the price of foreign currency rises, this means the value of our currency falls! The following slide shows the demand and supply of foreign currency

15. The Basic Foreign Exchange Market e $/€ S€S€ S’ € D€D€ D’ € Euros (€)Q eq e eq

16. Movement in the market  An increase in demand for the foreign currency results in a rightward shift of the demand curve.  It now takes more domestic currency to buy the foreign currency.  Therefore, when e rises, the value of the foreign currency rises and the value of OUR currency falls. We call this an appreciation of the foreign currency or a depreciation of OUR currency in relation to the foreign currency

17. The Basic Foreign Exchange Market e $/€ S€S€ D€D€ D’ € Euros (€)Q eq Q’ e eq e’

18. Increase in supply of foreign currency  When foreign currency supply increases, the supply curve shifts right  the price of the foreign currency falls This means the value of our own currency rises, (our currency appreciates and the foreign currency depreciates)

19. The Basic Foreign Exchange Market e $/€ S€S€ S’ € D€D€ Euros (€)Q”Q eq e eq e”

20. Demand and supply and the current account  The demand and supply of foreign exchange can be broken into 2 components –Goods & services (current account) –financial transactions These sum to total demand and supply  The equilibrium exchange rate is determined by the total demand and supply

21. Demand and supply and the current account  In the following slide, the equilibrium exchange rate is lower than the rate needed for a current account balance (our exchange rate would be more valuable than would be the case if there were only current account transactions)  Therefore, there is a current account deficit (shown as Q 2 – Q 1 )  this deficit is also the surplus in financial transactions. (Q eq -Q 1 ) – (Q eq -Q 2 )=Q 2 -Q 1

22. Demand and supply and the current account e S G&S S Total D Total Foreign Ex Q2Q2 Q eq e eq D G&S Q1Q1

23. Concept checks  The market for international currency is called the…

24. Concept checks  The market for current transactions of foreign exchange to be delivered immediately is called..…

25. Concept checks  The two markets for future transactions in foreign exchange are called…

26. Concept checks  The three sources of demand for foreign exchange are…

27. Concept checks  An increase in demand for foreign currency results in __________ of our currency and ___________________ of the foreign currency

28. Concept checks  If the foreign exchange rate is too high for our current account transaction, this means we will have a current account __________ (surplus/deficit) and a capital account ______________ (surplus/deficit)

29. Meaning of Exchange Rate and Measuring Changes in Exchange Rates  Value of one currency in units of another currency  A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation.  If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated  If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

30. Appreciation/Depreciation  Percentage change in value US $ New Value of Foreign Currency per unit of $- Old value of foreign currency per $ -------------------------------------------------- X 100 Old value of Foreign Currency per $  Percentage change in value of Foreign Currency New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency -------------------------------------------------- X 100 Old value of $ per unit of Foreign Currency

31. Exchange Rate Equilibrium  Forces of Demand and Supply  Demand for foreign currency negatively related to the price of foreign currency  Supply of foreign currency positively related to the price of foreign currency  Forces of demand and supply together determine the exchange rate

32. Demand for Foreign Currency Price for Foreign Currency Units of Foreign Currency (£) $1.50 $2.00 D D 50m 75 m

33. Supply of Foreign Currency Supply for Foreign Currency Units of Foreign Currency (£) $1.50 $2.00 50 m75 m S S

34. Equilibrium Exchange Rate Exchange Rate Units of Foreign Currency(£) S S D D $1.6775

35. Factors that influence the Exchange Rate  Expectations of the Market  Political Events  Relative Inflation Rates  Relative Interest Rates  Relative Income Levels Exchange rate is the results of an interaction of these factors

36. Market Expectations  Expectations about future exchange rate changes on the basis of current and future political and economic conditions  1960s Strong $  Between 1960s and 1970s: weak $  Strong $ in 1999 – 2001  Weak Dollar today 2005  1995 European Exchange Rate Mechanism  Devaluation of Asian Currencies

37. Political Events  Fall of Berlin Wall and unification of East and West Germany  Rumors about resignation of Mikhail Gorbachov  Tiannanmon Square  Persian Gulf War  September 11, 2001

38. Relative Inflation  High inflation relative to a foreign country, decline in value of currency—Why?  Low inflation relative to a foreign country, increase in value of currency—Why?

39. Relative Interest Rates  High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?

40. Relative Income Levels  Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?

41. Exchange Rate Determination  An interaction of factors  Is it possible for a country with high real returns to have a low currency value?  Is it possible for a country with low real returns to have a high currency value?

42. Definitions of Exchange Rates  Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. –How much can be exchanged for one dollar? ¥102/$1 –How much can be exchanged for one yen? $0.0098/¥1 Exchange rate allow us to denominate the cost or price of a good or service in a common currency. –How much does a Honda cost? ¥3,000,000 –Or, ¥3,000,000 x $0.0098/¥1 = $29,400

43. Depreciation and Appreciation  Depreciation is a decrease in the value of a currency relative to another currency. –A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency. –$1/€1 ! $1.20/€1 means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable. –The euro has appreciated relative to the dollar: it is now more valuable.

44. Depreciation and Appreciation (cont.)  Appreciation is an increase in the value of a currency relative to another currency. –An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency. –$1/€1 ! $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable. –The euro has depreciated relative to the dollar: it is now less valuable.

45. Depreciation and Appreciation (cont.)  A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency. –How much does a Honda cost? ¥3,000,000 –¥3,000,000 x $0.0098/¥1 = $29,400 –¥3,000,000 x $0.0100/¥1 = $30,000  A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive.  A depreciated currency lowers the price of exports relative to the price of imports.

46. Depreciation and Appreciation (cont.)  An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency. –How much does a Honda cost? ¥3,000,000 –¥3,000,000 x $0.0098/¥1 = $29,400 –¥3,000,000 x $0.0090/¥1 = $27,000  An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive.  An appreciated currency raises the price of exports relative to the price of imports.

47. The Effects of Changes in Exchange Rates  How do changes in exchange rates affect a country's net exports since currency appreciations or depreciations change international relative prices? (Remember: the basic role of an exchange rate is to convert one country’s prices into another country’s currency.)

48. Exchange Rates and Home Currency Prices 30,000 Yen TV Set$1,000 US Home PC Exchange Rate Price in Japan Price in The US Price in The US Price in Japan $1 = 120 yen $/Y=.0083 30,000 Y$250$1,000 120,000 Y $1 = 100 yen $/Y=.01 30,000 Y$300$1,000 100,000 Y

49.  From the American consumer’s viewpoint, a television set that costs 30,000 yen in Japan goes up in price from $250 (that is, 30,000/120) to $300 (that is, 30,000/100).  To Americans, it is just as if Japanese manufacturers had raised TV prices by 20 percent.  The Dollar price of the yen went from $0.0083 to $0.01 – an appreciation of the yen.

50.  What about the implications for Japanese consumers interested in buying American personal computers that cost $1,000?  When the dollar falls from 120 yen to 100 yen, they see the price of these computers falling from 120,000 yen to 100,000 yen.  To them it is just as if American producers had offered a 16.7 percent drop in the price of PCs.

51.  A currency depreciation should raise net exports and increase aggregate demand.  A currency appreciation should reduce net exports and therefore decrease aggregate demand.  In this case the U.S. dollar has depreciated. Thus, U.S. exports should rise.

52. AS 1 AD 1 Depreciation Q1 P1 P GDP A AD 2 B

53. AS 1 AD 1 Appreciation Q1 P1 P GDP A AD 2

54. Conclusions to date:   currency depreciations increase AD.   currency appreciations decrease AD.

55. Evaluation of exchange rate systems

56. Fixed Exchange Rates: Advantages 1. Favour business investments No uncertainty → easy to plan future investments No exch rate movements that alter relative prices 2. Favour international trade by making it possible to accurately compare prices among countries. 3. No room for speculation → more currency stability. Exception: when people believe that a country may devalue or revalue its currency.

57. 4. Firms and gov more disciplined to keep inflation under control: a.Firms: keep costs down so that domestic goods do not lose competitiveness b.Government: if allows inflation to increase: ↓X and ↑M → AD↓ → possible recession and UE and BoP deficit

58. 1. Possibility of insufficient reserves to maintain the fixed exchange rate. 2. Difficult to handle external shocks (eg ↑oil price → deficit ). If reserves to correct deficit are not readily available, country must resort to protectionist measures, contractionary policies or exchange controls, with negative effects. a.Policies to correct deficits conflict with domestic priorities and can cause a recession. Contractionary policy → ↓AD → ↓Y (↑UE) → ↓M Fixed Exchange Rates: Disadvantages

59. b.Increased protectionism reduces world trade and worsens global allocation of resources. c.Exchange controls worsen global allocation of resources. The control by the gov of currency transactions: a.Distorts trade patterns b.Restricts consumer choice c.Causes development of black market for foreign exchange 3. Speculation. If devaluation is anticipated (because of a large and persistent deficit), speculators may sell the currency, which worsens deficit and forces devaluation.

60. Floating Exchange Rates  Floating exchange rate: exchange rate between two currencies can move in price each day –Value of currencies is determined by supply and demand in marketplace.

61. Floating Exchange Rates  Under the floating exchange rate regime, international businesses must account for currency translation risk. –Currency translation risk: risk that value of foreign currency changes in a way which makes business less profitable, absent an exchange rate “devaluation”

62. Floating Exchange Rates  Exchange rate of a particular currency with U.S. dollar is either: 1.How many dollars it takes to buy one unit of foreign currency 2.How many units of foreign currency it takes to buy one dollar  Cross rate (American perspective): exchange rate between two foreign currencies because it can be calculated by multiplying their rates relative to the U.S. dollar

63. Floating exchange rates: Advantages 1. Automatic adjustment. Correction of deficits and surpluses in an automatic way. 2. No need to hold official reserves to intervene in foreign exchange markets. 3. No conflict between BoP objectives and domestic objectives. 4. Easy adjustment to external schocks. If oil price ↑ → value of currency↓, eliminating the deficit.

64. 1. Speculation can be destabilizing: when currency is expected to depreciate, it does it further than otherwise. 2. Excessive exchange rate volatility. Large and abrupt changes cause problems for countries depending on X → risk of financial crises (MX, Thailand, Russia) → intervention by IMF. 3. Exchange rate fluctuations cause uncertainty for traders and investors → inability to plan for the future → negative effects on trade and investment flows. Floating exchange rates: Disadvantages

65. Managed Float: the supporters’view 1. Allows countries some flexibility in carrying out domestic policies. 2. Allows economies to adjust more easily to shocks. 3. Offers governments the opportunity to prevent sudden and large exch. rate fluctuations. 4. Makes currency speculation more difficult as speculators ignore if and when a CB will intervene.

66. 1. Cannot do enough to prevent large fluctuations, which especially damage countries dependent on X. 2. Not successful in eliminating large trade imbalances (US case) 3. Offers opportunity to cheat by undervaluing the currency and gaining unfair comparative advantage. Managed Float: the critics’view

67. Changes in exchange rates

68. Different types of ER.  Spot Exchange Rate  Forward Exchange Rate  Bi-lateral Exchange Rate  Effective Exchange Rate Index (EER)  Real Exchange Rate What do you think these mean?

69. Different types of ER.  Spot Exchange Rate - the spot rate is the actual exchange rate for a currency at current market prices. This is determined by the FOREX market on a minute-by-minute basis on the basis of the flow of supply and demand for any one particular currency.  Forward Exchange Rate - a forward rate involves the delivery of currency at some time in the future at an agreed rate. Companies wanting to reduce the risk of exchange rate uncertainty by buying their currency ‘forward’ on the market often use this.  Bi-lateral Exchange Rate - this is simply the rate at which one currency can be traded against another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro  Effective Exchange Rate Index (EER) - the EER is a weighted index of sterling's value against a basket of international currencies the weights used is determined by the proportion of trade between the UK and each country.  Real Exchange Rate - this measure is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country.

70. Different types of Exchange rate systems… –Fully Fixed ….  –Semi Fixed (peg) –Managed (dirty floating) –Free Floating….  ….  need to know

71. Fixed Exchange Rate

72. Fully-fixed Exchange Rates  Central target for the exchange rate (currency peg)  No fluctuations permitted  Occasional revaluation or devaluation when economic fundamentals demand one  Central Bank intervention to maintain the currency

73. J curve effect…

74. The J curve Devaluation at ‘A’ initially pulls the BoP into further deficit (inelasticity of S) After a time lag upto ‘B’ domestic firms can react to the foreign demand and increase output & so increase X (BoP moves into a surplus)

75. Issues of elasticity  J curve will only happen if there is an ‘elastic’ demand for the country’s exports  The devaluation should generate new interest in the country’s goods and services – ONLY if elastic PeD!  What would happen if the PeD was inelastic?

76. Mashall Lerner condition  The Marshall Lerner Condition shows the conditions under which a change in the exchange rate of a country's currency leads to an improvement or worsening of a country's balance of payments.  If elastic demand – devaluation will improve the BoP  If inelastic demand – devaluation will worsen the BoP.

77. Floating Exchange Rates

78. –Rate determined purely by market demand and supply –No government intervention –Currency finds its own value –Little need for central bank to hold or use foreign currency reserves –Sterling has been a free-floating exchange rate since September 1992

80. Managed Exchange Rates  Government may seek to influence the market value of the currency  National Bank intervention  Uses stocks of gold and other foreign currencies  May decide to change short term interest rates to manage the external value of the currency  Increasingly difficult to manage the exchange rate given the size and power of the FOREX markets FOREX = foreign exchange market

81. Semi Fixed Exchange Rates –Exchange rate is given a central target (peg) –Band of fluctuation allowed –Day to day – currency finds its own market level –Interest rates are set to meet the exchange rate target –Central Bank intervention

82. Fixed Exchange rates analysis  Benefits  Certainty & stability  Financial discipline for govts & global trade harmony…  Stabile macro economics, firms know the future value of currency  Problems  Continued over / under valuation of currency  Deflation with deficit BoP or inflation with surplus.  Opportunity cost of govt using finances to ‘support’ currency.

83. Floating Exchange rates analysis  Problems  International uncertainty  Speculation impact on currency & macro ec (think Black Wed!)  Cost push and Demand pull inflationary pressures.  Impact on PPP (long term impact over decades!)  Benefits  Market mechanism equilibrium  More robust – allows economies to adjust to exogenous shocks!  Independent monetary policy – no govt intervention needed!

84. The Asian Financial Crisis Hung-Gay Fung University of Missouri-St. Louis

85. Presentation Outline âDiscuss briefly the behavior of the Foreign Exchange (FX) of Southeast Asian Countries. âAssess different factors that lead to the currency crisis. âOpportunities and Implications for U.S. companies

86. Foreign Exchange Rates âSince June 1997, FX rates in many Southeast Asian countries have experienced a substantial decline. âThese countries include the Philippines, Malaysia, Thailand, Indonesia, and Korea. âMany of these countries linked their exchange rates to the U.S. dollar before the currency crisis.

87. Change in FX rates (6/30/1998) FX:1 $US FX: 1 $US % 6/30/98 6/30/97change 6/30/98 6/30/97change Chinese yuan 8.281 8.289 +0.09 HK dollar 7.745 7.747 +0.03 Indonesia rupiah 14568.891760 -87.92 Japanese yen 138.31 114.61 -17.58 Malaysian ringgit 4.1 1.827 -55.44 Korean won1370 641.4 -53.18 Philippine peso 41.5 19.08 -54.02 Thai baht 42.16 17.9 -57.54

88. Immediate Results of Crisis âIn addition to currency devaluation: âCollapse of their Stock Markets (all Southeast countries); âCall for an IMF rescue plan in the Philippines, Thailand, Indonesia and Korea; âBankruptcy and financial reforms (all Southeast countries).

89. Reasons for the Currency Crisis âDecline in Export Earnings âExcessive and Risky Investment âCurrent Account Deficit âOvervalued Currency âUnderdevelopment of credit market âProperty market bubble

90. What Really Causes A Crisis? âCorruption? âKorea, Indonesia, Thailand -corruption âItaly and India have corruption, but no crisis âBank Transparency âinadequate regulatory framework âirrational lenders?

91. Inflation Rate 1993199419951996 Indonesia9.608.539.438.03 Korea4.826.244.494.96 Malaysia3.573.715.283.56 Philippines7.589.068.118.41 Thailand3.365.195.695.85 Source: Corsetti, Pesenti and Roubini (1998).

92. Savings Rates (% of GDP) Country1990199119921993199419951996 China38.138.337.740.642.641.042.9 Hong Kong35.833.833.834.633.130.430.6 Indonesia27.928.727.331.427.628.428.1 Japan33.534.233.832.831.430.731.3 Korea36.135.935.135.234.635.133.3 Malaysia29.128.431.333.032.733.536.7 Philippines18.718.019.518.419.417.819.7 Singapore44.145.447.344.949.850.050.1 Taiwan22.422.223.223.722.922.921.0 Thailand32.635.234.334.934.934.333.1 Source: Statistical Appendix, IMF, 1997.

93. Human Development Indicators CountryLife-ExpectancyLiteracy RateAverage Income of (years) (%) Poorest 20% (years) (%) Poorest 20% in ‘85 US$ in ‘85 US$ 1970199519701995 1970 1995 Indonesia 48 64 54 84 392 908 Korea 60 72 88 98 303 2071 Malaysia 62 72 60 85 431 1070 Philippines 57 66 83 95 218 435 Thailand 58 69 79 94 361 726 Source: Radelet and Sachs (1998).