1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 10 Exchange Rates and Exchange Rate Systems

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-2 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

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-3 Introduction 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

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-4 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 on a daily basis in the financial pages of major newspapers and in numerous Web sites

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-5 Exchange Rates and Currency Trading (cont.) Appreciation of a currency: the currencys becoming more valuable (or able to buy more units of another currency) Depreciation of a currency: the currencys becoming less valuable in relation to another currency

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-6 TABLE 10.1 Exchange Rates for Selected Countries, September 1, 2006

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-7 3 Reasons for Holding Foreign Currency 1.Trade and investment purposes 2.Interest rate arbitrage: taking advantage of interest rate differentials between countries; arbitrageurs buy money where interest rates are low and sell it where interest rates are high 3.Speculation: buying and selling of currency in anticipation of changes in the currencys exchange rate; speculators sell overvalued currencies and buy undervalued currencies

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-8 Institutions 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 –Foreign exchange brokers: middlemen between buyers (banks) and sellers of foreign currency –Central banks: a countrys bank of banks

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-9 Exchange Rate Risk Exchange rate risk stems 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

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-10 Two Ways to Deal with Exchange Rate Risk 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: market in which the buying and selling of currencies for future delivery takes place; important mechanism for exporters, importers, financial investors, and speculators

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-11 Dealing with Exchange Rate Risk Hedging: an interest rate arbitrageurs 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: use of forward market by an interest rate arbitrageur against exchange rate risk

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-12 Foreign Exchange: Supply and Demand A currencys 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

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-13 FIGURE 10.1 The Demand Curve for Foreign Exchange

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-14 FIGURE 10.2 The Supply of Foreign Exchange

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-15 FIGURE 10.3 Supply and Demand in the Foreign Exchange Market

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-16 FIGURE 10.4 An Increase in Demand for British Pounds

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-17 FIGURE 10.5 An Increase in the Supply of British Pounds

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-18 TABLE 10.2 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

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-19 Exchange Rates: Medium Run Medium run forces affecting exchange rate –The countrys 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

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-20 Exchange Rates: Short Run 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 Lets analyze these forces more closely…

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-21 Short-Run Forces 1: Interest Rates 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

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-22 Short-Run Forces 2: Expectations of Future Rates 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

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-23 FIGURE 10.6 The Effects of an Increase in Homes Interest Rate

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-24 TABLE 10.5 Major Determinants of an Appreciation or Depreciation

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-25 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) = R r = R n (P*/ P)

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-26 Alternatives to Flexible Exchange Rates Fixed system: the value of a nations money is defined in terms of a fixed amount of a commodity (e.g., gold) or of another currency (e.g., U.S. dollar) Flexible (floating) system: the value of the currency is allowed to float up and down with market forces 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 Purely fixed or floating systems are today rare

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-27 FIGURE 10.7 Fixed Exchange Rates and Changes in Demand

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-28 FIGURE 10.8 Selling Reserves of Pounds to Counter a Weakening Dollar

29. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-29 Pegged System 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

30. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-30 Single Currency Areas In 1999, 11 of 15 European Union (EU) members adopted a common currency, the euro, which began circulating in 2002 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

31. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-31 Single Currency Areas (cont.) Optimal currency area: Robert Mundells criteria to determine whether two or more countries would be better off by sharing a currency For common currency to be viable, countries must share –synchronized business cycles –high degree of labor and capital mobility –regional policies to deal with economic imbalances –an integration effort that goes beyond mere free trade

32. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-32 TABLE 10.3 Composition of World Currency Trades, April 2004

33. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-33 TABLE 10.4 Currency Trading Centers

34. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 10-34 TABLE 10.6 Inflation in Argentina, 1985-1994