Transcript Document

Chapter 10
Exchange Rates
and Exchange
Rate Systems
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
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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
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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
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Exchange Rates
and Currency Trading (cont.)
• Appreciation of a currency: the
currency’s becoming more valuable
(or able to buy more units of
another currency)
• Depreciation of a currency: the
currency’s becoming less valuable in
relation to another currency
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Examples
of Exchange
Rates
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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 currency’s exchange
rate; speculators sell overvalued currencies and buy
undervalued currencies
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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 country’s bank of banks
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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
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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
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Dealing with Exchange Rate Risk
• Hedging: an interest rate arbitrageur’s
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
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Foreign Exchange:
Supply and Demand
• A currency’s 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
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FIGURE 10.1 The Demand Curve
for Foreign Exchange
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FIGURE 10.2
The Supply of Foreign Exchange
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FIGURE 10.3 Supply and Demand
in the Foreign Exchange Market
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FIGURE 10.4 An Increase
in Demand for British Pounds
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FIGURE 10.5 An Increase
in the Supply of British Pounds
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Exchange Rates in the Long Run:
Purchasing Power Parity
• 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
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Exchange Rates: Medium Run
• Medium run forces affecting
exchange rate
– The country’s 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
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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
• Let’s analyze these forces
more closely…
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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
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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
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FIGURE 10.6 The Effects of an
Increase in Home’s Interest Rate
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Determinants of an
Exchange Rate: Summary
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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) =
Rr = Rn(P*/ P)
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Alternatives to Flexible
Exchange Rates
• Fixed system: the value of a nation’s 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
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FIGURE 10.7 Fixed Exchange Rates
and Changes in Demand
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FIGURE 10.8 Selling Reserves of
Pounds to Counter a Weakening Dollar
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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
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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
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Single Currency Areas (cont.)
• Optimal currency area: Robert Mundell’s 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
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