Exchange Rate Behavior

Topics CoveredExchange Rate RegimesDeterminants of Exchange Rate

What is money?Barter economyCommodity moneyFiat moneyThe gold standard

The Monetary SystemBimetallism: Before 1875

Free coinage was maintained for both gold and silverGresham’s Law: Only the abundant metal was used as

money, diving more scarce metals out of circulationClassic gold standard: 1875-1914

Great Britain introduced full-fledged gold standard in 1821, France (effectively) in the 1850s, Germany in 1875, the US in 1879, Russia and Japan in 1897.

Gold alone is assured of unrestricted coinageThere is a two-way convertibility between gold and

national currencies at a stable ratioGold may be freely exported and importedCross-border flow of gold will help correct misalignment

of exchange rates and will also regulate balance of payments.

The gold standard provided a 40 year period of unprecedented stability of exchange rates which served to promote international trade.

Cont… Interwar period: 1915-1944

World War I ended the classical gold standard in 1914Trade in gold broke down After the war, many countries suffered hyper inflationCountries started to “cheat” (sterilization of gold)Predatory devaluationsThe US, Great Britain, Switzerland, France and the

Scandinavian countries restored the gold standard in the 1920s.

After the great depression, and ensuing banking crises, most countries abandoned the gold standard.

Bretton Woods system: 1945-1972U.S. dollar was pegged to gold at $35.00/oz.Other major currencies established par values against

the dollar. Deviations of ±1% were allowed, and devaluations could be negotiated.

Cont… Jamaica Agreement (1976)

Central banks were allowed to intervene in the foreign exchange markets to iron out unwarranted volatilities.

Gold was officially abandoned as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold, with proceeds used to help poor nations.

Non-oil exporting countries and less-developed countries were given greater access to IMF funds.

Plaza Accord (1985)G-5 countries (France, Japan, Germany, the U.K., and

the U.S.) agreed that it would be desirable for the U.S. dollar to depreciate.

Louvre Accord (1987)G-7 countries (Canada and Italy were added) would

cooperate to achieve greater exchange rate stability.G-7 countries agreed to more closely consult and

coordinate their macroeconomic policies.

Exchange Rate SystemsExchange rate systems can be classified

according to the degree to which the rates are controlled by the government.

Exchange rate systems normally fall into one of the following categories:FixedFreely floatingManaged floatPegged

In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow bands.

Pros: Work becomes easier for the MNCs.Cons: Governments may revalue their

currencies. In fact, the dollar was devalued more than once after the U.S. experienced balance of trade deficits.

Cons: Each country may become more vulnerable to the economic conditions in other countries.

Fixed Exchange Rate System

In a freely floating exchange rate system, exchange rates are determined solely by market forces.

Pros: Each country may become more insulated against the economic problems in other countries.

Pros: Central bank interventions that may affect the economy unfavorably are no longer needed.

Pros: Governments are not restricted by exchange rate boundaries when setting new policies.

Pros: Less capital flow restrictions are needed, thus enhancing the efficiency of the financial market.

Freely Floating Exchange Rate System

Cons: MNCs may need to devote substantial resources to managing their exposure to exchange rate fluctuations.

Cons: The country that initially experienced economic problems (such as high inflation, increasing unemployment rate) may have its problems compounded.

Cont…

In a managed (or “dirty”) float exchange rate system, exchange rates are allowed to move freely on a daily basis and no official boundaries exist. However, governments may intervene to prevent the rates from moving too much in a certain direction.

Pros: Work becomes easier for the MNCs.Cons: A government may manipulate its

exchange rates such that its own country benefits at the expense of others.

Managed Float Exchange Rate System

In a pegged exchange rate system, the home currency’s value is pegged to a foreign currency or to some unit of account, and moves in line with that currency or unit against other currencies.

The European Economic Community’s snake arrangement (1972-1979) pegged the currencies of member countries within established limits of each other.

Pegged Exchange Rate System

The European Monetary System which followed in 1979 held the exchange rates of member countries together within specified limits and also pegged them to a European Currency Unit (ECU) through the exchange rate mechanism (ERM).The ERM experienced severe problems in

1992, as economic conditions and goals varied among member countries.

Cont…

In 1994, Mexico’s central bank pegged the peso to the U.S. dollar, but allowed a band within which the peso’s value could fluctuate against the dollar.By the end of the year, there was substantial

downward pressure on the peso, and the central bank allowed the peso to float freely. The Mexican peso crisis had just began ...

Cont…

Exposure of a Pegged Currency to Interest Rate Movements

A country that uses a currency board does not have complete control over its local interest rates, as the rates must be aligned with the interest rates of the currency to which the local currency is tied.

Note that the two interest rates may not be exactly the same because of different risks.

A currency that is pegged to another currency will have to move in tandem with that currency against all other currencies.

So, the value of a pegged currency does not necessarily reflect the demand and supply conditions in the foreign exchange market, and may result in uneven trade or capital flows.

Cont…

Current Exchange Rate Arrangements36 major currencies, such as the U.S. dollar, the

Japanese yen, the Euro, and the UK pound are determined largely by market forces.

50 countries, including the China, India, Russia, and Singapore, adopt some forms of “Managed Floating” system.

41 countries do not have their own national currencies!

40 countries, including many islands in the Caribbean, many African nations, UAE and Venezuela, do have their own currencies, but they maintain a peg to another currency such as the U.S. dollar.

Many countries have some mixture of fixed and floating exchange-rate regimes.

DollarizationDollarization refers to the replacement of a

local currency with U.S. dollars.Dollarization goes beyond a currency board,

as the country no longer has a local currency.For example, Ecuador implemented

dollarization in 2000.

Government InterventionEach country has a government agency (called

the central bank) that may intervene in the foreign exchange market to control the value of the country’s currency.

Central banks manage exchange ratesto smooth exchange rate movements,to establish implicit exchange rate boundaries,

and/orto respond to temporary disturbances.

Often, intervention is overwhelmed by market forces. However, currency movements may be even more volatile in the absence of intervention.

Direct intervention refers to the exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market.

Direct intervention is usually most effective when there is a coordinated effort among central banks.

Cont…

Government Intervention

Quantity of £

S1

D1

D2

Valueof £

V1

V2

Exchanges $ for £to strengthen the £

Quantity of £

S2

D1

Valueof £

V2

V1

Exchanges £ for $to weaken the £

S1

When a central bank intervenes in the foreign exchange market without adjusting for the change in money supply, it is said to engaged in nonsterilized intervention.

In a sterilized intervention, Treasury securities are purchased or sold at the same time to maintain the money supply.

Government Intervention

Some speculators attempt to determine when the central bank is intervening, and the extent of the intervention, in order to capitalize on the anticipated results of the intervention effort.

Government Intervention

Central banks can also engage in indirect intervention by influencing the factors that determine the value of a currency.

For example, the central bank may attempt to increase interest rates (and hence boost the currency value) by reducing the money supply.Note that high interest rates adversely affects

local borrowers.

Government Intervention

Governments may also use foreign exchange controls (such as restrictions on currency exchange) as a form of indirect intervention.

Government Intervention

Intervention as a Policy ToolLike tax laws and money supply, the

exchange rate is a tool which a government can use to achieve its desired economic objectives.

A weak home currency can stimulate foreign demand for products, and hence local jobs. However, it may also lead to higher inflation.

Intervention as a Policy ToolA strong currency may cure high inflation,

since the intensified foreign competition should cause domestic producers to refrain from increasing prices. However, it may also lead to higher unemployment.

The percentage change (% in the value of a foreign currency is computed as

St – St-1

St-1

where St denotes the spot rate at time t.

• A positive % represents appreciation of the foreign currency, while a negative % represents depreciation.

Measuring Exchange Rate Movements

Value of £

Quantity of £

D: Demand for £

$1.55

$1.50

$1.60

S: Supply of £

equilibrium exchange rate

Exchange Rate EquilibriumAn exchange rate represents the price of a

currency, which is determined by the demand for that currency relative to the supply for that currency.

Factors that Influence Exchange RatesRelative inflation ratesIf the domestic inflation rate is higher than the foreign

inflation rate, domestic goods will become more expensive than foreign goods.

These changes affect the foreign exchange market by an increase in the demand for and decrease in the supply for foreign currency.

The demand curve shift to right and supply curve to the left.

As a result exchange rate moves up and domestic currency depreciates.

If a country has higher inflation rate than their trading partners its currency would depreciate.

Factors that Influence Exchange RatesRelative interest ratesA relatively high interest rate may actually reflect

expectations of relatively high inflation, which discourages foreign investment.

It is thus useful to consider real interest rates, which adjust the nominal interest rates for inflation.

Real interest rate Nominal interest rate – Inflation rateThis relationship is also called the Fisher effect.

If the domestic interest rate rises relative to foreign interest rate, domestic financial assets becomes more attractive than foreign financial assets.

This result in restructuring portfolios, leading to capital flows out of foreign assets and into the domestic assets.

Factors that Influence Exchange RatesIn the foreign exchange market this factor translated in to

decrease in demand for and increase in the supply of foreign exchange.

The demand curve shift down to left and supply curve shift to right. lead to fall in exchange rate that is appreciation of the domestic currency.

The effect of change in the interest rate runs through the capital account.

The reason is that high interest rate reflect high expected inflation, which is in case of countries experiencing hyperinflation.

While the high interest rate attract capital, high expected inflation cause underlying currency to depreciate, producing a lower expected rate of return.

That is why the changes in the relative real interest rate rather than nominal interest rate are considered.

Factors that Influence Exchange RatesRelative income levelsIf the growth rate of domestic income is higher

than that of foreign income their imports grow faster than exports.

The demand for foreign exchange grow faster than supply resulting in bigger shift in the demand curve to right than in supply curve.

The net effect is rise in the exchange rate that is depreciation of the domestic currency.

Factors that Influence Exchange RatesGovernment ControlsGovernments may influence the equilibrium

exchange rate by:imposing foreign exchange barriers,imposing foreign trade barriers,intervening in the foreign exchange market, andaffecting macro variables such as inflation, interest rates, and income levels.

ExpectationsForeign exchange markets react to any news

that may have a future effect.Institutional investors often take currency

positions based on anticipated interest rate movements in various countries.

Because of speculative transactions, foreign exchange rates can be very volatile.

If speculators expect the foreign currency to appreciate they switch from domestic currency assets to foreign currency assets.

Factors that Influence Exchange Rates

Interaction of FactorsTrade-related factors and financial factors

sometimes interact. Exchange rate movements may be simultaneously affected by these factors.

For example, an increase in the level of income sometimes causes expectations of higher interest rates.

Over a particular period, different factors may place opposing pressures on the value of a foreign currency.

The sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries.

Factors that Influence Exchange Rates

Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Gov’t Trade Restrictions

Financial Factors1. Interest Rate Differential2. Capital Flow Restrictions

How Factors Can Affect Exchange Rates

U.S. demand for foreign goods, i.e. demand for foreign currency

Foreign demand for U.S. goods, i.e. supply of foreign currency

U.S. demand for foreign securities, i.e. demand for foreign currency

Foreign demand for U.S. securities, i.e. supply of foreign currency

Exchange rate between foreign currency and the dollar

How Factors Have Influenced Exchange RatesBecause the dollar’s value changes by

different magnitudes relative to each foreign currency, analysts often measure the dollar’s strength with an index.

The weight assigned to each currency is determined by its relative importance in international trade and/or finance.

Factors that Influence Exchange Rates