exchange rates 2

7/27/2019 Exchange Rates 2

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Exchange Rates

The theory of relativity applied to

international trade


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Exchange Rates

Before diving into something that sounds reallycomplicated (but actually isnt) determiningthe relative value of different currencieslets

start with something simple.

Think of the $ (or Euro, Peso, or any othercurrency) as a commodity.

What determines the price of any commodity ina free market system?


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Floating Exchange Rates

Yes, we are back to supply and demand.

In a free market system, the relative value ofcurrencies float up and down based on the

forces of supply and demand.

These are known as floating exchange rates.

Floating exchange rates move continuously inresponse to market forces, unless (or until)government intervenes


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Basic Exchange Rate Movements

If demand for a currency goes up (or supplygoes down)the currency appreciates (orstrengthens)

If supply increases (or demand decreases)thecurrency depreciates (weakens)


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Factors that Impact Exchange Rates

Change in Income

Change in Relative Prices

Change in Relative Investment Prospects Speculation

Use of Foreign Reserves


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Change in Income

U.S. income goes up

U.S. consumption increasesdemand forEuropean imports goes up

Supply of US$ goes up, demand for Euro goesup

Both forces act to depreciate the US$ relative tothe Euro (takes fewer Euros to buy a US$)


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A Graphical Example

D

S1

S2

Q of $

E/$


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Change in IncomeIn Reverse

EU income goes up

Demand for U.S. imports increases

Euros flood the currency market, in order toexchange for US$

Demand for US$ goes up

US$ appreciates relative to the Euro (US$ isworth more in Euros)


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Back to the Graph

D1

SE/$

Q of $

D2


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Change in relative prices = relative rates ofinflation

Higher rates of domestic inflation in the U.S.make imports relatively cheaperdemand forEuropean imports goes up.

Higher inflation in the U.S. also make exportsless competitiveexports to Europe go down

Both factors act to weaken the US$


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Rememberit is the relative rate of inflationthat counts.

5% inflation in the U.S. will not cause the US$to weaken relative to the Euro if the inflationrate within the EU is running at 8%.

But, 3% inflation in the U.S. will cause the US$to depreciate relative to the Euro if inflation isonly 1% in the EU.


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Relative Investment Prospects

Currency values change in response to relativeinvestment opportunities

US investors see more attractive risk adjustedinvestment opportunities in India versus in thedomestic marketdemand for Indian Rupeesgoes up, and supply of US$ goes up

US$ depreciates relative to the Rupee


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New government elected in India based on aplatform of increased regulation andprotectionist policies

Perceived risk of investing in India increases,reducing the relative attractiveness of investingin India versus the U.S.

Demand for US$ goes upUS$ appreciatesrelative to the Rupee


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Relative Interest Rates

In a global market, investors always have choicesin terms of where (and in what form) to investtheir money.

Relative interest rates have a significant impactin determining the relative attractiveness ofholding investments in one currency or another.

Increasing interest rates in the U.S. (on a relativebasis) provide an incentive for investors to holdUS$ denominated financial instruments


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An increase in demand for US$ denominatedinstruments (think U.S. Treasuries) increasesdemand for US$ -- US$ strengthens

When interest rates in the U.S. decline on arelative basis, demand for US$ denominatedinstruments goes downand the US$

depreciates.


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Speculation

It just wouldnt be a market without speculation.

All markets (including currency markets) aredriven by expectations of future performance

The past and present are relevant only to theextent that they can help predict where marketsare going in the future.

Expectations of future changes that will impactthe value of a currency will be factored into thecurrent market price of the currency


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Speculation

Expectations regarding

Relative rates of inflation

Which impact relative interest rates

Which will impact economic performance andincome

Which can change views on investment

prospects Impact currency markets in a never ending

circular loop of profit motivated speculation


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Speculation

The goal?

Buy currencies (or investments denominated incurrencies) that you think are undervalued

Sell currencies that you think are overvalued

Of course, these speculative trades create market

movements that reduce or eliminate theperceived over or under valuation.


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Use of foreign reservesotherwise known asgovernment intervention

Governments can buy or sell their own (oranother) currency in order to stabilize or changethe relative value of their currency

When governments intervene in the currencymarkets = dirty float


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Do these Factors Really Move

Markets?

Lets take a look


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Exchange Rates Meet BOP

The same factors that impact exchange rates alsoimpact balance of payments.

Change in income

Increase in income

Increased demand for imports

Net exports decline (Current Account goes down)


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Exchange Rates and BOP


High relative inflation

Imports up; exports down

Net exports decline (Current Account goes down)


Strong investment prospects attract flows of capital

from foreign investors

Improves the Capital Account


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Increase in domestic U.S. interest rates will increasedemand for US$ denominated instruments

When foreign investors buy U.S. financialinstrumentsCapital Account improves

Speculation

Speculative buying and selling of impacts the CapitalAccount and market exchange rates


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If the Fed buys US$ -- positive impact on value ofUS$

But, negative impact on Capital Account (reductionin reserves)


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Everything is Related

Economic growth and income, balance ofpayments and exchange rates are all related

Y = C + I + G + (X-M)

Changes in net exports (X-M) cause changes inGDP (Y)

Changes in economic growth (income) and net

exports drive changes in exchange rates, whichin a circular fashion impact net exports andnational income


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A Self-Correcting System

A floating exchange rate system is self-correcting

Balance of payments will adjust (or shouldadjust) automatically based on changes inexchange rates

A country that runs a large trade deficit willdevalue its currency, making its exports cheaper

to the rest of the world

Exports riseself-correcting the BOP problem


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Your Assignment

1. Pick a currency (anything except the US$).

2. Summarize the exchange rate changes for thiscurrency over the last 12 months.

3. Explain the underlying causes of theseexchange rate movements.

4. Predict where this currency will trade over thenext 12 monthsand support your prediction.


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Your Assignment (Contd)

5. Required work product: 12 page paper summarizing your analysis and support

for your predictions (due at the beginning of next class)

Short (5 minutes or less) presentation of your analysisand conclusions


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Exchange Rates (Continued)

Agenda:

Floating versus fixed exchange rates

Advantages and disadvantages of floating andfixed exchange rate systems

Managed exchange rates

Purchasing power parityTerms of trade


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Floating vs. Fixed Exchange Rates

Floating exchange rate systems allow exchangerates to move based on supply and demanddynamics in the market.

In fixed exchange rate systems the exchange rateis pegged or locked in to a specific, fixed rate ofexchange.

Floating and fixed systems have some important(and fairly obvious) advantages anddisadvantages


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Fixed Exchange Rates

Advantages:

Certainty

Fixed exchange rates take the risk of currency fluctuations

out of business transactions (usually) Increased trade

If the greater certainty of fixed exchange rates leads to anincrease in trade, this would create a net economic benefit

Experience over the last 30 years does not support thiscorrelation


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Advantages:

Reduced speculation No opportunity to profit from day to day changes in the

exchange rate

Huge opportunity to take positions in expectation ofdevaluations or revaluations of a fixed exchange rate

Government discipline Without the self-correcting mechanisms of a floating

exchange rate, governments (theoretically) should be forcedto exercise more disciplined in the management of fiscal andmonetary policy


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Disadvantages:

Reserves

Governments must have sufficient reserves of gold and

foreign currency to support frequent intervention in themarket

Loss of control over monetary policy

If exchange rates are fixed, money supply and interest rates

must float based on flow of trade and investment

No auto-correction mechanism


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Advantages:

Self-correcting

No reserves required for market intervention Control over fiscal and monetary policy

Governments can adjust fiscal and monetary policyand allow changes in the exchange rate to adjust forchanges in the balance of payments (let the self-correcting mechanism do its thing)


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Advantages:

No large jumps Exchange rates move constantly, but usually in very

small daily increments No major jumps from devaluations or revaluations

Reduction in speculation (maybe)

In theory offsetting trades may cancel each other outand reduce the net impact of speculation on themarket


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Disadvantages:

Less certainty

Floating rates add an additional element ofuncertainty (risk) to international transactions

This risk can be mitigated by hedging in forwardcurrency markets

Difficult to hedge long-term investments

Increased speculation (probably)


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Lack of discipline

Adjustments in exchange rates can mute (or at leastdelay) the impact of irresponsible economic policies

on the part of government, businesses or labor. Example: Government adopts inflationary monetary

and fiscal policy; inflation increases; currencydecreases in value, which helps offset the negativeimpact of higher prices on exports


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Managed Exchange Rates

Managed exchange rate systems fall between the twoextremes of perfectly fixed and pure floating ratesystems

Two types of managed systems: Adjustable peg

Government pegs a target exchange rate

Manages based on a preset band around this target rate

Dirty float

Floating system with some government intervention


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Exchange Rate Management Tools

Buy or sell currency (ex: buy to appreciate currency)

Manipulate interest rates (ex: lower to depreciatecurrency)

Adopt protectionist policies (use of tariffs or exportsubsidies to protect value of currency)

Violates WTO agreement

Adjustments to exchange rate can have the same effect

Expenditure switching


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Exchange Rate Management Tools

Use fiscal and monetary policy to drive changesin GDP/national income Expenditure changing

Reductions in national income reduce spending onimports, which decreases the supply of currency onthe marketcurrency appreciates and balance ofpayments improves

Tradeoff between manging balance of payments anddomestic economic and political considerations(internal versus external balance)


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Purchasing Power Parity

Based on law of one price

Asserts that a good must sell for the same pricein all locations

Under this theory, each currency should havethe same purchasing power in its home

market, and

Nominal exchange rates should reflect the pricelevels in different countries


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Purchasing Power Parity

If the theory of purchasing power parity holds,the currency adjusted price of like products(think Big Mac) should be the same when

benchmarked against a single currency (like thedollar)

Why wouldnt this theory hold in practice?

Many goods are not easily traded Even goods that are easily traded are often not

perfect substitutes (product differentiation)


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Terms of Trade

What will happen to the volume of trade as the termsof trade improve or worsen?

Depends on the elasticity of demand for exports and

importsthe sensitivity of demand to changes in price If demand for exports and imports is elastic (highly

sensitive to price changes), an improvement in terms oftrade (export prices rising faster than import prices) will

worsen the balance of payments (as demand for exportsfalls more than imports)

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