Exchange RatesExchange Rates

The theory of relativity The theory of relativity applied to international tradeapplied to international trade

Exchange RatesExchange Rates

Before diving into something that Before diving into something that sounds really complicated (but sounds really complicated (but actually isn’t) – determining the actually isn’t) – determining the relative value of different currencies relative value of different currencies – let’s start with something simple.– let’s start with something simple.

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

What determines the price of any What determines the price of any commodity in a free market system?commodity in a free market system?

Floating Exchange RatesFloating Exchange Rates

Yes, we are back to supply and demand.Yes, we are back to supply and demand. In a free market system, the relative value In a free market system, the relative value

of currencies “float” up and down based on of currencies “float” up and down based on the forces of supply and demand.the forces of supply and demand.

These are known as floating exchange These are known as floating exchange rates.rates.

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

Basic Exchange Rate Basic Exchange Rate MovementsMovements

If demand for a currency goes up (or If demand for a currency goes up (or supply goes down) – the currency supply goes down) – the currency appreciatesappreciates (or strengthens) (or strengthens)

If supply increases (or demand If supply increases (or demand decreases) – the currency decreases) – the currency depreciatesdepreciates (weakens) (weakens)

Factors that Impact Factors that Impact Exchange RatesExchange Rates

Change in IncomeChange in Income Change in Relative PricesChange in Relative Prices Change in Relative Investment Change in Relative Investment

ProspectsProspects SpeculationSpeculation Use of Foreign ReservesUse of Foreign Reserves

Change in IncomeChange in Income

U.S. income goes upU.S. income goes up U.S. consumption increases – demand U.S. consumption increases – demand

for European imports goes upfor European imports goes up Supply of US$ goes up, demand for Supply of US$ goes up, demand for

Euro goes upEuro goes up Both forces act to depreciate the US$ Both forces act to depreciate the US$

relative to the Euro (takes fewer relative to the Euro (takes fewer Euros to buy a US$)Euros to buy a US$)

A Graphical ExampleA Graphical Example

D

S1

S2

Q of $

E/$

Change in Income – In Change in Income – In ReverseReverse

EU income goes upEU income goes up Demand for U.S. imports increasesDemand for U.S. imports increases Euros flood the currency market, in Euros flood the currency market, in

order to exchange for US$order to exchange for US$ Demand for US$ goes upDemand for US$ goes up US$ appreciates relative to the Euro US$ appreciates relative to the Euro

(US$ is worth more in Euros)(US$ is worth more in Euros)

Back to the GraphBack to the Graph

D1

SE/$

Q of $

D2

Change in Relative Change in Relative PricesPrices

Change in relative prices = Change in relative prices = relativerelative rates of inflationrates of inflation

Higher rates of domestic inflation in the Higher rates of domestic inflation in the U.S. make imports relatively cheaper – U.S. make imports relatively cheaper – demand for European imports goes up.demand for European imports goes up.

Higher inflation in the U.S. also make Higher inflation in the U.S. also make exports less competitive – exports to exports less competitive – exports to Europe go downEurope go down

Both factors act to weaken the US$ Both factors act to weaken the US$

Change in Relative Change in Relative PricesPrices

Remember – it is the relative rate of Remember – it is the relative rate of inflation that counts.inflation that counts.

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

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

Relative Investment Relative Investment ProspectsProspects

Currency values change in response Currency values change in response to relative investment opportunitiesto relative investment opportunities

US investors see more attractive risk US investors see more attractive risk adjusted investment opportunities in adjusted investment opportunities in India versus in the domestic market India versus in the domestic market – demand for Indian Rupees goes up, – demand for Indian Rupees goes up, and supply of US$ goes upand supply of US$ goes up

US$ depreciates relative to the US$ depreciates relative to the RupeeRupee

Relative Investment Relative Investment ProspectsProspects

New government elected in India New government elected in India based on a platform of increased based on a platform of increased regulation and protectionist policiesregulation and protectionist policies

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

Demand for US$ goes up – US$ Demand for US$ goes up – US$ appreciates relative to the Rupeeappreciates relative to the Rupee

Relative Interest RatesRelative Interest Rates In a global market, investors always have In a global market, investors always have

choices in terms of where (and in what choices in terms of where (and in what form) to invest their money.form) to invest their money.

Relative interest rates have a significant Relative interest rates have a significant impact in determining the relative impact in determining the relative attractiveness of holding investments in attractiveness of holding investments in one currency or another.one currency or another.

Increasing interest rates in the U.S. (on a Increasing interest rates in the U.S. (on a relative basis) provide an incentive for relative basis) provide an incentive for investors to hold US$ denominated investors to hold US$ denominated financial instrumentsfinancial instruments

Relative Interest RatesRelative Interest Rates

An increase in demand for US$ An increase in demand for US$ denominated instruments (think U.S. denominated instruments (think U.S. Treasuries) increases demand for Treasuries) increases demand for US$ -- US$ strengthensUS$ -- US$ strengthens

When interest rates in the U.S. When interest rates in the U.S. decline on a relative basis, demand decline on a relative basis, demand for US$ denominated instruments for US$ denominated instruments goes down – and the US$ goes down – and the US$ depreciates.depreciates.

SpeculationSpeculation It just wouldn’t be a market without It just wouldn’t be a market without

speculation.speculation. All markets (including currency markets) are All markets (including currency markets) are

driven by expectations of future driven by expectations of future performanceperformance

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

Expectations of future changes that will Expectations of future changes that will impact the value of a currency will be impact the value of a currency will be factored into the current market price of the factored into the current market price of the currencycurrency

SpeculationSpeculation

Expectations regardingExpectations regarding Relative rates of inflation …Relative rates of inflation … Which impact relative interest rates …Which impact relative interest rates … Which will impact economic Which will impact economic

performance and income …performance and income … Which can change views on investment Which can change views on investment

prospects …prospects … Impact currency markets in a never Impact currency markets in a never

ending circular loop of profit motivated ending circular loop of profit motivated speculationspeculation

SpeculationSpeculation

The goal?The goal? Buy currencies (or investments Buy currencies (or investments

denominated in currencies) that you think denominated in currencies) that you think are undervaluedare undervalued

Sell currencies that you think are Sell currencies that you think are overvaluedovervalued

Of course, these speculative trades create Of course, these speculative trades create market movements that reduce or market movements that reduce or eliminate the perceived over or under eliminate the perceived over or under valuation.valuation.

Use of Foreign ReservesUse of Foreign Reserves

Use of foreign reserves – otherwise Use of foreign reserves – otherwise known as government interventionknown as government intervention

Governments can buy or sell their Governments can buy or sell their own (or another) currency in order own (or another) currency in order to stabilize or change the relative to stabilize or change the relative value of their currencyvalue of their currency

When governments intervene in the When governments intervene in the currency markets = “dirty float” currency markets = “dirty float”

Do these Factors Really Do these Factors Really Move Markets?Move Markets?

Let’s take a look …Let’s take a look …

Exchange Rates Meet Exchange Rates Meet BOPBOP

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

Change in incomeChange in income Increase in incomeIncrease in income Increased demand for importsIncreased demand for imports Net exports decline (Current Account Net exports decline (Current Account

goes down)goes down)

Exchange Rates and BOPExchange Rates and BOP

Change in Relative PricesChange in Relative Prices High relative inflationHigh relative inflation Imports up; exports downImports up; exports down Net exports decline (Current Account Net exports decline (Current Account

goes down)goes down) Relative Investment ProspectsRelative Investment Prospects

Strong investment prospects attract Strong investment prospects attract flows of capital from foreign investorsflows of capital from foreign investors

Improves the Capital AccountImproves the Capital Account

Exchange Rates and BOPExchange Rates and BOP

Relative Interest RatesRelative Interest Rates Increase in domestic U.S. interest rates Increase in domestic U.S. interest rates

will increase demand for US$ denominated will increase demand for US$ denominated instrumentsinstruments

When foreign investors buy U.S. financial When foreign investors buy U.S. financial instruments – Capital Account improvesinstruments – Capital Account improves

SpeculationSpeculation Speculative buying and selling of impacts Speculative buying and selling of impacts

the Capital Account and market exchange the Capital Account and market exchange ratesrates

Exchange Rates and BOPExchange Rates and BOP

Use of Foreign ReservesUse of Foreign Reserves If the Fed buys US$ -- positive impact If the Fed buys US$ -- positive impact

on value of US$on value of US$ But, negative impact on Capital Account But, negative impact on Capital Account

(reduction in reserves) (reduction in reserves)

Everything is RelatedEverything is Related Economic growth and income, balance of Economic growth and income, balance of

payments and exchange rates are all payments and exchange rates are all relatedrelated

Y = C + I + G + (X-M)Y = C + I + G + (X-M) Changes in net exports (X-M) cause Changes in net exports (X-M) cause

changes in GDP (Y)changes in GDP (Y) Changes in economic growth (income) Changes in economic growth (income)

and net exports drive changes in and net exports drive changes in exchange rates, which in a circular exchange rates, which in a circular fashion impact net exports and national fashion impact net exports and national incomeincome

A Self-Correcting SystemA Self-Correcting System

A floating exchange rate system is self-A floating exchange rate system is self-correctingcorrecting

Balance of payments will adjust (or Balance of payments will adjust (or should adjust) automatically based on should adjust) automatically based on changes in exchange rateschanges in exchange rates

A country that runs a large trade deficit A country that runs a large trade deficit will devalue its currency, making its will devalue its currency, making its exports cheaper to the rest of the worldexports cheaper to the rest of the world

Exports rise – self-correcting the BOP Exports rise – self-correcting the BOP problemproblem

Your AssignmentYour Assignment

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

2.2. Summarize the exchange rate changes Summarize the exchange rate changes for this currency over the last 12 for this currency over the last 12 months.months.

3.3. Explain the underlying causes of these Explain the underlying causes of these exchange rate movements.exchange rate movements.

4.4. Predict where this currency will trade Predict where this currency will trade over the next 12 months – and support over the next 12 months – and support your prediction.your prediction.

Your Assignment Your Assignment (Cont’d)(Cont’d)

5.5. Required work product:Required work product: 1 – 2 page paper summarizing your 1 – 2 page paper summarizing your

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

Short (5 minutes or less) presentation of Short (5 minutes or less) presentation of your analysis and conclusionsyour analysis and conclusions

Exchange Rates Exchange Rates (Continued)(Continued)

Agenda:Agenda: Floating versus fixed exchange ratesFloating versus fixed exchange rates Advantages and disadvantages of Advantages and disadvantages of

floating and fixed exchange rate floating and fixed exchange rate systemssystems

Managed exchange ratesManaged exchange rates Purchasing power parityPurchasing power parity Terms of tradeTerms of trade

Floating vs. Fixed Exchange Floating vs. Fixed Exchange RatesRates

Floating exchange rate systems Floating exchange rate systems allow exchange rates to move based allow exchange rates to move based on supply and demand dynamics in on supply and demand dynamics in the market.the market.

In fixed exchange rate systems the In fixed exchange rate systems the exchange rate is pegged or locked in exchange rate is pegged or locked in to a specific, fixed rate of exchange.to a specific, fixed rate of exchange.

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

Fixed Exchange RatesFixed Exchange Rates

Advantages:Advantages: CertaintyCertainty

Fixed exchange rates take the risk of currency Fixed exchange rates take the risk of currency fluctuations out of business transactions fluctuations out of business transactions (usually)(usually)

Increased tradeIncreased trade IfIf the greater certainty of fixed exchange rates the greater certainty of fixed exchange rates

leads to an increase in trade, this would create leads to an increase in trade, this would create a net economic benefita net economic benefit

Experience over the last 30 years does not Experience over the last 30 years does not support this correlationsupport this correlation

Fixed Exchange RatesFixed Exchange Rates

Advantages:Advantages: Reduced speculationReduced speculation

No opportunity to profit from day to day changes No opportunity to profit from day to day changes in the exchange ratein the exchange rate

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

Government disciplineGovernment discipline Without the self-correcting mechanisms of a Without the self-correcting mechanisms of a

floating exchange rate, governments floating exchange rate, governments (theoretically) should be forced to exercise more (theoretically) should be forced to exercise more disciplined in the management of fiscal and disciplined in the management of fiscal and monetary policymonetary policy

Fixed Exchange RatesFixed Exchange Rates

Disadvantages:Disadvantages: ReservesReserves

Governments must have sufficient reserves of Governments must have sufficient reserves of gold and foreign currency to support frequent gold and foreign currency to support frequent intervention in the marketintervention in the market

Loss of control over monetary policyLoss of control over monetary policy If exchange rates are fixed, money supply and If exchange rates are fixed, money supply and

interest rates must “float” based on flow of interest rates must “float” based on flow of trade and investmenttrade and investment

No auto-correction mechanismNo auto-correction mechanism

Floating Exchange RatesFloating Exchange Rates

Advantages:Advantages: Self-correctingSelf-correcting No reserves required for market No reserves required for market

interventionintervention Control over fiscal and monetary policyControl over fiscal and monetary policy

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

Floating Exchange RatesFloating Exchange Rates

Advantages:Advantages: No large jumpsNo large jumps

Exchange rates move constantly, but Exchange rates move constantly, but usually in very small daily incrementsusually in very small daily increments

No major jumps from devaluations or No major jumps from devaluations or revaluationsrevaluations

Reduction in speculation (maybe)Reduction in speculation (maybe) In theory offsetting trades may cancel In theory offsetting trades may cancel

each other out and reduce the net each other out and reduce the net impact of speculation on the marketimpact of speculation on the market

Floating Exchange RatesFloating Exchange Rates

Disadvantages:Disadvantages: Less certaintyLess certainty

Floating rates add an additional element Floating rates add an additional element of uncertainty (risk) to international of uncertainty (risk) to international transactionstransactions

This risk can be mitigated by hedging in This risk can be mitigated by hedging in forward currency marketsforward currency markets

Difficult to hedge long-term investmentsDifficult to hedge long-term investments Increased speculation (probably)Increased speculation (probably)

Floating Exchange RatesFloating Exchange Rates

Lack of disciplineLack of discipline Adjustments in exchange rates can mute Adjustments in exchange rates can mute

(or at least delay) the impact of (or at least delay) the impact of irresponsible economic policies on the irresponsible economic policies on the part of government, businesses or labor.part of government, businesses or labor.

Example: Government adopts Example: Government adopts inflationary monetary and fiscal policy; inflationary monetary and fiscal policy; inflation increases; currency decreases inflation increases; currency decreases in value, which helps offset the negative in value, which helps offset the negative impact of higher prices on exports impact of higher prices on exports

Managed Exchange Managed Exchange RatesRates

Managed exchange rate systems fall between Managed exchange rate systems fall between the two extremes of perfectly fixed and pure the two extremes of perfectly fixed and pure floating rate systemsfloating rate systems

Two types of managed systems:Two types of managed systems: Adjustable pegAdjustable peg

Government “pegs” a target exchange rateGovernment “pegs” a target exchange rate Manages based on a preset band around this Manages based on a preset band around this

target ratetarget rate Dirty floatDirty float

Floating system with some government Floating system with some government interventionintervention

Exchange Rate Exchange Rate Management ToolsManagement Tools

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

Manipulate interest rates (ex: lower to Manipulate interest rates (ex: lower to depreciate currency)depreciate currency)

Adopt protectionist policies (use of tariffs or Adopt protectionist policies (use of tariffs or export subsidies to protect value of export subsidies to protect value of currency)currency) Violates WTO agreementViolates WTO agreement Adjustments to exchange rate can have the same Adjustments to exchange rate can have the same

effecteffect ““Expenditure switching”Expenditure switching”

Exchange Rate Exchange Rate Management ToolsManagement Tools

Use fiscal and monetary policy to drive Use fiscal and monetary policy to drive changes in GDP/national incomechanges in GDP/national income ““Expenditure changing”Expenditure changing” Reductions in national income reduce Reductions in national income reduce

spending on imports, which decreases the spending on imports, which decreases the supply of currency on the market – currency supply of currency on the market – currency appreciates and balance of payments appreciates and balance of payments improvesimproves

Tradeoff between manging balance of Tradeoff between manging balance of payments and domestic economic and payments and domestic economic and political considerations (“internal versus political considerations (“internal versus external balance”)external balance”)

Purchasing Power ParityPurchasing Power Parity

Based on “law of one price’Based on “law of one price’ Asserts that a good must sell for the Asserts that a good must sell for the

same price in all locationssame price in all locations Under this theory, each currency Under this theory, each currency

should have the same purchasing should have the same purchasing power in its “home” market, andpower in its “home” market, and

Nominal exchange rates should Nominal exchange rates should reflect the price levels in different reflect the price levels in different countriescountries

Purchasing Power ParityPurchasing Power Parity If the theory of purchasing power parity If the theory of purchasing power parity

holds, the currency adjusted price of like holds, the currency adjusted price of like products (think “Big Mac”) should be the products (think “Big Mac”) should be the same when benchmarked against a single same when benchmarked against a single currency (like the dollar)currency (like the dollar)

Why wouldn’t this theory hold in Why wouldn’t this theory hold in practice?practice?

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

often not perfect substitutes (product often not perfect substitutes (product differentiation)differentiation)

Terms of TradeTerms of Trade

Ratio of average export prices to Ratio of average export prices to average import pricesaverage import prices

If export prices rise faster than If export prices rise faster than import prices – terms of trade import prices – terms of trade improveimprove

If import prices rise more than If import prices rise more than export prices – terms of trade export prices – terms of trade worsenworsen

Terms of TradeTerms of Trade

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

Depends on the elasticity of demand for Depends on the elasticity of demand for exports and imports – the sensitivity of exports and imports – the sensitivity of demand to changes in pricedemand to changes in price

If demand for exports and imports is elastic If demand for exports and imports is elastic (highly sensitive to price changes), an (highly sensitive to price changes), an improvement in terms of trade (export prices improvement in terms of trade (export prices rising faster than import prices) will worsen rising faster than import prices) will worsen the balance of payments (as demand for the balance of payments (as demand for exports falls more than imports)exports falls more than imports)