the notion and types of exchange rate

8/7/2019 The Notion and Types of Exchange Rate

1/43

Exchange rates and exchange

rate regimes

International Finance130440-1165



2/43

Lecture outline

The notion of the exchange rate

Types of exchange rate regimes

Types of exchange rate

The equilibrium on the currency market



3/43

Exchange rate

The price of one currency expressed in another

currency

Direct quotation the price of the foreigncurrency expressed in domestic currency

Indirect quotation the price of the domestic

currency expressed in foreign currency



4/43


5/43

Free floating

A currencys ER may fluctuate free versus other currencies ER

A currencys exchange rate is determined by the demand and

supply

Managed floating- central bank interventions

Examples

the majority of key currencies: EUR, USD, GBP, JPY, CHF



6/43

Crawling band

The ER fluctuates within a band around a central

parity, the band is adjusted periodically at a

preset rate

Examples

CLP (Chile), COP (Columbia) , VEB (Venezuela)



7/43

Fixed band system

The ER may fluctuate within a fixed band around

the central parity

Example:

ERM/ERM II- a system aimed at stabilizing the

ER of euro area candidate countries



8/43

Crawling peg

The ER is fixed at a central parity, the parity is

periodically adjusted at a preset rate

Example:

RMB (China)



9/43

Fixed ER (hard peg)

The ER is pegged to another currency, to a

basket of currencies or to another value e.g.

gold

Example:

RMB (China) till 2005 currency pegged to

USD



10/43

Currency board system

The ER is pegged to a foreign currency at a set and

fixed exchange rate

The domestic monetary base issuance is 100% backed

by reserves of the foreign anchor currency

Examples: LTL (Lithuania), EEK (Estonia) pegged to

EUR

HKD (Hong Kong), BMD (Bermuda) pegged to USD



11/43

Monetary union

Two or more states using the same currency

Unilateral and multilateral monetary union

Unilateral - euroisation, dollarisation

Multilateral- EMU



12/43

De iure and de facto classification

Free floating- mostly developed economies

Peg to the EUR- 40 countries

Peg to the USD- 70 countries



13/43

Advantages and disatvantages of

floating Adjustment of the balance of payments +

Adjustment after shocks +

Volatility concerning foreign trade and

investment

The fear of floating



14/43

Advantages and disatvantages of

pegs Stability concerning foreign trade and

investment +

Possibility to import monetary stability +

Higher risk of speculative attacks

Constraint for the domestic economic policy-

The need of large reserves



15/43

Impossible trinity



16/43

No single currency regimeisright forall countries oratall

times.

J.A. Frankel



17/43

Exchange rate regime choices

Estonia

Argentina

China


18/43

Estonia

Currency board

1992-1999 ER pegged to DEM, since 1999 to

EUR

Reasons for CB introduction in Estonia

Inflation up to 300% in the early 90-ties

Small open economy- outward oriented economic policy

Goal the join the EU (later the euro area)



19/43

Estonia- CPI

8

8(

)

Source: Estonian Central Bank

International Finance-


20/43

Argentina

Currency board

ER pegged to USD 1991- 2002

Reasons for introduction:

Hyperinflation till 1990

Large macroeconomic imbalances



21/43

Argentina

CPI

200

0

200

400

600

00

1000

1200

1400

1600

1990 1991 1992 1993 1994 1995 1996 1997 199

1999 2000 2001 2002

Results:

Monetary stabilityachieved

External shocks-

liquidity crunch-late 90-ties

Overvalued pesodue to wrong peg

Floating since2002-extreme

depreciation of thepeso



22/43

China

Fixed ER

1997-2005 peg against the USD

Export oriented strategy

2005- switching from the USD peg to a basket

crawling peg

Reasons for switching

RMB undervalued

Large global imbalances



23/43

Curre

acc

unt ba ance

50

0

50

100

150

200

250

300

350

400

450

190

192

194

196

19 1990

1992

1994

1996

199

2000

2002

2004

2006

200

b

on

Revaluation of the

RMB

Gradual movement

towards moreflexible ER

Lifting capital

controls

Source: IMF



24/43

Types of exchange rate

Nominal and real ER

Nominal ER- the price of a currency expressed

in a foreign currency

Real ER - the price of commodities of one

country expressed in prices of foreign

commodities -ratio of the domestic price leveland the foreign price level



25/43

Types of ER

Billateral and effective

Billateral- the price of a currency

expressed in a foreign currency

Effective- ER weighted with the shares of

trade partners in the whole foreign trade

International Finance

130440-1165


26/43

Equlibrium on the currency market

The state of equilibrium is reached when the

supply of a foreign currency equals the demand

for this currency Appreciation / Depreciation

Revaluation / Devaluation


130440-1165


27/43

Depreciation and appreciation


28/43

Demand and supply on the FX

market

Companies involved in foreign trade

Foreign investors

Central banks


130440-1165


29/43

A French investor buys Japanese

stock


130440-1165


30/43

An American company buys

products from the EU


130440-1165


31/43

Factors determining the exchange

rate in the short term

Fundamental economic values

Trends

Events


130440-1165


32/43

Fundamental economic values

GDP growth rate

Interest rates

Prices


130440-1165


33/43

Growth rate


130440-1165


34/43

Interest rate


130440-1165


35/43

The interest rate parity theory

The FX market reaches equilibrium if the

deposits in all currencies command the

same expected rate of return

iUSD=iEUR+ (EReEUR-E

eUSD)/EUSD/EUR


130440-1165


36/43


Example:

iUSD=10%, iEUR= 6%

Expected % USD depreciation p.a. the

expected rate of return in EUR is 4%

higher than in USD higher demand for

EUR unequlibrium ER changes


130440-1165


37/43


If iUSD > iEUR USD appreciates

If iUSD < iEUR USD depreciates


130440-1165


38/43

Prices


130440-1165


39/43

Trends

Inflationary path

Fiscal developments

Expectations

Example:

PLN - introduction of direct inflationtargeting appreciation of PLN


130440-1165


40/43

Events

Sudden decisions concerning economic policy

Market psychology Example:

Hungarian ER regime switch depreciation of

HUF + market psychology depreciation of allcurrencies in the region


130440-1165


41/43

Summing up

ER regime choice depends on the

features of the economy

No ER regime is right for all countries or

at all times

Impossible trinity


130440-1165


42/43

Summing up

Equlibrium in the short term depends on

market participants actions

Fundamental values

Trends

Events


130440-1165


43/43

References

P. Krugman, M.Obstfeld, International economics: theory

and policy. Part II, Pearson, Addison Wesley, Boston

2009

A. Budnikowski, Midzynarodowe stosunki gospodarcze,

PWE, Warszawa 2004

J. Frankel, No single currency regime is right for all

countries or at all times, Essays in International Finance,1999.


130440-1165

the notion and types of exchange rate

Documents