The Evolution of Exchange Rate System

in the US
BY:

|
Contents
Introduction to Foreign Exchange Market.............................................................................................1
Dollarization..........................................................................................................................................3
Pegged Rates.........................................................................................................................................3
Objectives of the study..........................................................................................................................3
Scope of the study.................................................................................................................................4
Need for Foreign Exchange...................................................................................................................4
Review of the Literature........................................................................................................................5
What is the Foreign Exchange Rate?.....................................................................................................6
BREAKING DOWN.........................................................................................................................6
Types of Foreign Exchange Rates.........................................................................................................7
Theories of Exchange Rate....................................................................................................................8
Classification of Factors affecting Exchange Rate Levels...................................................................10
Factors influencing Foreign Exchange Rates.......................................................................................11
Differentials in Inflation..................................................................................................................12
Differentials in Interest Rates..........................................................................................................12
Current-Account Deficits.................................................................................................................13
Public Debt......................................................................................................................................13
Consequences of Exchange Rate Fluctuations.....................................................................................13
Conclusion...........................................................................................................................................15
References...........................................................................................................................................16
Introduction to Foreign Exchange Market

The foreign exchange market (forex, FX, or currency market) is a global

decentralized market for the trading of currencies. This includes all aspects of

buying, selling and exchanging currencies at current or determined prices. In

terms of volume of trading, it is by far the largest market in the world. The main

participants in this market are the larger international banks. Financial centres

around the world function as anchors of trading between a wide range of

multiple types of buyers and sellers around the clock, with the exception of

weekends. The foreign exchange market does not determine the relative values

of different currencies, but sets the current market price of the value of one

currency as demanded against another.

The foreign exchange market works through financial institutions, and it

operates on several levels. Behind the scenes banks turn to a smaller number of

financial firms known as "dealers", who are actively involved in large quantities

of foreign exchange trading. Most foreign exchange dealers are banks, so this

behind-the-scenes market is sometimes called the "interbank market", although

a few insurance companies and other kinds of financial firms are involved.

Trades between foreign exchange dealers can be very large, involving hundreds

of millions of dollars. Because of the sovereignty issue when involving two

currencies, forex has little (if any) supervisory entity regulating its actions.
The foreign exchange market assists international trade and investments by

enabling currency conversion. For example, it permits a business in the United

States to import goods from European Union member states, especially

Eurozone members, and pay Euros, even though its income is in United States

dollars. It also supports direct speculation and evaluation relative to the value of

currencies, and the carry trade, speculation based on the interest rate differential

between two currencies.

In a typical foreign exchange transaction, a party purchases some quantity of

one currency by paying with some quantity of another currency. The modern

foreign exchange market began forming during the 1970s after three decades of

government restrictions on foreign exchange transactions (the Bretton Woods

system of monetary management established the rules for commercial and

financial relations among the world's major industrial states after World War II),

when countries gradually switched to floating exchange rates from the previous

exchange rate regime, which remained fixed as per the Bretton Woods system.

Dollarization

Dollarization occurs when a country decides not to issue its own currency and

uses a foreign currency as its national currency. Although dollarization usually

allows a country to be seen as a more stable place for investment, the downside

is that the country's central bank can no longer print money or control the

country's monetary policy.

Pegged Rates

Pegging is when one country directly fixes its exchange rate to a foreign

currency so that the country will have somewhat more stability than a normal

float. More specifically, pegging allows a country's currency to be exchanged at

a fixed rate. The currency will only fluctuate when the pegged currencies

change.

Objectives of the study

• To understand the foreign exchange market and it’s working.

• To determine how the foreign exchange rate is set.

• To determine the factors influencing the foreign exchange rate.

• Consequences of foreign exchange rate fluctuations.

Scope of the study

• Foreign exchange markets.

• Factors influencing Foreign Exchange Rates.

• Consequences of exchange rate fluctuations.

Need for Foreign Exchange

The foreign exchange market is unique because of the following characteristics:

• its huge trading volume representing the largest asset class in the world

leading to high liquidity;

• its geographical dispersion;

• its continuous operation: 24 hours a day except weekends, i.e., trading

from 22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);

• the variety of factors that affect exchange rates;

• the low margins of relative profit compared with other markets of fixed

income; and

• the use of leverage to enhance profit and loss margins and with respect to

account size.

Review of the Literature

The topic of currency exchange rates and factors influencing their changes have

been reviewed by many scholars in the last decades and still remains to be one

of the hot topics in international economic studies. The first attempts to analyze

exchange rates behavior were done by Rudiger Dornbusch in 1973, Richard

Meese in 1979 and Kenneth Rogoff in 1983.

The Dornbusch (or overshooting) model analyses exchange rate adjustments

considering sticky prices and rational expectations (Marrewijk, 2007, p. 540-

556). In the essay on purchasing power parity (1987) Dornbusch made clear that

it remains an important concept, though the evidence in recent years is more

remarkable for deviations from, than observance of, such parity (Boykorayev,

2008, p. 22-23).
The combination of exchange rate analysis and the factors that determine

nominal exchange rates was clearly performed by Philip Lane. He did

theoretical and empirical research on long-run exchange rates and built own

model. He analysed long run nominal and real exchange rates of 107 countries

in 890 1974-1992, and added to his model such variables like trade openness,

country size, central bank independence and government debt (Lane, 1999, p.

118-138). Before him all the works had considered a smaller number of

developed countries within less time period. His econometric results show that

the most important factor affecting nominal exchange rate is inflation and

factors driving long-run inflation. Moreover, openness, output growth and the

terms of trade resulted to be significant, but country size was insignificant. In

overall, results show that the debt effect is most important for high

depreciation/inflation countries. Openness, size, and the stock of nominal

government debt - variables that affect the tendency to inflate - are significant in

explaining the rate of nominal depreciation. However, the results for the terms

of trade, another factor that ought to affect the nominal exchange rate via its

influence on the real exchange rate, are mixed. For the OECD countries, the

factors driving inflation appear to dominate the determination of the nominal

exchange rate (Lane, 1999, p. 130).

What is the Foreign Exchange Rate?

The price of a nation’s currency in terms of another currency. An exchange rate

thus has two components, the domestic currency and a foreign currency, and

can be quoted either directly or indirectly. In a direct quotation, the price of a

unit of foreign currency is expressed in terms of the domestic currency. In an

indirect quotation, the price of a unit of domestic currency is expressed in terms

of the foreign currency. An exchange rate that does not have the domestic

currency as one of the two currency components is known as a cross currency,

or cross rate.

Also known as a currency quotation, the foreign exchange rate or forex rate.

BREAKING DOWN

An exchange rate has a base currency and a counter currency. In a direct

quotation, the foreign currency is the base currency and the domestic currency

is the counter currency. In an indirect quotation, the domestic currency is the

base currency and the foreign currency is the counter currency.

Most exchange rates use the US dollar as the base currency and other currencies

as the counter currency. However, there are a few exceptions to this rule, such

as the euro and Commonwealth currencies like the British pound, Australian

dollar and New Zealand dollar.

Exchange rates for most major currencies are generally expressed to four places

after the decimal, except for currency quotations involving the Japanese yen,

which are quoted to two places after the decimal.

Types of Foreign Exchange Rates

Floating Rates: Floating rates is one of the primary reasons for fluctuation of

currency in foreign exchange market. This is one of the most important

commonly and main type of exchange rate. Under this market force, all the

economies of developed countries allow there currency to flow freely. When the

value of the currency becomes low it makes the imports more and the exports

are cheaper, so the countries domestic goods and services are demanded more in

foreign buyers. The country can withstand the fluctuation only if the economy is

strong. When the country’s economy is able to meet the demand then it can

adjust between the foreign trade and domestic trade automatically.

Fixed Rates: Fixed exchange rates are used to attract the foreign investments

and to promote foreign trade. This type of rates is used only by small developed

countries. By Fixed exchange rates the country assures the investors for the

stable and constant value of investment in the country. A monetary policy of the

country becomes ineffective. In this type the exchange rates the imports become

expensive. The exchange value of the currency does not move. This normally

reduces the country’s currency against foreign currencies.

Pegged Rates: This rate is between the floating rate and the fixed rate. Pegged

rates appropriate more for developed country. A country allows its currency to

fluctuation to some extend for adjusted central value. Pegged allow some

adjustments and stability. No artificial rates are found in fixed and floating

exchange rates. Pegged can fix the economic problem by itself and provide

growth opportunity also. When a fixed value is not maintains by the country it

can’t follow the fixed exchange rate.

Theories of Exchange Rate

The theories of the exchange rate began to flourish in the beginning of 1960s.

However, despite their large number and considerable diversity, most of them

consider only some selected issues and there are few works carried out,

conducting a comprehensive analysis of the factors influencing the exchange

rate levels.

The modern explanation of the long-term exchange rate determination is based

upon the theory of purchasing power parity (PPP) between different currencies,

that derives its essential validity from the law of the single price. According to

the purchasing power parity theory, in the long run, identical products and

services in different countries should cost the same. This is based on the

principle that exchange rates will adjust to eliminate the arbitrage opportunity of

buying cheaper goods or services in one country and selling it at increased

prices in another (Boykorayev, 2008, pp. 8-9). The theory only holds for
tradable goods and ignores several real world factors, such as transportation

costs, tariffs and transaction costs. The other assumption is existence of

competitive markets for the goods and services in all countries.

The relative version of the PPP doctrine avoids some of the weaknesses

characteristic of its absolute version and continues to serve as the foundation for

the theory of evolution of exchange rates over time. It assumes a causal link

between the path of the price of a unit of one currency in terms of another and

the relative dynamics of price levels in the respective two countries within a

lengthy period of time. The determinants of the long-term behavior of exchange

rates through time are essentially reduced to the same factors which govern the

evolution of the domestic value of money. However, specific factors like

changes in the structure of production (e.g. shift in relative weights of tradables

and non-tradables), differences in dynamics of labour productivity or changes in

the magnitude and composition of aggregate demand are liable to induce not

only temporary but also relatively durable divergences of exchange rates away

from their presumed long-term equilibrium (or PPP) levels (Lutkowski, 2007, p.

56).

Short-term behaviour of exchange rates can be explained by the uncovered

interest parity (UIP) condition (Montiel, 2012, p. 82-87). The characteristic

feature of this approach is regarding currencies basically as assets. Assuming

free cross-border capital mobility and perfect substitutability of the domestic

and currency deposits, the relative demand for currencies is largely determined

by the expected yields, which they offer. That yield is dependent upon the rates

of interest at home and abroad and upon the expected change in the rate of

exchange of the two currencies (Rubaszek and Serwa, 2009, p. 131-133).

The fundamental importance of the long-term rate of exchange, as explained by

the PPP doctrine with all the attendant qualifications, resides within this context

in anchoring the current exchange rate in expectations for the future, after

accounting for the difference in the foreign and domestic interest rates.

However, long-run general equilibrium implies, that both the PPP condition and

the UIP condition hold simultaneously (Lutkowski, 2007, p. 56).

Classification of Factors affecting Exchange Rate Levels

The nominal exchange rate is the home-country currency price of a foreign

currency. It measures the relative price of two countries’ currencies (in a given

moment in the foreign exchange market). The real exchange rate can be defined

as the rate at which two countries’ goods trade against each (Reinert, 2012, p.

229-232; Krugman, Obstfeld, 2007, p. 47). Like any price, exchange rate

deviates from the valuation basis - the purchasing power of currencies - under

the influence of demand and supply of currency. The correlation of such supply

and demand depends on several factors. Exchange rate reflects its relationship

with other economic categories - cost, price, money, interest rate, the balance of

payments (Boykorayev, 2008, p. 9).

There is no consensus in the literature on the factors affecting exchange rates

and their volatility. Usually they are divided into two groups: economic and

non-economic factors. In the first group, we can distinguish the long-term and

short-term factors. Analysing the impact of various factors on exchange rate, the

relative values (in relation to situation abroad – especially in main trading

partners’ countries) should be taken into account.

Recently, global factors have been becoming more and more important. It also

concerns the Polish currency market, that in comparison to the world market, is

characterized by a relatively high share of foreign entities. The dominance of

transactions with non-residents1 indicates that the Polish foreign exchange

market is gaining features of extra-territorial market. This phenomenon causes

the zloty exchange rate fluctuations are strongly influenced by changes in the

financial performance of the global market.

Factors influencing Foreign Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading

relationship between two countries. Remember, exchange rates are relative, and

are expressed as a comparison of the currencies of two countries. The following

are some of the principal determinants of the exchange rate between two

countries. Note that these factors are in no particular order; like many aspects of

economics, the relative importance of these factors is subject to much debate.

Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a

rising currency value, as its purchasing power increases relative to other

currencies. During the last half of the 20th century, the countries with low

inflation included Japan, Germany and Switzerland, while the U.S. and Canada

achieved low inflation only later. Those countries with higher inflation typically

see depreciation in their currency in relation to the currencies of their trading

partners. This is also usually accompanied by higher interest rates.

Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By

manipulating interest rates, central banks exert influence over both inflation and

exchange rates, and changing interest rates impact inflation and currency values.

Higher interest rates offer lenders in an economy a higher return relative to

other countries. Therefore, higher interest rates attract foreign capital and cause

the exchange rate to rise. The impact of higher interest rates is mitigated,

however, if inflation in the country is much higher than in others, or if

additional factors serve to drive the currency down. The opposite relationship

exists for decreasing interest rates - that is, lower interest rates tend to decrease

exchange rates.
Current-Account Deficits

The current account is the balance of trade between a country and its trading

partners, reflecting all payments between countries for goods, services, interest

and dividends. A deficit in the current account shows the country is spending

more on foreign trade than it is earning, and that it is borrowing capital from

foreign sources to make up the deficit. In other words, the country requires

more foreign currency than it receives through sales of exports, and it supplies

more of its own currency than foreigners demand for its products. The excess

demand for foreign currency lowers the country's exchange rate until domestic

goods and services are cheap enough for foreigners, and foreign assets are too

expensive to generate sales for domestic interests.

Public Debt

Countries will engage in large-scale deficit financing to pay for public sector

projects and governmental funding. While such activity stimulates the domestic

economy, nations with large public deficits and debts are less attractive to

foreign investors. The reason? A large debt encourages inflation, and if inflation

is high, the debt will be serviced and ultimately paid off with cheaper real

dollars in the future.

Consequences of Exchange Rate Fluctuations

A high exchange rate will mean that prices of exports are higher and imports are

lower. This will reduce demand for exports and reduce AD. A reduction in AD
will create unemployment and reduce economic growth. This would therefore

deteriorate the current account.

Similar effects are added by an increased demand for imports, however this is

all dependent on the price elasticities of exports and imports. Should they be

price inelastic, then there is likely to be little change. Lower import prices can

be beneficial to customers however. This is because households can buy more

goods and services which is likely to increase their living standards.

Fluctuating exchange rates however are riskier because they create uncertainty.

Producers will be reluctant to buy international stock for fear that its value will

depreciate in the following months. The profit of selling the goods may be less

than what it was initially or perhaps more. Uncertainty therefore acts as a

disincentive to trade.

There are ways to avoid this risk however. One way is to use future markets.

This is where firms can guarantee an exchange rate by buying currencies at a

fixed rate some point in the future.

World prices despite exchange rate fluctuation are stable. This is because

exporters price their products for their export markets and absorb exchange rate

changes in their profit margins. This means that exchange rate fluctuations,

while important, do not have as strong an impact on international trade that

some may claim.

Nevertheless, the argument for exchange rate stability still exists with some

arguing the case for a single currency as is the case with the EU. They believed

that since trade was high between their countries, a fixed exchange rate would

be beneficial and encourage trade and investment.

Conclusion

Exchange rates are basically the prices of one currency in terms of other

currencies driven by the normal forces of supply and demand. The empirical

studies relating to the link between exchange rate variability and its factors are

not conclusive.

The conducted analysis reveals that the financial account balance and inflation

rate are the most important factors determining the level of EUR/PLN exchange

rate. While a rise in Poland’s financial account surplus contributes to

appreciation of the country’s currency, an increase in inflation rate has a

negative effect and reduces the value of Polish currency.

The market interest rate is the third most important factor determining the zloty

exchange rate level. The relative rise in interest rates contributes to appreciation

of the Polish currency, because it encourages foreign investors to invest in

Poland. The fourth important variable which bring more variation in the zloty

exchange rate is the government deficit, while the economic growth and the

current account are less significant.

Based on these evidence it is clear that in Poland fiscal and monetary policies

play an important role in affecting the zloty exchange rate changes. It is

recommended to harmonize these both policies and to make an effective link

between them and other economic policies (like investment or trade policy).

Effective and smooth running of fiscal and monetary policies are required to

reduce inflation and boost up economic growth.

References

 https://www.investopedia.com/articles/forex/053115/understand-indirect-

effects-exchange-rates.asp

 https://www.compareremit.com/money-transfer-guide/key-factors-

affecting-currency-exchange-rates/

 https://www.bis.org/publ/work4.pdf

 https://www.economicsdiscussion.net/foreign-exchange/theories-foreign-

exchange/theories-of-exchange-rate-determination-international-

economics/30637

 https://www.nber.org/system/files/chapters/c6829/c6829.pdf

 https://www.sciencedirect.com/science/article/abs/pii/

S0304393203000916