IE II Chapter One

International Economics II
CHAPTER ONE
1. THE FOREIGN EXCHANGE MARKET
Introduction
Among the factors that make international economics a distinct subject is the existence of
different national monetary units of account. In the United States, prices and money are
measured in terms of the dollar1, whereas the birr signify this role in Ethiopia. A typical
international transaction requires two distinct purchases. First, the foreign currency is
bought; second, the foreign currency is used to facilitate the international transaction. For
example, before Ethiopian importers can purchase commodities from, say, U.S.
exporters, they must first purchase dollars to meet their international obligation. Some
institutional arrangements are required that provide an efficient mechanism whereby
monetary claims can be settled with a minimum of inconvenience to both parties. Such a
mechanism exists in the form of the foreign-exchange market. In this chapter, we will
examine the nature and operation of this market.
1.1.What is a Foreign Exchange Market?
Just as other prices in the economy are determined by the interaction of buyers and
sellers, exchange rates are determined by the interaction of the households, firms, and
financial institutions that buy and sell foreign currencies to make international payments.
A given money (currency), in addition to buying goods and services, can buy another
money (currency). It may also be sold by itself for yet another currency. This implies that
there is market (a place or an arrangement) in which currencies of different countries are
purchased and sold. That market is termed the foreign exchange market. The market
consists of various groups (individuals) of the society. The foreign exchange market
refers to the organizational setting with in which individuals businesses, governments and
banks buy and sell foreign currencies.
The market in which international currency trades take place is called the foreign
exchange market. The foreign-exchange market refers to the organizational setting
within which individuals, businesses, governments, and banks buy and sell foreign
currencies and other debt instruments. In general, the foreign exchange market is the
mechanism by which participants:
– Transfer purchasing power between countries;
– Obtain or provide credit for international trade transactions, and
– Minimize exposure to the risks of exchange rate changes.
1
Because of its pivotal role in so many foreign exchange deals, the dollar is sometimes called a
vehicle currency. A vehicle currency is one that is widely used to denominate international
contracts made by parties who do not reside in the country that issues the vehicle currency.
Compiled BY: Temesgen Z. (MSc) Page 1

Unlike stock or commodity exchanges (markets), the foreign-exchange market is not an

organized structure. It has no centralized meeting place and no formal requirements for
participation. Nor is the foreign-exchange market limited to anyone country. Three of the
largest foreign-exchange markets in the world are located in London, New York, and
Tokyo.
Indeed, the foreign exchange market is a round-the-clock operation. A typical foreign-
exchange market functions at three levels: (1) in transactions between commercial banks
and their commercial customers, who are the ultimate demanders and suppliers of foreign
exchange; (2) in the domestic interbank market conducted through brokers; and (3) in
active trading in foreign exchange with banks overseas. Exporters, importers, investors,
and tourists buy and sell foreign exchange from and to commercial banks rather than each
other.
1.2.Characteristics and Participants of the Foreign Exchange Market
Characteristics of Foreign exchange market

 Largest of all financial markets with average daily turnover of over $2 trillion!
 66% of all foreign exchange transactions involve cross-border counterparties.
 Only 11% of daily spot transactions involve non-financial customers.
 London is the largest FX market.
 US dollar involved in 87% of all transactions.
The Actors in Foreign exchange market
The foreign exchange market assists international trade and investment by enabling
currency conversion. This market consists of two tiers. The interbank or wholesale
market and the client or retail market in which specific and small amounts of transactions
are involved. Five broad categories of participants operate within these two tiers. (1)
Bank and nonbank foreign exchange dealers (use the difference between Bid and Ask
price which is called spread price). (2) Individuals (such as tourists) and firms such as
exporters or importers (they use hedgers to avoid or minimize exchange rate risk). (3)
Speculators and arbitragers. (4) Central banks and treasuries. (5) Foreign exchange
brokers.
1.3.Functions of the Foreign Exchange Markets
The principal function of foreign exchange market is the transfer of funds from
one nation and currency to another. This is usually accomplished by Reuter’s
electronic trading system, where all markets around the world are connected
through a network.

The role of commercial banks as clearing houses for the foreign exchange
demanded and supplied in the course of foreign transactions by the nations
residents.
In the absence of this function, for example, a domestic importer needing US
dollars would have to locate a domestic exporter with US dollars to sell. This
would be time consuming and inefficient.
Another function of foreign exchange markets is the credit function. Credit is
usually needed when goods are in transit and also to allow the buyer time to resell
the goods and make payment. Most commonly, exporters allow 90 days for
importer to pay. However, the exporter usually discounts the importer’s
obligation to pay at the foreign department of his commercial bank. As a result,
the exporter receives payment right away, and the bank will eventually collect the
payment from the importer when due.
The last and most important function of foreign exchange market is to provide the
facilities for hedging (exchange risk avoidance) and speculation (exchange risk
taking).
United States Dollar as a Vehicle Currency
A currency such as the U.S. dollar used to denominate international contacts and
international transactions, without involving United States. This is because today US
dollar is dominant vehicle currency, serving unit of account, medium of exchange, and
store of value not only for domestic transactions but also for official international
transactions. The benefit that the US receives from the dollar being used as a vehicle
currency is called seignorage and it amounts to an interest-free loan from foreigners to
the US on the amounts of dollars held abroad.
1.3. Supply and Demand for Foreign Exchange
The value of a nation’s money, like most goods and services, can be analyzed by looking
at its supply and demand. For example an increase in the demand for the dollar will raise
its price (cause an appreciation in its value), while an increase in its supply will lower its
price (cause a depreciation). These are only tendencies, however, and depend on other
factors remaining constant.
A) Demand for foreign exchange

Figure 1.1 shows the demand for US $ in Ethiopia. The exchange rate is measured on the
vertical axis and quantity of the foreign currency (US$) is measured on the X-axis. The
exchange rate R is a measure of the price of the foreign currency (US$) in terms of
domestic currency (Ethiopia Birr). An increase in R implies a decline in the value of Birr
and an increase in the value of US$.

In other words, a movement up on the vertical axis represents an increase in the price of
foreign currency (which is equivalent to a fall in the price of Birr). For Ethiopians,
American goods are less expensive when the Dollar is cheaper and the Birr is stronger.
Hence, at the depreciated values for the dollar, Ethiopians will switch from home made or
third-party supplies of goods and service to American suppliers.
Exchange rate in Birr/$ = R
Quantity of foreign currency
Figure 1.1. Demand for foreign exchange
Before they can purchase goods made in USA, however, they must first exchange Birr for
US$. Consequently, the increased demand for US goods is simultaneously an increase in
the quantity of US $ demanded.
A nation’s demand for foreign exchange is derived from, or corresponds to, the debit
items on its balance of payments. For example, the Ethiopian demand for pounds may
stem from its desire to import British commodities, to make investments in Britain, or to
make transfer payments to residents in Britain!
Like most demand schedules that you know, Ethiopian demand for pounds varies
inversely with its price. That is fewer pounds are demanded at higher prices than at lower
prices. This relation ship is depicted by line D fe in figure 2.1. As the birr price of the
pound rises (called depreciation of the birr) UK goods and services become more
expensive to Ethiopian importers. This is because more birrs are required to purchase
each pound needed to finance the import purchases. The higher exchange rate, R, reduces
the number of imports bought, lowering the number of pounds demanded by Ethiopian
residents.
In like manner, when the birr price of the pound falls (known as appreciation of the birr),
UK commodities will be cheaper to import by Ethiopians. Since relatively fewer birrs are
required, there would be an expectation of larger import purchases and thus more pounds
will be demanded by Ethiopians.

The Ethiopian demand for pounds is based on the assumption that all relevant factors
other than the exchange rate are given and constant. These other factors include changes
in income, prices, interest rates, costs, and tastes and preferences. All these can induce
changes in the debit items of the balance of payments.
B) Supply curve for foreign exchange
The supply of foreign exchange for a given country results from transactions that appear
on the credit side of that country’s BoPs. The supply of pounds, for instance, is generated
by the desire of UK residents and businesses to import Ethiopian goods and services, to
lend funds and make investments in Ethiopia, and to extend transfer payments to
Ethiopian residents. In each of these cases, the British offer pounds in the foreign
exchange market to obtain the birrs they need to make payments to Ethiopians.
The supply of pounds is denoted by line Sfe in figure 2.1.The graph represents the number
of pounds offered by the British to obtain birrs which to buy Ethiopian goods, services
and assets. It is depicted in the figure as a positive function of the Ethiopian exchange
rate. As the birr depreciates against the pound (as the birr price of the pound rises), the
British will be inclined to buy more Ethiopian commodities.
The reason for that huge purchase is of course, at higher and higher birr prices of pounds
the UK can get more Ethiopian birrs and hence more goods per pound. Ethiopian goods
thus become cheaper to the British, who are induced to purchase additional quantities.
These purchases results in more pounds being offered in the foreign exchange market to
buy birrs with which to pay Ethiopian exporters. But, note that the supply of foreign
exchange can not necessarily be upward sloping.
The supply curve of foreign currency slopes up

because foreign firms and consumers are
willing to buy a greater quantity of domestic
goods as the domestic currency becomes
cheaper. The supply of US$ will increase if US
and/or foreign citizens are willing to buy a
greater quantity of Ethiopia’s goods as the Exchange rate in Birr/$ =
Ethiopian currency becomes cheaper (i.e. as the
foreigners receive more birr per USD). Before S
the foreign citizens can buy Ethiopia goods,

however, they must first convert Dollar into
Birr, so the increase in quantity of Ethiopian
good demanded is simultaneously an increase
in the quantity of foreign currency supplied to
$
the Ethiopian Economy.
Quantity of foreign currency
Figure 5.2. Supply of foreign exchange

1.4.The Foreign Exchange Rate

1.5.1 Different Concepts of Exchange Rates
Most daily newspapers publish foreign-exchange rates for major currencies. The exchange rate
is the price of one currency in terms of another-for example, the number of Ethiopian birr (ETB)
required to purchase 1 British pound (£) or 1 U.S. dollar ($). In shorthand notation, ER =
ETB1£ (or ETB/$), where ER is the exchange rate. For example, if ER = 25, then purchasing £1
will require 25ETB. It is also possible to define the exchange rate as the number of units of
foreign currency required to purchase 1 unit of domestic currency, or ER' =$/ETB. Exchange
rates play a central role in international trade because they allow us to compare the prices of
goods and services produced in different countries.
The exchange rate (E) is the rate at which one currency exchanges for another. It is, therefore, a
monetary phenomenon. One may view the exchange rate as indicator of the relative price goods
and services denominated in currencies of the two nations concerned. Put the other way,
exchange rate can be regarded as the relative price of assets denominated in the currencies of a
pair of countries. There are two conventions for measuring the exchange rate, the distinction
between which is often the source of serious confusion.
1. Domestic Currency Units per Unit of Foreign Currency
Let's take Birr is the home currency and Dollar is the foreign currency, and birr 1 exchanges for
$2, then the exchange rate is 0.5. The domestic currency is on the numerator of the ratio. Note
that this definition means whenever E raises the home currency gets weaker; it depreciates. For
example, a rise from 0.5 to 0.67 means that birr exchanged for $1.5, less than before.
Conversely, when E falls, the domestic currency gets stronger; it appreciates.
2. Foreign Currency Units per Unit of Domestic Currency
Under flexible exchange rate system the exchange rate is completely market determined, without
any interference from government authorities (the central bank). The balance of payments
balances: surpluses are eliminated via exchange rate appreciation; deficits are cured through
exchange rate depreciation. In other word, balance of payments disequilibrium is self correcting.
On the other hand, under fixed exchange rate system the rate of exchange is a policy parameter
fixed by the authorities. They have to meet excess demand for a foreign currency (not financed
by the sales in that foreign country) from the reserves of foreign currency. Net inflows of foreign
currency swell the domestic money supply, as private economic agents who don't use it to
purchase goods abroad convert foreign currency to domestic currency at the fixed rate of
exchange. Fixed exchange rate makes the domestic money supply dependent on foreign
exchange reserves. In addition, balance of payments deficit cause reserve losses and surpluses
cause reserve to be built up: there is no self-correcting mechanism to balance of payments
disequilibria. These two exchange rates are the two polar extremes in the economics of exchange
rate. In realty we have a pastiche of arrangement, somewhere in between the two. Even with
flexible rates, central banks do interfere with the market determined exchange rate, often in an
internationally concerted fashion. This is known as a managed float (consider the Ethiopian

case). Fixed exchange rate also allow for realignments and changes in the exchange rate, usually
devaluation.
1.5.2. Spot and Forward Exchange Rates
There are two types of exchange rate, depending on the timing of the actual exchange of
currencies. (1) The spot exchange rate: which is the price for the immediate exchange of
currencies. For standard large trades in the market, immediate exchange for most currencies
means exchange or delivery in two working days after the exchange is agreed.
(2) The Forward exchange rate: is the price of currencies set now for an exchange of those
currencies that will take place sometime in the future such as 30 , 60 days, or 180 days from
now.
As we said earlier, the most common type of foreign exchange transaction involves the payment
and receipt of the foreign exchange within two business days after the day the transaction is
agreed upon. This type of transaction is called a spot transaction. The exchange rate at which a
spot transaction takes place is called the spot rate (SR). The exchange rate R = Br/₤ = 56 is thus
a spot rate.
On the other hand, we have forward transactions. These involve an agreement today to buy or
sell a specified amount of a foreign currency at a specified future date at a rate agreed upon today
(the forward rate, FR). The equilibrium forward rate is determined at the intersection of the
market demand and supply curves of foreign exchange for future delivery. For example, you may
agree to buy $2000 a month later at a rate of 8.60 birr per dollar = FR = 8.6. Note that no
currencies are paid out on the day you sign the agreement. It is rather after a month that you will
get the $2000 when you pay Br.17,200 (= 2000x8.60). At the time payments are paid out, the
spot rate may be exactly equal to, greater than, or less than the forward rate.
If the forward rate is below the present spot rate, the foreign currency is said to be at a forward
discount (FD) with respect to the domestic currency. For our earlier example, if the spot rate
when you take the $2000 after a month at a forward rate of Br.8.60 per dollar was, 8.70 the
dollar is at a forward discount of 10 cents or 1.15 percent (or at a 13.8 percent annual discount)
with respect to the birr.
When the forward rate is above the present spot rate the foreign currency is at a forward
premium (FP) with respect to the domestic currency. For example, suppose the monthly forward
rate is still Br 8.60 = $1 but the spot rate is instead 8.55 birr per dollar. The dollar is therefore
said to be at a premium of 5 cents (= 8.60 - 8.55) or 0.6 percent (or at a 7 percent forward
premium per year) with respect to the Ethiopian currency.
Dear Learner! Forward discounts and premiums are usually expressed as percentages per year
from the corresponding spot rate. They can be calculated formally with the following formula:
Forward = Forward rate – Spot rate χ ___12________ χ 100
Premium (Discount) Spot rate No. of Months forward

If the result is negative, it means a forward discount. A positive result implies a forward
premium of the foreign currency.
1.5.3 Nominal, Real and Effective Exchange Rates
The real exchange rate is the ratio of foreign to domestic prices, measured in the same currency.
It measures a country’s competitiveness in the international trade. The real exchange rate R, is
usually defined as
R=ePf/P
Where P and Pf are the price levels here and abroad, respectively and e is the birr price of foreign
exchange (the nominal exchange rate). If the exchange rate equals 1, currencies are at purchasing
power parity (PPP). A real exchange rate above 1 means, that goods abroad are more expensive
than goods at home. Other things equal, this implies that people- both at home and abroad- are
likely to switch some of their spending to goods produced at home. This is often described as an
increase in the competitiveness of our products. As long as R is greater than 1, we expect the
relative demand for domestically produced goods to rise.
Nominal Exchange rate (e) is the relative price of currency of two countries. For example, if the
exchange rate between the Ethiopian birr and the U.S dollar is 8 birr per dollar, then you can
exchange one dollar for 8 birr in the world markets for foreign currency.
Effective Exchange Rate
Over time, a given currency may appreciate with respect to some currencies and depreciate
against others. Such events may leave the general public confused as to the actual value of that
given currency.
Throughout the day, the value of the birr may change relative to the values of any number of
currencies under market determined exchange rates. Direct comparison of the birr’s exchange
rate over time thus requires a weighted average of all the bilateral changes. Suppose the
Ethiopian birr appreciates 3 percent relative to the Japanese yen and depreciates 5 percent against
the German mark. The change in the birr’s international value is some weighted average of the
changes of these two bilateral exchange rates. This average is referred to as the birr’s effective
exchange rate.
 Effective exchange rate is a weighted average of the exchange rates between the
domestic currency and the nation’s most important trade partners, with weights given by
the relative importance of the nation’s trade with each of these trade partners.
The effective exchange rate may be nominal or real. The nominal effective exchange rate is one
that does not take in to account differences between domestic and foreign inflation rates. An
increase in the birr’s nominal effective exchange rate, for instance, indicates an appreciation of
the birr relative to other currencies of trading partners. This is a loss of price competitiveness for
Ethiopia. Conversely, a decrease in the birr’s nominal effective exchange rate implies birr

depreciation relative to the other currencies and an improvement in Ethiopia’s international price
competitiveness.
It is widely maintained, however, that international trade patterns depend on inflation – adjusted
exchange rates, rather than on the purely nominal exchange value of currencies. The real
effective exchange rate of the Ethiopian birr is thus derived by adjusting the nominal exchange
rate for the differential between Ethiopian inflation rate and the weighted average of the inflation
rates in the important trade partners of Ethiopia. If this real value rises, the birr appreciates
relative to other currencies, and vice versa.
1.5.4 The Determinants of Exchange Rates
Have you ever wondered how exchange rates are determined? As one of the leading factors
behind the economic health level of any given country, exchange rates are one of the most
analysed economic measures on the planet. But what exactly influences currency exchange rates
and why are they so important to everyone from governments and large financial institutions to
small investors?
Supply and demand dictate foreign exchange rates. For example, greater demand for British
goods would see an increase in the value (appreciation) of the Pound. Markets worried about the
future of the Eurozone economies would tend to sell Euros leading to a depreciation of the Euro.
1. Inflation
Inflation is a general rise in prices in an economy, i.e., goods, and services and is usually
expressed in percentages. If, for example, inflation was lower in the Ethiopia, the purchasing
power of the birr would increase relative to other currencies. Ethiopian exports become more
competitive and the demand to purchase birr for Ethiopian goods will increase.
2. Interest rates
There is also a strong correlation between inflation, interest rates and exchange rates.
Governments and Central Banks have the authority to influence exchange rates by increasing
interest rates. An example of this is “Hot money”: the higher the interest rate the more attractive
the currency offer is to foreign investors.
This involves investor’s rapidly and frequently moving money from a currency with lower
interest rates to a country with higher interest rates, giving a quick return on investment.
3. Government/Public debt
A country’s debt rating is also a factor that influences its currency exchange rate. Public sector
projects sometimes require large-scale deficit financing which boosts the domestic economy.
However, foreign investors are less likely to invest in countries with large public deficits and
government debt. Fear of a debt default can result in the selling of bonds denominated in that
currency by investors, resulting in a fall in the value of the exchange rate. Governments may
also need to print money to pay parts of a large debt, resulting in inflation.

4. Political stability
The strength of a currency can also be influenced by the political stability of a particular country.
Foreign investors are more attracted to invest in countries displaying a lower propensity for
political turmoil. This injection of foreign investment leads to an appreciation of the domestic
currency. Conversely, unpredictable events leading to unstable conditions in a country mean less
foreign investment naturally leading to depreciation in the domestic currency.
5. Economic recession
In theory, when a country enters a recession there is normally a depreciation of its currency. Why
so? Firstly, it is commonplace for interest rates to fall in a recession and when this happens, we
see a flow of money out of the country to countries with higher interest rates.
If for example, Canada entered a recession and money started to flow out of the country, its
people would sell Canadian dollars to buy other currencies resulting in a fall in the value of CAD
(Canadian dollar). It must be noted that economic and political events in other countries will also
influence how a domestic currency moves in times of recession.
For example, in a global recession, the United States may still be seen as a haven for investors
(even though it may experience high inflation and low interest rates) keeping its currency stable
or even stronger than other currencies.
6. Terms of Trade
The Terms of Trade (ToT) or Balance of Trade as it is sometimes known, is the difference
between the monetary value of a nation’s exports and imports over a certain time period.
The terms of trade will improve if the price of a given country’s exports rises by a greater rate
than that of its imports.
A greater demand for a country’s exports means an improvement in terms of trade resulting in
rising revenues and, consequently, an increased demand for that country’s currency. This will
naturally increase the value of that currency.
7. Current account deficits
The current account deficit is closely related to the terms or balance of trade.
The current account measures imports and exports of goods and services but also payments to
foreign holders of a country’s investments, payments received from investments abroad, and
transfers such as foreign aid and remittances.
If for example, Britain, as a regular trading partner with Canada had a higher current account
deficit this could weaken the pound relative to the Canadian dollar.
Countries therefore with lower current account deficits will tend to have stronger currencies than
those with higher deficits.
8. Confidence and speculation
Political events or changes in commodity prices may cause a currency to fall in value. If
speculators believe the Euro will fall, they will sell now for a currency they feel will rise in
value. For this reason, sentiments in the financial markets can heavily influence foreign
exchange rates.

If the markets are alerted to the possibility of an interest rate increase in the Eurozone for
example, we are more likely to see a rise in the valuation of the Euro as a result.
If a US speculator expects the euro to appreciate over the next 5 months, he will contract to buy
euros in 5 months at a fixed exchange rate. This is known as a forward contract and this
mitigates any risk and losses caused by exchange rate volatility.
9. Government intervention
Governments and Central Banks have the monetary authority to intervene to stabilize a currency
by formulating trade policies, printing more money, or increasing and decreasing interest rates.
China, for example, is reluctant to allow its currency to appreciate because it will negatively
impact its exports.
The Chinese government aims to boost its exports and attract foreign investment by keeping the
yuan artificially low. As an export dependent economy, China does so to compete with
neighbouring countries like Japan and South Korea.
Given China’s large trade surplus, its central bank, the Peoples Bank of China (PBOC) absorbs
large inflows of foreign capital. It purchases foreign currency from exporters and then issues that
currency in local yuan currency.
10. The stock markets
Both the stock market and foreign exchange are the most financially traded markets on the globe.
To help with price predictions, traders often look for correlations between both markets.
The mood of investors is buoyed when a domestic stock market rises as it is an indicator that the
country’s economy is doing well.
As a result, there is increased interest from foreign investors and the demand for local domestic
currency also increases.
When the stock market is underperforming, a lack of confidence means investors will take their
funds back to their own currencies.
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1.6. Exchange Rate Systems
Nations may adopt a fixed (pegged) exchange rate system or a floating one which is determined
solely by the forces of supply and demand in a free market.
1.6.1. Fixed Exchange Rate System
Under a fixed exchange rate system today, governments assign their currencies a par value in
terms of other key currencies. A key currency is one that is widely used with relatively stable
value overtime. The most common key currency is the U.S. dollar. We can thus determine the
official exchange rate of two currencies by comparing their par values. It is developing countries
who usually peg (tie) their currencies to a key currency. Assume, for example, that Argentine
central bankers fix their currency (peso) at 20 peso per U.S $1, where as Ecuador’s sucre is set at
10 sucres = $1 U.S. The official exchange rate between Argentina’s peso and Ecuador’s sucre
becomes 1 peso = 0.5 sucre   10sucre  0.5 
 20 peso 
Note that per values were expressed in terms of gold until gold was phased out of the
international monetary system in the early 1970 s.
Maintaining pegs to a key currency provides several benefits for developing nations. First, the
prices of many developing nation’s traded products are determined primarily in the markets of
industrialized nations such as the United States; by pegging , say to the dollar, these nations can
stabilize the domestic currency prices of their imports and exports. Second, many nations could
reduce inflation by pegging to a key currency. Lessening of inflationary expectations leads to
lower interest rates, less loss of output due to disinflation, and a moderation of price pressures.
Dear Learner! In maintaining fixed exchange rates, nations must decide whether to peg their
currencies to another currency or to a currency basket. Pegging to a single currency is generally
done by developing countries whose trade and financial relationships are mainly with a single
industrial-country partner. For example, Ivory Coast, which trades primarily with France, pegs
its currency to the French franc.
Developing nations with more than one major trading partner often peg their currencies to a
group or basket of currencies. The basket is composed of prescribed quantities of foreign
currencies in proportion to the amount of trade done with the nation pegging its currency. Once
the basket has been selected, the currency value of the nation is computed using the exchange
rates of the foreign currencies in the basket. Pegging the domestic currency value of the basket
enables a nation to average out fluctuation in export or import prices caused by exchange rate
movements. The effects of exchange rate changes on the domestic economy are thus reduced.
A first requirement for a nation participating in a fixed exchange rate system is to determine an
official exchange rate for its currency after pegging. The next step is to set up an exchange
stabilization fund to defend the official rate. Through purchases and sales of foreign currencies,
the exchange stabilization fund attempts to ensure that the market exchange rate does not move
above or below the official exchange rate.

Under a fixed exchange rate system, a nation’s monetary authority may decide to pursue BOPs
equilibrium by devaluing or revaluing its currency. The purpose of devaluation is to cause the
home currency’s exchange value to depreciate, thus counteracting a payments deficit. The
purpose of currency revaluation is to cause the home currency’s exchange value to appreciate,
thus counteracting a payment surplus.
Note that the terms devaluation and revaluation refer to a legal redefinition of a currency’s par
value under a system of fixed exchange rates. The terms depreciation and appreciation,
however, refer to the actual impact on the market exchange rate caused by a redefinition of a par
value, or to changes in an exchange rate stemming from changes in the supply of or demand for
foreign exchange.
1.6.2. Floating Exchange Rate System
By floating (flexible) exchange rates, we mean currency prices that are established daily in the
foreign exchange market. They are fixed independent of restrictions made by government policy
on the extent to which the prices can move. With floating rates, there is an equilibrium exchange
rate that equates the demand for and supply of the home currency. Changes in the exchange rate
will ideally correct a payments imbalance by bringing about shifts in imports and exports of
goods services and short-tem capital movements. The exchange rate in flexible system depends
on relative money supplies, income levels, interest rates prices and other factors discussed in
section 2.3 of the second chapter.
One advantage claimed for floating rates is their simplicity. Floating rates allegedly respond
quickly to changing supply and demand conditions, clearing the market of shortages and
surpluses of a given currency. Because floating rates fluctuate throughout the day, they permit
continuous adjustment in the balance of payments. The adverse effects of prolonged disequilibria
that tend to occur under fixed exchange rates are minimized under floating rates.
It is also argued that floating rates partially insulate the home economy from external forces.
This means that governments will not have to restore payments equilibrium through painful
inflationary and deflationary adjustment policies. Switching to flexible rates frees a nation from
having to adopt policies that perpetuate domestic disequilibrium as the price of maintaining a
satisfactory BOP s position.
Although there are strong arguments in favor of floating exchange rates, this system is
considered to be of limited usefulness for bankers and business people. Critics of flexible rates
maintain that an unregulated market may lead to wide fluctuations in currency values,
discouraging foreign trade and investment. Even though traders and investors may be able to
hedge exchange rate risk by dealing in the forward market, the cost of hedging may become
prohibitively high.
 Adjustable Pegged Rates

A consensus was reached by most nations of the world that neither completely fixed exchange
rates nor floating rates were optimal; instead, they adopted a kind of managed exchange rate
system known as adjustable pegged exchange rates. This system lasted from 1944 to 1973. The
main feature of this system was that currencies are tied to each other to provide stable exchange
rates for commercial and financial transactions. When the BOPs moves a way from its long–run
equilibrium position, a nation can repeg its exchange rate via devaluation or revaluation policies.
This is provided that fiscal and monetary policies fail to make the equilibrium.
1.6.3 Managed Floating Rates
These substituted the international monetary system based on adjustable pegged rates after 1973.
Under managed floating rates, a nation can alter the degree to which it intervenes on the foreign
exchange market. Heavier intervention moves the nation nearer the fixed exchange rate case,
whereas less intervention moves the nation nearer the floating exchange rate system.
Under a managed float, market intervention (central bank or monetary authority’s intervention)
is used to stabilize exchange rates in the short-run. However, in the long run, market forces are
permitted to determine exchange rates.
Fixed versus Flexible Exchange rates
First, there are flexible exchange rates. Under this system the exchange rate is completely
market- determined, without any interference from government authorities (the center bank). The
balance of payments balances: surpluses are eliminated via exchange rates appreciation; deficits
are cured by exchange rate depreciation. In other words, balance of payments disequilibria are
self-correcting. Secondly, there are fixed exchange rates. Here the rate of exchange is a policy
parameter fixed by the authorities. They have to meet excess demand for a foreign currency (not
financed by sales in that foreign country) from their reserves of foreign currency.
Net inflows of foreign currency swell the domestic money supply, as private economic agents
who do not use it to purchase goods abroad convert foreign currency to domestic money at the
fixed rate of exchange.
Fixed exchange rates make the domestic money Supply dependent on changes in foreign
exchange reserves. Also, balance of payments deficits cause reserve losses and surpluses cause
reserve to be built up: there is no self- correcting mechanism to balance of payments
disequilibria. These two exchange rate regimes are the two polar extremes in the economics of
exchange rate. In reality we have a pastiche of arrangement, somewhere in between the two.
Even with flexible rates, central banks do interfere with the market- determined exchange rate,
often in an internationally concerted fashion. This is known as a managed float (consider the
Ethiopian case). Fixed Exchange rates also allow for realignments and changes in the exchange
rate, usually devaluation.
1.7 The Interaction of Hedgers, Arbitrageurs, and Speculators

Arbitrage
We have seen how the supply and demand for foreign exchange can set the market exchange
rate. This analysis was from the perspective of the U.S. (New York) foreign-exchange market.
But what about the relationship between the exchange rate in the U.S. market and that in other
nations? When restrictions do not modify the ability of the foreign exchange market to operate
efficiently, normal market forces result in a consistent relationship among the market exchange
rates of all currencies. That is to say, if £1 = $2 in New York, then $1 = £0.5 in London. The
prices for the same currency in different world locations will be identical.
The factor underlying the consistency of the exchange rates is called exchange arbitrage.
Exchange arbitrage refers to the simultaneous purchase and sale of a currency in different foreign
exchange markets in order to profit from exchange-rate differentials in the two locations. This
process brings about an identical price for the same currency in different locations and thus
results in one market. It take advantage of inconsistent prices to make risk-free profits. Suppose
that the dollar/pound exchange rate is £1 =$2 in New York but £1 =$2.01 in London. Foreign-
exchange traders would find it profitable to purchase pounds in New York at $2 per pound and
immediately resell them in London for $2.01. A profit of 1 cent would be made on each pound
sold, less the cost of the bank transfer and the interest charge on the money tied up during the
arbitrage process. This return may appear to be insignificant, but on a $1 million arbitrage
transaction it would generate a profit of approximately $5,000-not bad for a few minutes' work!
As the demand for pounds increases in New York, the dollar price of a pound will rise above $2;
as the supply of pounds increases in London, the dollar price of the pound will fall below $2.01.
This arbitrage process will continue until the exchange rate between the dollar and the pound in
New York is approximately the same as it is in London. Arbitrage between the two currencies
thus unifies the foreign-exchange markets. The preceding example illustrates two-point arbitrage,
in which two currencies are traded between two financial centers. A more intricate form of
arbitrage, involving three currencies and three financial centers, is known as three-point
arbitrage, or triangular arbitrage. Three-point arbitrage involves switching funds among three
currencies in order to profit from exchange-rate inconsistencies, as seen in the following
example. Consider three currencies- the U.S. dollar, the Swiss franc, and the British pound, all of
which are traded in New York, Geneva, and London. Assume that the rates of exchange that
prevail in all three financial centers are as follows: (1) £1 =$1.50; (2) £1 =4 francs; (3)1 franc

=$0.50. Because the same exchange rates (prices) prevail in all three financial centers, two-point
arbitrage is not profitable. However, these quoted exchange rates are mutually inconsistent.
Thus, an arbitrager with $1.5 million could make a profit as follows:
1) Sell $1.5 million for £1 million.
(2) Simultaneously, sell £1 million for 4 million francs.
(3) At the same time, sell 4 million francs for $2 million.
The arbitrager has just made a risk-free profit of $500,000 ($2 million - $1.5 million) before
transaction costs! These transactions tend to cause shifts in all three exchange rates that bring
them into proper alignment and eliminate the profitability of arbitrage. From a practical
standpoint, opportunities for such profitable currency arbitrage have decreased in recent years,
given the large number of currency traders-aided by sophisticated computer information
systems-who monitor currency quotes in all financial markets. The result of this activity is that
currency exchange rates tend to be consistent throughout the world, with only minimal
deviations due to transaction costs.
The Forward Market

Foreign-exchange markets, as we have seen, may be spot or forward. In the spot market,
currencies are bought and sold for immediate delivery (generally, two business days after the
conclusion of the deal). In the forward market, currencies are bought and sold now for future
delivery, typically 1 month, 3 months, or 6 months from the date of the transaction. The
exchange rate is agreed on at the time of the contract, but payment is not made until the future
delivery actually takes place. Only the most widely traded currencies are included in the regular
forward market, but individual forward contracts can be negotiated for most national currencies.
The Forward Rate
The rate of exchange used in the settlement of forward transactions is called the forward rate.
This rate is quoted in the same way as the spot rate: the price of one currency in terms of another
currency. Thus, under the Tuesday quotations, the selling price of l-month forward U.K. pounds
is $1.8200 per pound; the selling price of 3-month forward pounds is $1.8107 per pound, and for
6-momh forward pounds it is $1.7953 per pound. It is customary for a currency's forward rate to
be stated in relation to its spot rate. When a foreign currency is worth more in the forward market
than in the spot market, it is said to be at a premium; conversely, when the currency is worth less

in the forward market than in the spot market, it is said to be at a discount. The per annum
percentage premium (discount) in forward quotations is computed by the following formula:
Premium (discount) = (Forward rate - Spot rate)/(spot rate)X12/(No. of months forward)
If the result is a negative forward premium, it means that the currency is at a forward discount.
Given the 1month forward Swiss franc selling at $0.7803 and the spot price of the franc at
$0.7797. Because the forward price of the franc exceeded the spot price, the franc was at a
1month forward premium of 0.06 cents, or at a 0.92 percent forward premium per annum against
the dollar:
Premium = ($0.7803 - $0.7797)/$0.7797 X 12/1 =.0092
Similarly, the franc was at a 3-month premium of 0.17 cents, or at a 0.87 percent forward
premium per annum against the dollar: Premium = ($0.7814 - $0.7797)/ $0.7797 X 12/3 =
0.0087
As for the British pound, the 6-month forward pound was at a discount of 3.25 percent per
annum against the dollar: Discount =($1.7953 - $1.8250)/$1.8250 X 12/6 =-0.0325
Functions of Forward Market
The forward market can be used to protect international traders and investors from the risks
involved in fluctuations of the spot rate. The process of avoiding or covering a foreign exchange
risk is known as hedging. Hedging is the act of balancing your assets and liabilities in a foreign
currency to become safe from the risk resulting from future changes in the value of foreign
currency. People who expect to make or receive payments in a foreign currency at a future date
are concerned that if the spot rate changes, they will have to make a greater payment or will
receive less in terms of the domestic currency than expected. This could wipe out anticipated
profit levels. In 1997, many Asian companies lost large sums when Asian currencies sharply
depreciated against the U.S. dollar.
For example, Ayka Addis was forced to absorb an extraordinary loss of $517 million in the third
quarter of 2014. The company had $4.2 billion in foreign borrowing, and none of it was hedged.
The foreign-exchange loss wiped out all of the profits that Siam Cement had chalked up between
1994 and 1996! Prior to 1997, few Asian economies bothered to hedge their foreign-exchange
risks because most Asian currencies were tied to the dollar. The ties were broken, however, as a
result of the Asian financial crises of 1997, and this caught many Asian managers by surprise;

they were unprepared for the adverse effects of volatile currencies. How can firms and investors
insulate themselves from volatile currency values? They can deal in the forward market, as
shown in the following examples when U.S. exporter hedges against a dollar appreciation.
Assume that Microsoft Corporation anticipates receiving 1 million francs in three months from
its exports of computer software to a Swiss retailer. During this period, Microsoft is in an
uncovered position. If the dollar price of the franc falls (the dollar appreciates against the franc),
say, from $0.50 to $0.40 per franc, Microsoft's receipts will be worth $100,000 less when the 1
million francs are converted into dollars. To avoid this foreign-exchange risk, Microsoft can
contract to sell its expected franc receipts in the forward market at today's forward rate. By
locking into a set forward-exchange rate, Microsoft is guaranteed that the value of its franc
receipts will be maintained in terms of the dollar, even if the value of the franc should happen to
fall.
The forward market thus eliminates the uncertainty of fluctuating spot rates from international
transactions. Exporters can hedge against the possibility that the domestic currency will
appreciate against the foreign currency, and importers can hedge against the possibility that the
domestic currency will depreciate against the foreign currency.
Hedging is not limited to exporters and importers. It applies to anyone who is obligated to make
a foreign-currency payment or who will enjoy foreign- currency receipts at a future time.
International investors, for example, also make use of the forward market for hedging purposes.
As our examples indicate, importers and exporters participate in the forward market to avoid the
risk of fluctuations in foreign-exchange rates. Because they make forward transactions mainly
through commercial banks, the foreign-exchange risk is transferred to those banks. Commercial
banks can minimize foreign-exchange risk by matching forward purchases from exporters with
forward sales to importers. However, because the supply of and demand for forward currency
transactions by exporters and importers usually do not coincide, the banks may assume some of
the risk.
Suppose that on a given day, a commercial bank's forward purchases do not match its forward
sales for a given currency. The bank may then seek out other banks in the market that have

offsetting positions. Thus, if Chase Manhattan Bank has an excess of 50-million euro forward
purchases over forward sales during the day, it will attempt to find another bank (or banks) that
has an excess of forward sales over purchases. These banks can then enter forward contracts
among themselves to eliminate any residual exchange risk that might exist.
Foreign-Exchange Market Speculation
Besides being used for the financing of commercial transactions and investments, the foreign
exchange market is also used for exchange-rate speculation. Speculation is the attempt to profit
by trading on expectations about prices in the future. It means taking a long or a short position in
a foreign currency, thereby gambling its future exchange value. Some speculators are traders
acting for financial institutions or firms; others are individuals. In either case, speculators buy
currencies that they expect to go up in value and sell currencies that they expect to go down in
value. Note the difference between arbitrage and speculation. With arbitrage, a currency trader
simultaneously buys a currency at a low price and sells that currency at a high price, thus making
a riskless profit. A speculator's goal is to buy a currency at one moment (such as today) and sell
that currency at a higher price in the future (such as tomorrow). Speculation thus implies the
deliberate assumption of exchange risk: If the price of the currency falls between today and
tomorrow, the speculator loses money. An exchange-market speculator deliberately assumes
foreign-exchange risk on the expectation of profiting from future changes in the spot exchange
rate. Such activity can exert either a stabilizing or a destabilizing influence on the foreign-
exchange market.
1.8. Appreciation / Revaluation and Depreciation / Devaluation of Currencies
18.1. Devaluation versus Revaluation.
Exchange rate language can be very confusing. In particular, the terms depreciation,
appreciation, devaluation and revaluation (overvaluation) recur in any discussion of open
economy macroeconomics. Here we will try to define such terminologies here so that we can
able to facilitate our upcoming discussions.
Devaluation takes place when the price of foreign currencies under fixed exchange rate regime is
increased by official action (you can consider the action of the Ethiopian government to devalue
the currency in 1992. The Birr was devalued in 1992 and this is expected to promote exporters
and discourage importers. This will narrow the gap between exports and imports and
consequently improve the current account. It also narrows the gap between the official and
parallel or black market rates and abolishes illegal trade in the country.) Devaluation thus means

that foreigners pay less for devalued currency and that residents of the devaluing country pay
more for foreign currencies. The opposite of devaluation is revaluation.
1.8.2 Depreciation versus Appreciations

A currency is said to be depreciate when under floating rates it becomes less expensive in terms
of foreign currency. By contrast currency appreciates when it becomes more expensive in terms
of foreign money.
 Foreign Exchange market versus other Financial Markets
The Forex (or currency) market is one of four financial markets. These markets include the
stock, bond, commodity, and currency markets. Each market has its own special characteristics
that attract banks and financial institutions to trade its products. Individuals have only recently
been permitted to trade in the currency markets. Previously, the Forex market was traded
primarily by banks, large financial institutions, and governments. Individuals have been trading
in the other financial markets for many years. Let’s take a look at a few basic characteristics of
the other markets and their major differences with the Forex market.
The Stock Market: The stock market is a system that permits the buying and selling (or trading)
of a company’s shares and derivatives. There are stock markets around the world. The worldwide
stock market is valued at $51 trillion. Key differences from the Forex Market
 The stock market has lower liquidity.

 The stock market has lower leverage and risk (2:1 vs. 100:1 in Forex).
 The stock market has more regulation, control, and remedies.
The Bond Market: The bond market is a loosely connected system in which buyers and
sellers trade fixed income assets and securities. Bond and other fixed income assets are
traded informally in the over-the-counter market. The worldwide bond market is valued
at $45 trillion.

Key differences from Forex Market
 The bond market has the world’s largest investment sector.

 The bond market has lower volatility and risk.
 The bond market has limited trading hours.
 The bond market is a decentralized market without a common exchange.
The Commodities Market: The commodities market is an exchange where raw goods or
products are traded. Like the stock market, there are commodities markets around the world.
Commodities from apples to zinc are sold in commodities exchanges.
Key differences from Commodities Market
 The commodities market has lower leverage (10:1 vs. 100:1 in Forex).
 The commodities market has lower liquidity.
 The commodities market tends to have longer trends.
 The commodities market has limited trading hours.
 The commodities market has more errors and slippage (misquoted prices).
These four markets are operating simultaneously. Each has its own advantages and challenges.
Many Forex traders will study how these markets work together, which is called Inter-market
Analysis.

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International Economics II

1. THE FOREIGN EXCHANGE MARKET

Compiled BY: Temesgen Z. (MSc) Page 1

Unlike stock or commodity exchanges (markets), the foreign-exchange market is not an

1.2.Characteristics and Participants of the Foreign Exchange Market

Characteristics of Foreign exchange market

1.3.Functions of the Foreign Exchange Markets

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1.3. Supply and Demand for Foreign Exchange

A) Demand for foreign exchange

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Exchange rate in Birr/$ = R

Quantity of foreign currency

Figure 1.1. Demand for foreign exchange

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B) Supply curve for foreign exchange

The supply curve of foreign currency slopes up

the foreign citizens can buy Ethiopia goods,

Figure 5.2. Supply of foreign exchange

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1.4.The Foreign Exchange Rate

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Forward = Forward rate – Spot rate χ ___12________ χ 100

Premium (Discount) Spot rate No. of Months forward

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1.5.4 The Determinants of Exchange Rates

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How Fexco can help you with exchange rates

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1.6. Exchange Rate Systems

1.6.1. Fixed Exchange Rate System

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1.6.2. Floating Exchange Rate System

 Adjustable Pegged Rates

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1.6.3 Managed Floating Rates

Fixed versus Flexible Exchange rates

1.7 The Interaction of Hedgers, Arbitrageurs, and Speculators

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The Forward Market

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18.1. Devaluation versus Revaluation.

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1.8.2 Depreciation versus Appreciations

 Foreign Exchange market versus other Financial Markets

 The stock market has lower liquidity.

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Key differences from Forex Market

 The bond market has the world’s largest investment sector.

Key differences from Commodities Market

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Forward = Forward rate – Spot rate χ _12______ χ 100