Exchange Rates

Exchange Rates
 Think of the $ (or Euro, Peso, or any other currency) as a
commodity.
 In a free market system, the relative value of currencies “float”
up and down based on the forces of supply and demand.
 These are known as floating exchange rates.
 Floating exchange rates move continuously in response to
market forces, unless (or until) government intervenes
 If demand for a currency goes up (or supply goes down) – the
currency appreciates (or strengthens)
 If supply increases (or demand decreases) – the currency
depreciates (weakens)
 Factors that Impact Exchange Rates
 Change in Income
 Change in Relative Prices - Inflation rates
 Interest rates - Change in Relative Investment
Prospects
 Speculation
 Use of Foreign Reserves
 Current account deficit - BoP
 Public debts,
 Political stability and Economic performance
 Change in Income
 India income goes up - consumption increases
– demand for US imports goes up - demand
for $ goes up - Both forces act to depreciate
the Rs. relative to the $. Or US$ appreciates
relative to Indian Rs.
 Change in Income – (In Reverse) will
depreciate US$
 A Graphical Example

E/$ S1

S2

Q of $
 Back to the Graph

E/$ S

D2

D1

Q of $
 Change in Relative Prices - Inflation
 Change in relative prices = relative rates of inflation
 Higher rates of domestic inflation in the U.S. make imports relatively
cheaper – demand for European imports goes up.
 Higher inflation in the U.S. also make exports less competitive –
exports to Europe go down
 Both factors act to weaken the US$
 Remember – it is the relative rate of inflation that counts.
 5% inflation in the U.S. will not cause the US$ to weaken relative to
the Euro if the inflation rate within the EU is running at 8%.
 But, 3% inflation in the U.S. will cause the US$ to depreciate relative
to the Euro if inflation is only 1% in the EU.
 Relative Investment Prospects

 Currency values change in response to relative investment

opportunities
 US investors see more attractive risk adjusted investment
opportunities in India versus in the domestic market – demand for
Indian Rupees goes up, and supply of US$ goes up
 US$ depreciates relative to the Rupee
 New government elected in India based on a platform of
increased regulation and protectionist policies
 Perceived risk of investing in India increases, reducing the
relative attractiveness of investing in India versus the U.S.
 Demand for US$ goes up – US$ appreciates relative to the Rupee
 Relative Interest Rates
 In a global market, investors always have choices in terms
of where (and in what form) to invest their money.
 Relative interest rates have a significant impact in
determining the relative attractiveness of holding
investments in one currency or another.
 Increasing interest rates in the U.S. (on a relative basis)
provide an incentive for investors to hold US$ denominated
financial instruments
 An increase in demand for US$ denominated instruments
(think U.S. Treasuries) increases demand for US$ -- US$
strengthens
 When interest rates in the U.S. decline on a relative basis,
demand for US$ denominated instruments goes down – and
the US$ depreciates.
 Speculation
 The goal? - Buy currencies (or investments denominated in
currencies) that you think are undervalued
 Sell currencies that you think are overvalued

 Of course, these speculative trades create market movements that

reduce or eliminate the perceived over or under valuation.
All markets (including currency markets) are driven by expectations of
future performance. Expectations of future changes that will impact
the value of a currency will be factored into the current market price
of the currency
Expectations regarding
 Relative rates of inflation, relative interest rates, economic

performance and income, investment prospects,

 Impact currency markets in a never ending circular loop of profit
motivated speculation
 Use of Foreign Reserves
 Use of foreign reserves – otherwise known as
government intervention
 Governments can buy or sell their own (or
another) currency in order to stabilize or
change the relative value of their currency
 When governments intervene in the currency
markets = “dirty float”
 Exchange Rates and BOP
 The same factors that impact exchange rates also impact balance of payments.
 Change in income
 Increase in income - Increased demand for imports

 Net exports decline (Current Account goes down)

 Change in Relative Prices

 High relative inflation - Imports up; exports down

 Net exports decline (Current Account goes down)

 Relative Investment Prospects

 Strong investment prospects attract flows of capital from foreign investors

 Improves the Capital Account

 Relative Interest Rates

 Increase in domestic U.S. interest rates will increase demand for US$ denominated instruments

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

 Speculation
 Speculative buying and selling of impacts the Capital Account and market exchange rates
 Everything is Related
 Economic growth and income, balance of
payments and exchange rates are all related
Y = C + I + G + (X-M)
 Changes in net exports (X-M) cause changes
in GDP (Y)
 Changes in economic growth (income) and net
exports drive changes in exchange rates, which
in a circular fashion impact net exports and
national income
 Floating vs. Fixed Exchange Rates
 Floating exchange rate systems allow
exchange rates to move based on supply and
demand dynamics in the market.
 In fixed exchange rate systems the exchange
rate is pegged or locked in to a specific, fixed
rate of exchange.
 Floating and fixed systems have some
important (and fairly obvious) advantages and
disadvantages
Advantages:
 Certainty Fixed Exchange Rates
 Fixed exchange rates take the risk of currency fluctuations out of business transactions (usually)

 Increased trade

 If the greater certainty of fixed exchange rates leads to an increase in trade, this would create a net
economic benefit
 Experience over the last 30 years does not support this correlation
 Reduced speculation
 No opportunity to profit from day to day changes in the exchange rate
 Huge opportunity to take positions in expectation of devaluations or revaluations of a fixed
exchange rate
 Government discipline
 Without the self-correcting mechanisms of a floating exchange rate, governments (theoretically)
should be forced to exercise more disciplined in the management of fiscal and monetary policy
Disadvantages:
 Reserves -Governments must have sufficient reserves of gold and foreign currency to support frequent
intervention in the market
 Loss of control over monetary policy - If exchange rates are fixed, money supply and interest rates must
“float” based on flow of trade and investment
 No auto-correction mechanism
Advantages:
 Self-correcting
Floating Exchange Rates
 No reserves required for market intervention

 Control over fiscal and monetary policy

 Governments can adjust fiscal and monetary policy and allow changes in the exchange rate to
adjust for changes in the balance of payments (let the self-correcting mechanism do its thing)
 No large jumps
 Exchange rates move constantly, but usually in very small daily increments
 No major jumps from devaluations or revaluations
 Reduction in speculation (maybe)
 In theory offsetting trades may cancel each other out and reduce the net impact of speculation
on the market
Disadvantages:
 Floating rates add an additional element of uncertainty (risk) to international transactions

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

 Difficult to hedge long-term investments

 Increased speculation (probably)

 Floating Exchange Rates
 Lack of discipline
 Adjustments in exchange rates can mute (or at
least delay) the impact of irresponsible economic
policies on the part of government, businesses or
labor.
 Example: Government adopts inflationary
monetary and fiscal policy; inflation increases;
currency decreases in value, which helps offset the
negative impact of higher prices on exports
 Managed Exchange Rates
 Managed exchange rate systems fall between the two
extremes of perfectly fixed and pure floating rate
systems
Two types of managed systems:
 Adjustable peg
 Government “pegs” a target exchange rate
 Manages based on a preset band around this target rate
 Dirty float
 Floating system with some government intervention
 Exchange Rate Management Tools
 Buy or sell currency (ex: buy to appreciate currency)
 Manipulate interest rates (ex: lower to depreciate
currency)
 Adopt protectionist policies (use of tariffs or export
subsidies to protect value of currency)
 Violates WTO agreement
 Adjustments to exchange rate can have the same effect

 “Expenditure switching”

Use fiscal and monetary policy to drive changes in

GDP/national income
 Terms of Trade
 Ratio of average export prices to average import prices
 If export prices rise faster than import prices – terms of trade improve
 If import prices rise more than export prices – terms of trade worsen
 What will happen to the volume of trade as the terms of trade improve or
worsen?
 Depends on the elasticity of demand for exports and imports – the
sensitivity of demand to changes in price
 If demand for exports and imports is elastic (highly sensitive to price
changes), an improvement in terms of trade (export prices rising faster than
import prices) will worsen the balance of payments (as demand for exports
falls more than imports)