Foreign exchange market

o Most countries of the world have their own

currencies: the USA (dollars), India (rupee),

the European Monetary Union, (euro),
Tanzania (Tshs), etc. The market where
individual, firms and/or banks buy and sell
currencies of different countries is called the
foreign exchange market.
 Foreign exchange rates
o The price at which these currencies are sold
and bought is called exchange rate. Exchange
rate, is therefore, price of one currency in
terms of another currency. Alternatively, it is
the value of a country’s currency expressed
in terms of another country’s currency. For
instance, 1USD = 2000TSH.
 Foreign exchange rates

• The real exchange rate is the rate at which a person

can trade the goods and services of one country for
the goods and services of another country
• For example, suppose that you go shopping and find
that a case of German tea is twice as expensive as a
case of American tea. The real exchange rate is 1/2
German tea per American tea
• Notice that, like the nominal exchange rate, we
express the real exchange rate as units of the foreign
item per unit of the domestic item. But in this
instance the item is a good rather than a currency
 Foreign exchange rates
• Real and nominal exchange rates are closely related. To
see how, consider an example. Suppose that a bushel of
American rice sells for $100, and a bushel of Japanese rice
sells for 16,000 yen. What is the real exchange rate
between American and Japanese rice?
• To answer this question, we must first use the nominal
exchange rate to convert the prices into a common
currency. If the nominal exchange rate is 80 yen per dollar,
then a price for American rice of $100 per bushel is
equivalent to 8,000 yen per bushel.
• American rice is half as expensive as Japanese rice. The
real exchange rate is 1/2 bushel of Japanese rice per
bushel of American rice
 Foreign exchange rates
• We can summarize this calculation for the real
exchange rate with the following formula:
• Real exchange rate= (e * pd) /pf
• Real exchange rate = 80 * 100/16000
• 1/2 bushel of Japanese rice per bushel of American
rice
• Thus, real exchange rate depends on the nominal
exchange rate and on the prices of goods in the two
countries measured in the local currencies.
• The real exchange rate is a key determinant of how
much a country exports and imports
 Foreign exchange rates
Quiz
o If a Japanese car costs 500,000 yen, a similar
American car costs $10,000, and a dollar can
buy 100 yen, what are the nominal and real
exchange rates?
o Nominal exchange rate is 1 dollar = 100 yen
o Real exchange rate = 100 * 10,000 / 500,000
o That is 2 Japanese car per American car
 Appreciation and depreciation
o When a currency increases in value, it
experiences appreciation and when it falls
in value, it undergoes depreciation.
o For instance, in early1999 the euro was
valued at 1.18 dollars while in match 2003
it was valued at 1.08 dollar.
 Appreciation and depreciation

o This means the euro depreciated by 8% (1.08

-1.18)/1.18 = - 0.08 = - 8%. Equivalently, we
could say that dollar which went from a
value of 0.85 euro per dollar in 1999 to a
value of 0.93 euro per dollar in 2003,
appreciated by 9%: (0.93-0.85)/0.85 = 0.09 =
9%
 Why are exchange rates important?
o Exchange rates are important because they affect the
relative price of domestic and foreign goods.
Generally, when a country’s currency appreciates its
exports become more expensive while its imports
become cheaper. Conversely, when a country’s
currency depreciates, its goods abroad become
cheaper while foreign goods in that country become
more expensive
 Exchange rates determination systems
1) Fixed exchange rate system: is the system in
which the price of the country’s currency in
terms of other currencies is set and
maintained by the government. For example,
if market exchange rate is 1USD = 1500
TSH, the government can decide the
exchange to be 1USD = 1400TSH.
 Devaluation
o Is an official act that changes the level
of fixed exchange rate downward in
terms of other currencies. In essence,
it is a one-step depreciation of a
currency under a fixed exchange rate
system
 Fixed exchange rate system

o In order to maintain a currency at a fixed

value, the central bank must stand ready to
buy and sell the currency at fixed prices.
When the central bank buys its own currency
it reduces reserves of foreign currencies and
when it sell domestic currencies it adds to its
foreign reserves
 Merits of fixed exchange rate system

o The fixed exchange rate system removes

the uncertainty associated with floating
rates
o Fixed exchange rate system also impose
discipline on a country to avoid the
inflation
Demerits of fixed exchange rate system
• The burden of adjusting balance of payment rest on

domestic economy

• There are circumstances exchange rates cannot be

held and adjustments may not yield expected outcome

• With pegged system, fiscal and monetary policies are

less effective
 Floating exchange rate system

2) Floating exchange rate system: is the system

where the value of the currency is determined by

market forces of demand and supply, without
government interference. When there is excess
demand for foreign currency, local currency
depreciates (foreign appreciate) and when there is
excess supply of it, local currency appreciates
(foreign depreciates)
 Floating exchange rate system
o For example, figure 1 shows the
equilibrium price of pounds in terms of
dollars. If the demand for local currency
(pounds) increases, it will appreciates
against dollar from $ 1.5 to $ 1.7.
similarly when its demand falls, it will
depreciates.
 Floating exchange rate system
Price of Figure 1
pound in $
S

1.7 $

1.5 $ D2

D1

Quantity of
pound
0 Q1 Q2
 Merits of floating exchange rate system
o Floating exchange rate provides automatic
mechanism for keeping balance of payment in
equilibrium. No need to hold reserves of foreign
currencies.
o It also stop the exchange rate being a target. No
need for the government to introduce measures to
protect the value of the currency at fixed rate
 Demerits of floating exchange rate system

o The main problem of floating rate is that it

adds a further element of uncertainty to
international trading.
o Moreover, floating rates causes external prices
of domestically produced goods to be subject
to constant changes. i.e. prices of goods and
services change as exchange rate changes
 Managed exchange rate system

3) Managed exchange rate system: this is the system

where the central bank directly intervene foreign

exchange market by selling and buying currencies. This
occurs when the market forces of demand and supply
fail to determine equilibrium price (market failure). For
instance, if a country’s exchange rate is falling near to
its lower limit, the central bank is expected to buy its
currency, if this failed, to rise its domestic interest rate
 Determinants of exchange rates

1) Relative price levels:

a rise in a country’s price level (inflation)

relative to the foreign price level causes
its currency to depreciate, and a fall in
the country’s relative price level causes
its currency to appreciate.
 Determinants of exchange rates

2)Trade barriers:

Barriers to free trade such as tariffs (taxes on

imported goods) and quotas (restrictions on the
quantity of foreign goods that can be imported)
can affect the exchange rate. Suppose Tanzania
increases its tariff or puts a lower quota on
Chinese products.
 Trade barriers

o This increase in trade barriers increase the

demand for Tanzania’s products, and the Tsh
tends to appreciate because Tanzania’s
products will still sell well even with a
higher value of the Tsh. Therefore,
increasing trade barriers cause a country’
currency to appreciate in the long run
 Determinants of exchange rates

3) Preferences for domestic versus foreign

goods: Increased demand for a country’s
exports causes its currency to appreciate in
the long run; conversely, increased demand
for imports causes the domestic currency to
depreciate.
 Preferences for domestic versus foreign goods
o For example, if the Americans prefer
Japanese cars to American cars, the
increased demand for Japanese goods
(imports) tends to depreciate the dollar. In
the same vein, if Tanzanian prefer Chinese
products to Tanzanian products, rise in
imports depreciates the Tanzanian shilling.
 Determinants of exchange rates
4) Productivity:
In the long run, as a country becomes more
productive relative to other countries, its goods
become relatively cheaper, and its currency
appreciates. If, however, its productivity lags
behind that of other countries, its goods become
relatively more expensive, and the currency tends
to depreciate
 Determinants of exchange rates

Note: In general, in the long-run, if a factor

increases the demand for domestic goods
relative to foreign goods, the domestic
currency will appreciate, and if a factor
decreases the relative demand for domestic
goods, the domestic currency will depreciate
 Determinants of exchange rates

o While exchange rate determination in the

long-run depends greatly on the demand for
exports and imports, in the short-run
exchange rate is more affected by decisions
to hold domestic and/or foreign bank
deposits. Thus, in the short-run exchange
rate is determined by the following:
 Determinants of exchange rates

1)Expected returns on domestic and foreign deposits: the

most important factor affecting the demand for domestic

(TSH) and foreign (USD) deposits is the expected return
on them. For example, when people expect the return on
dollar deposits to be higher relative to the return on TSH
deposits, there is a higher demand for dollar deposits
(appreciation) and a correspondingly lower demand for
TSH deposits (depreciation)
 Determinants of exchange rates
2) Interest rate:

When domestic real interest rates rise, the

domestic currency appreciates, and when it falls

the domestic currency depreciates. A rise in

foreign interest rate, on the other hand, causes

domestic currency to depreciates and vice versa.

 Determinants of exchange rates

o Change in nominal interest rates has

different impact on exchange rates. For
example, when domestic nominal interest
rates rise due to an expected increase in
inflation, domestic currency depreciates.
Recall the Fisher equation which states
that (i = ir + π).
 Equilibrium in foreign exchange market
o Equilibrium in the foreign exchange market
occurs when expected return on domestic
deposits (RD) equals expected return on

foreign deposits (RF)

o R D = RF

o What will happen if RD > RF or RD < RF ?

 Theories of exchange rate determination
1) Law of one price: If two countries produce
an identical good, and transportation costs and
trade barriers are very low, the price of the good
should be the same throughout the world no
matter which country produces it. Suppose that
American steel costs $100 per ton and identical
Japanese steel costs 10,000 yen per ton.
 Law of one price

oFor the law of one price to hold, the exchange

rate between the yen and the dollar must be
100 yen per dollar ($0.01 per yen) so that one
ton of American steel sells for 10,000 yen in
Japan (the price of Japanese steel) and one ton
of Japanese steel sells for $100 in the United
States (the price of U.S. steel).
 Law of one price

o If the exchange rate were 200 yen to the

dollar, Japanese steel would sell for $50 per

ton in the United States or half the price of

American steel, and American steel would

sell for 20,000 yen per ton in Japan, twice

the price of Japanese steel.

 Law of one price

o Because American steel would be more expensive

than Japanese steel in both countries and is identical to
Japanese steel, the demand for American steel would
go to zero. Given a fixed dollar price for American
steel, the resulting excess supply of American steel
will be eliminated only if the exchange rate falls to
100 yen per dollar, making the price of American steel
and Japanese steel the same in both countries.
 Theories of exchange rate determination

2)Theory of purchasing power parity: one of

the most prominent theories of how
exchange rates are determined is the theory
of purchasing power parity (PPP). It states
that exchange rates between any two
currencies will adjust to reflect changes in
the price levels of the two countries.
 Theory of purchasing power parity

o Suppose that the yen price of Japanese steel

rises 10% (to 11,000 yen) relative to the
dollar price of American steel (unchanged at
$100). Theory of purchasing power parity
maintains that if the Japanese price level
rises 10% relative to the U.S. price level, the
dollar will appreciate by 10%.
 Theory of purchasing power parity

o The purchasing power parity conclusion that

exchange rates are determined solely by
changes in relative price levels rests on the
assumption that all goods are identical in both
countries and that transportation costs and
trade barriers are very low. This assumption
does not hold in the real world situations.
 Mundell-Flaming Theoretical Model
• Mundell - Flaming model shows that an increase in
public spending or a tax cut has effect on exchange
rate.
• The model holds that in small open economy with a
floating exchange rate regime, rise in public spending
widens fiscal deficit which results to high interest
rate.
• As soon as “domestic interest rate” starts to increase
above the “world interest rate”, capital quickly flows
in from abroad to take advantage of the higher
return.
 Mundell-Flaming Model
• Capital inflow has exchange rate appreciation
effect
• This is because foreign investors need to buy the
domestic currency to invest in the domestic
economy
• Thus, capital inflow increases demand for
domestic currency in the market, bidding up the
value of domestic currency relative to foreign
currency
 Mundell-Flaming Model
• The appreciation of domestic currency makes
domestic goods more expensive relative to
foreign goods, reducing net exports, which in
turns, off-sets the growth-effects of fiscal
expansion
• But, this effect exist in short-run, as investors can
quickly shift their funds from one country to
another in response to changes in interest rates
• The opposite outcome occurs in fixed exchange
regime