Chapter

Exchange Rate Determination and Government Influence on Exchange Rate

Learning Objectives
To explain how exchange rate movements are measured; To describe the exchange rate systems used by various
governments;

To explain how the equilibrium exchange rate is determined; To examine the factors that affect the equilibrium exchange rate;
and

To explain how governments can use direct and indirect

intervention to influence exchange rates;

Exchange Rate
Exchange Rate: An exchange rate measures the value of one currency in units of another currency.

When a currency declines in value, it is said to depreciate. When it

increases in value, it is said to appreciate.

If currency A can buy you more units of foreign currency, currency

A has appreciated and foreign currency depreciated

If currency A can buy you less units of foreign currency, currency

A has depreciated and foreign currency appreciated.

Measuring Exchange Rate Movements, Cont.

To compare a foreign currencys spot rate at two specific points in time, the following equation can be used, Percentage change (% () in foreign currency value =

Where, S denotes the recent spot rate at time t

S  St 1 v 100 St 1

St 1 denotes the earlier spot rate at time t

A positive % ( represents appreciation of the foreign currency,

while a negative % ( represents depreciation. On the days when some currencies appreciate while others depreciate against the dollar, the dollar is said to be mixed in trading.

Exchange Rate System

Exchange rate systems can be classified according to the degree
to which the rates are controlled by the government.

Exchange rate systems normally fall into one of the following

categories:

Fixed Freely floating Managed float Pegged

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Exchange Rate System, Cont..

Fixed Exchange Rate System:
In a fixed exchange rate system, exchanges rates are either held constant or allowed to fluctuate only within very narrow boundaries. A fixed exchange rate would be beneficial to a country for the following reasons:

Exporters and importers could engage in international trade

without concern about exchange rate movements of the currency to which their local currency is linked.

Firm could engage in direct foreign investment, without concern

about exchange rate movements of that currency.
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Exchange Rate System, Cont..

Investors would be able to invest funds in foreign countries, without
concern that the foreign currency denominating their investment might weaken over time. Pros: Work becomes easier for the MNCs. Cons:

Governments may revalue their currencies. In fact, the dollar was

devalued more than once after the U.S. experienced balance of trade deficits.

Each country may become more vulnerable to the economic

conditions in other countries.
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Exchange Rate System, Cont..

Freely Floating Exchange Rate System:
In a freely floating exchange rate system, exchange rate values are determined by market forces without intervention by Governments. A freely floating exchange rate system allows complete flexibility. A freely floating exchange rate adjust on a continual basis in response to demand and supply conditions for that currency.

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Exchange Rate System, Cont..

Pros:

Each country may become more insulated against the economic problems in other
countries.

Central bank interventions that may affect the economy unfavorably are no longer
needed.

Governments are not restricted by exchange rate boundaries when setting new
policies.

Less capital flow restrictions are needed, thus enhancing the efficiency of the
financial market. Cons:

MNCs may need to devote substantial resources to managing their exposure to

exchange rate fluctuations.

The country that initially experienced economic problems (such as high inflation,
increasing unemployment rate) may have its problems compounded.

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Exchange Rate System, Cont..

Managed Float Exchange Rate System:
In a managed (or dirty) float exchange rate system, exchange rates are allowed to move freely on a daily basis and no official boundaries exist. However, governments may intervene to prevent the rates from moving too much in a certain direction. Cons:

A government may manipulate its exchange rates such that its own
country benefits at the expense of others.

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Exchange Rate System, Cont..

Pegged Exchange Rate System:
In a pegged exchange rate system, the home currencys value is pegged to a foreign currency or to some unit of account, and moves in line with that currency or unit against other currencies. Some Government peg their currencys value to that of a stable currency, because that forces the value of their currency to be stable.

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Exchange Rate System, Cont..

For Example: A country may peg their currencys value to dollar. So their currency exchange rate with the dollar to be fixed and the currency will move against non-dollar currencies by the same degree as the dollar. Since the dollar is more stable than most currency, it will make their currency more stable than most currencies.

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Exchange Rate Determination

An exchange rate represents the price of a currency. Like any other products sold in market, the price of a currency is determined by the demand for that currency relative to the supply for that currency. The concept of an Equilibrium Exchange Rate will help us to understand, how currencies exchange rates are determined. For each possible price of a currency, there is a corresponding demand for that currency, and corresponding supply of that currency for sale. At any point in time, that currency should exhibit the price at which the demand for the currency is equal to supply, and that point is represents the equilibrium exchange rate.

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Exchange Rate Equilibrium

We will use British pound and US dollar to explain exchange rate equilibrium. Demand for a Currency: This exhibit shows the quantity of pounds that would be demanded at various exchange rates at specific point in time. The demand schedule is down word sloping. Value of $1.60 $1.55 $1.50

D: Demand for Quantity of

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Exchange Rate Equilibrium, Cont..

Supply of a Currency for Sale: This exhibit shows the quantity of pounds for sale corresponding to each possible exchange rate at a given point in time. There is positive relationship between the value of the pound and the quantity of pounds for sale.

Value of

$1.60 $1.55 $1.50

S: Supply of

Quantity of
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Exchange Rate Equilibrium, Cont..

Equilibrium: The demand and supply schedule for pound are combined in the following exhibit. According to exhibit the equilibrium exchange rate is $1.55 because this rate equates the quantity of pounds demanded with the supply of pounds for sale. S: Supply of $1.60 $1.55 $1.50 Equilibrium Exchange Rate D: Demand for Quantity of

Value of

Factors that Influence Exchange Rates

The equilibrium exchange rate will change over time as supply and demand schedules change. The factors that causes currency supply and demand schedule to change are:

Relative Inflation Rates Relatives Interest Rates Relative Income Levels Government Controls Expectation
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Factors that Influence Exchange Rates, Cont..

Relative Inflation Rates:
Changes in relative inflation rates can affect international trade activity, which influences the demand for and supply of currencies and therefore influences exchange rates. $/ r1 r0 U.S. inflation o

S1 S0 D1 D0 Quantity of

o U.S. demand for British goods, and hence . q British desire for U.S. goods, and hence the supply of .

Factors that Influence Exchange Rates, Cont..

Relative Interest Rates:
Changes in relative interest rates affect investment in foreign securities, which influences the demand for and the supply of currencies and therefore influences exchange rates. $/ r0 r1 D0 D1 Quantity of

S0 S1

U.S. interest rates o q U.S. demand for British bank deposits, and hence . o British desire for U.S. bank deposits, and hence the supply of .

Factors that Influence Exchange Rates, Cont..

Though A relatively high interest rate may attract foreign

inflows, the relatively high interest rate may reflect expectations of relatively high inflation, which discourages foreign investment.

Because high inflation can place down ward pressure on the local
currency, for this reason, it is helpful to consider the Real Interest Rate, which is adjusts the nominal interest rate for inflation: Real Interest Rate $ Nominal Interest Rate Inflation Rate This relationship is sometimes called the Fisher effect.

Factors that Influence Exchange Rates, Cont..

Relative Income Levels:
A third factor affecting exchange rates is relative income levels. Because income can affect the amount of imports demanded, it can affect exchange rates. Changing income can also affect exchange rates indirectly through effects on interest rates. $/ S0 r1 r0 D1 D0 Quantity of

U.S. income level o o U.S. demand for British goods, and hence . No expected change for the supply of .

Factors that Influence Exchange Rates, Cont..

Government Controls:
The Governments of foreign countries can influence the equilibrium exchange rate in many ways, including:

Imposing foreign exchange barriers, Imposing foreign trade barriers, Intervening (buying and selling currencies) in the foreign exchange market, and Affecting macro variables such as inflation, interest rates, and income levels.

Factors that Influence Exchange Rates, Cont..

Expectations:
A fifth factor affecting exchange rates is market expectations of future exchange rates. Like other financial markets, foreign exchange markets react to any news that may have a future effect. News of a potential surge in US inflation may cause currency traders to sell dollars, anticipating a future decline in the dollars value. This response places immediate down ward pressure on the dollar.

Institutional investors often take currency positions based on

anticipated interest rate movements in various countries.

Because of speculative transactions, foreign exchange rates can be

very volatile.

How Factors Can Affect Exchange Rates

Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Govt Trade Restrictions Financial Factors 1. Interest Rate Differential 2. Capital Flow Restrictions

U.S. demand for foreign goods, i.e. demand for foreign currency Foreign demand for U.S. goods, i.e. supply of foreign currency U.S. demand for foreign securities, i.e. demand for foreign currency Foreign demand for U.S. securities, i.e. supply of foreign currency Exchange rate between foreign currency and the dollar

Government Intervention
Each country has a government agency (called the central bank) that may intervene in the foreign exchange market to control the value of the countrys currency. In particular, they attempt to control the growth of the money supply in their respective countries in a way that will favorably affect economic conditions.

Reasons for Government Intervention

Central banks commonly manage exchange rates for three reasons: to smooth exchange rate movements, to establish implicit exchange rate boundaries, and/or to respond to temporary disturbances.
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Government Intervention, cont..

Direct Intervention:
To force the dollar to depreciate, the government can intervene directly by exchanging dollars that it holds as reserves for other foreign currencies in the foreign exchange market. If the government desires to strengthen the dollar, it can exchange foreign currencies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar.

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Government Intervention, cont..

Fed exchanges $ for to strengthen the Value of V2 V1 S1

Fed exchanges for $ to weaken the Value of V1 V2 D1 Quantity of S1 S2

D2 D1 Quantity of

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Government Intervention, cont..

Non-Sterilized Vs. Sterilized Intervention:
When a central bank intervenes in the foreign exchange market without adjusting for the change in money supply, it is said to engaged in non-sterilized intervention. For example: if the government exchanges dollars for foreign currencies in the foreign exchange markets in an attempt to strengthen foreign currencies (weaken the dollar), the dollar money supply increases. In a sterilized intervention, the government intervenes in the foreign market and Treasury securities are purchased or sold at the same time to maintain the money (dollar) supply.
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Government Intervention, cont..

Non-Sterilized Intervention Federal Reserve To Strengthen the C$: $ C$

Banks participating in the foreign exchange market Federal Reserve

To Weaken the C$:

C$

Banks participating in the foreign exchange market

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Government Intervention, cont..

Sterilized Intervention Federal Reserve To strengthen The C$ $ C$
T- securities

Banks participating in the foreign exchange market Federal Reserve $ C$ $

T- securities

Financial institutions that invest in Treasury securities

To Weaken the C$

Banks participating in the foreign exchange market

Financial institutions that invest in Treasury securities

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Government Intervention, cont..

Indirect Intervention:
Central banks can also engage in indirect intervention influencing the factors that determine the value of a currency.

Inflation Rates Interest Rates Income Levels Government Controls

Expectation For example: the Fed may attempt to increase interest rates (and hence boost the dollars value) by reducing the U.S. money supply. Note that high interest rates adversely affects local borrowers.
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Impact of Exchange Rates on an MNCs Value

Inflation Rates, Interest Rates, Income Levels, Government Controls, Expectations

m ER CF E  j , t v E  j , t n !1 j Value = t 1  k t =1

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent