8.3 Exchange Rates - Systems and Calculations Flashcards
Four systems for setting exchange rates
- Fixed rates
- Freely floating rates
- Managed floating rates
- Pegged rates
Fixed Exchange Rate System
- value fixed or allowed to fluctuate only within a very narrow range
- advantage: high degree of predictability. uncertainty about gains and losses on exchange rate fluctuations is eliminated.
- disadvantage: government can manipulate the value of its currency
Freely Floating Exchange Rate System
- government steps aside.determined entirely by the market forces of supply and demand
- disadvantage:country vulnerable to economic conditions in other countries
Freely floating exchange rates Correct a lack of equilibrium in the balance of payments
Managed Float Exchange Rate System
- government allows market forces to determine exchange rates until they move too far
- This system is the one currently in use by the major trading nations.
- advantage: Hybrid of Free Float, while allowing for intervention
- criticism:makes exporting countries vulnerable to sudden changes in exchange rates.
Pegged Exchange Rate System
Spot Rate
number of units of a foreign currency that can be received today in exchange for a single unit of the domestic currency
D-domesitic F-Foreign
1 D = 1.1654 F Spot rate for D is 1.1654
Spot rate for F = .6046 (1/1.1654)
Forward Rate
- number of units of a foreign currency that can be received in exchange for a single unit of the domestic currency at some definite date in the FUTURE.
(Same Calculations as spot)
Forward Premium
If the domestic currency exchanges for more units of a foreign currency in the forward market than in the spot market
Forward Discount
domestic currency exchanges for fewer units of a foreign currency in the forward market than in the spot market
Calculating Forward Premium or Discount
Forward - Spot
——————– x
Spot
Days in Forward
Cross Rate
-two currencies involved are not stated in terms of each other
Foreign Currency Per Dollar
The question will ask the “spot rate for the Dollar) of D and F
Exchange Rates and Purchasing Power
Graph
- X is price of one unit of foreign currency in terms of domestic.
- Y Quantity of Foreign Currency
- demand curve for the foreign currency is downward sloping because, when that currency becomes CHEAPER, goods and services denominated in that currency become more affordable to domestic consumers, leading them to demand more of that currency.
- The supply curve for the foreign currency is upward sloping because, when that currency becomes more expensive, goods and services become more affordable to users of the foreign currency, leading them to inject more of their currency into the domestic market.
Currency Depreciation
Def
If it takes more D to by F, the currency has depreciated.
And vice-versa
Effective Interest Rate on a Foreign Currency Loan
Amt Borrowed 12M Pesos x .921496 = $1,105,795 USD
x Stated Interest Rate 6.5%
= 780,000 Pesos
—————————————
12,780,000 Pesos……………..x .094 Pesos = 1,201,320 USD
Difference (1,105,795-1,201,320) = 95,525
Difference 95,525
————————— = 8.64% Effective Interest
Amt Borrow 1,105,795
balance of trade
Different than balance of payments
- difference between imports and exports of goods and services over a given period
1. If a country’s currency is WEAK, its goods and services are more affordable to foreign consumers. These countries tend to have a positive (surplus) balance of trade
2. if a country’s currency is STRONG, its goods and services are more expensive to foreign consumers. These countries tend to have a negative (deficit) balance of trade.
