chapter 15: Exchange Rates and Exchange Rate Systems Flashcards
Every country must choose an which types of exchange rate system?
fixed level
flexible
in between
fixed exchange rate system
no variation
flexible exchange rate system
variation determined by supply and demand for the country’s currency on a minute-by-minute basis
semi-fixed or semi- flexible exchange rates
between fixed and flexible
The exchange rate
the price of one currency stated in terms of a second currency
in which two ways can an exchange rate be given?
units of domestic currency per unit of foreign currency
vice versa
identify three reasons for holding foreign currency
trade and investment purposes
to take advantage of interest rate differentials, or interest rate arbitrage
to speculate
interest rate arbitrage
the practice of using favorable interest rate differentials to invest in a higher-yielding currency
arbitrageurs borrow money where interest rates are relatively low and lend it where rates are relatively high
arbitrage
the idea of buying something where it is relatively cheap and selling it where it is relatively expensive
Speculators
businesses that buy or sell a currency because they expect its price to rise or fall
They have no need for foreign exchange to buy goods or services or financial assets
they hope to realize profits or avoid losses through correctly anticipating changes in a currency’s market value
forex shit
they help to bring currencies into equilibrium after they have become over- or undervalued
four main participants in foreign currency markets
retail customers
commercial banks
foreign exchange brokers
central banks
the most participant in foreign currency markets
commercial banks
retail customers in currency markets include whom?
firms and individuals
why would retail customers hold foreign exchange?
to engage in purchases
to adjust their portfolios
to profit from expected future currency movements
forex broker
keeps track of buyers and sellers of currencies
acts as a deal maker by bringing together a seller and a buyer (most often banks buying for their customer)
Firms that do business in more than one country are subject to what?
exchange rate risks
how do exchange rate risks come to exist?
currencies are constantly changing in value and, as a result, expected future payments that will be made or received in a foreign currency will be a different domestic currency amount from when the contract was signed
who faces the exchange rate risks in a transaction? purchaser or the seller?
the purchaser is uncertain of the price in the currency of the seller
the seller knows the exact dollar amount it will receive
mechanisms to deal with exchange rate risks
the forward exchange rate
the forward market
the forward exchange rate
the price of a currency that will be delivered in the future
the forward market
the market in which the buying and selling of currencies for future delivery takes place
why are forward markets an everyday tool for international traders, investors, and speculators
because they are a way to eliminate the exchange rate risk associated with future payments and receipts
allow an exporter or importer to sign a currency contract on the day they sign an agreement to ship or receive goods
spot market
the market for buying and selling in the present
the transactions are denoted in spot prices
hedging
bondholders and other interest rate arbitrageurs using forward markets to protect themselves against the foreign exchange risk incurred while holding foreign bonds and other financial assets
how is hedging accomplished?
by buying a forward contract to sell foreign currency at the same time that the bond or other interest-earning asset matures
covered interest arbitrage
When interest rate arbitrageurs use the forward market to insure against exchange rate risk
what will an increase in demand of a currency do to its value?
it will cause an appreciation in value
raise in price
what will an increase in supply of a currency do to its value?
it will cause an depreciation in value
decrease in price
if the overall demand of a certain currency increases, what happens to the exchange rate?
why?
the exchange rate increases
the currency that is increasingly demanded will appreciate in value relative to the other currency that it is against
in the graph, the demand curve shifts to the right, making the equilibrium higher
if the overall demand of a certain currency decreases, what happens to the exchange rate?
why?
the exchange rate decreases
the currency that is less and less demanded will depreciate in value relative to the other currency that it is against
in the graph, the demand curve shifts to the left, making the equilibrium lower
if the overall supply of a certain currency decreases, what happens to the exchange rate?
why?
the exchange rate increases
the supply of the currency will be more scare making it gain value relative to the currency it is against
in the graph, the supply curve shifts to the left, making the equilibrium higher
purchasing power parity
a phenomenon in the long run
states that the equilibrium value of an exchange rate is the level that allows a given amount of money to buy the same quantity of goods abroad that it will buy at home
keeps the purchasing power over goods and services constant
so in the long run, the exchange price that should be that in which it allows to buy the same amount of goods
ex: $100 and 50Euros buy you one watch
the long term exchange rate should be $2 per Euro
what does it mean if in exchange rate is above that of the long term exchange rate?
the currency in the numerator position is under valued
the currency in the denominator position is over valued
what does it mean if in exchange rate is below that of the long term exchange rate?
the currency in the numerator position is over valued
the currency in the denominator position is under valued
what is key behind purchasing power parity (taking advantage of currencies being under value or over valued compared to another)?
is this realistic? why?
arbitrage
buying where the goods are cheaper and selling where they are more expensive
nahhh
ex: tariffs, bank costs, quotas, insurance etc
the forces tied to business cycles that have more immediate impacts on the position of the supply and demand curves for foreign exchange are considered long run, medium run, or short run?
why?
medium run
the time period from the peak of one expansion to the next is usually several years in duration
they are pressures on an exchange rate that may last for several years, but almost always less than a decade and usually less than five to seven years
The most important medium-run force that influences exchange rates
the strength of a country’s economic growth
what does rapid economic growth imply for exchange rates??
how?
the effect of rapid economic growth at home is a depreciating currency
Rapid growth implies rising incomes and increased consumption
consumer confidence increases so they spend more, some of which will be on imports and travel abroad
rapid economic growth at home is translated into increased imports and an outward shift in the demand for foreign currency, which increase the equilibrium exchange rate
the foreign currency will be increasingly stronger than the currency at home
what does slow economic growth such as a recession imply for exchange rates??
how?
reduces the exchange rate and appreciates the currency
increase in consumer uncertainty about jobs and reduction many people’s incomes
consumption expenditures fall, expenditures on imports decline falls as well
the demand for foreign exchange falls causing leftward shift of the demand curve, which lower the equilibrium rate
the foreign currency will be increasingly weaker than the currency at home
does foreign economic growth influence our domestic demand for foreign currency?
what will it affect tho?
naaah
it will affect the supply curve
what does more rapid foreign growth lead to when it comes to foreign currency?
why?
reduces the strength of the foreign currency compared to our domestic currency
leads to more exports from the home country
More exports to foreigners increase the supply of foreign currency and shift the supply curve rightward
reduces equilibrium rate
what does slower foreign growth lead to when it comes to foreign currency?
why?
increases the strength of the foreign currency compared to our domestic currency
leads to less exports from the home country
less exports to foreigners decreases the supply of foreign currency and shift the supply curve leftward
increases equilibrium rate
true or false
The effect of growth is symmetrical
true
how long are long run factors that affect the exchange rates?
over 10 years
how long are medium run factors that affect the exchange rates?
less than 10 years
sometimes less than 7 and 5 years
how long are short run factors that affect the exchange rates?
less than 1 year
the most important short run force affecting exchange rates
the flow of financial capital
how do the effects of financial capital flows range?
minor and subtle to dramatic and, at times, catastrophic.
Two variables particularly responsible for a large share of short-run capital flows
interest rates
expectations about future exchange rates
the interest parity condition
sums up the interest rate–exchange rate relationship in the short run
states that the difference between any pair of countries’ interest rates is approximately equal to the expected change in the exchange rate
how can investors investing abroad protect against unanticipated losses due to currency fluctuations?
known as covered interest arbitrage
signing a forward contract to sell the foreign exchange from their future earnings
when is a certain currency selling at a discount?
when the forward exchange rate (F) between the domestic currency and a foreign currency is higher than the spot rate (R)
F > R
the domestic currency is expected to depreciate
when is a certain currency selling at a premium?
when the forward exchange rate (F) between the domestic currency and a foreign currency is lower than the spot rate (R)
F < R
the domestic currency is expected to appreciate
The difference between the forward exchange rate (F) and the spot rate (R)
the expected appreciation or depreciation of a currency compared to another
the interest parity condition
formula and meaning
i - i*
est environ égal à
(F - R) / R
F = forward exchange rate
R = Spot Rate
i = domestic interest rates
i* = foreign interest rates
it says that interest rate differences are approximately equal to the expected change in the exchange rate
what will investors do if domestic interest rates are less than foreign interest rates (i < i) all the while forward rates are less than spot rates (F < R), but home policymakers decide for some reason to raise their inter- est rates to the same level as foreign rates: i = i?
why?
investors in both home and foreign markets will invest more at home because they earn the same rate of interest
they also expect domestic currency to appreciate in value (since F < R)
supply curve of foreign currency shifts right and demand shifts of foreign currency shifts left making the equilibrium spot rate decrease
what happens if investors suddenly come to believe that a currency must depreciate more than they had anticipated?
it lowers the expected value of assets denominated in that currency
This can create a sudden exodus of financial capital and put enormous pressure on the country’s supply of foreign exchange reserves
people will want more foreign currency
they will try to convert their assets in foreign currency
the largest center for forex exchange
London
long run factor influencing exchange rates
Purchasing Power Parity
if home goods are less expensive than foreign goods, what is the effect on R?
R Falls: An Appreciation in the Domestic Currency
if home goods are more expensive than foreign goods, what is the effect on R?
R Rises: A Depreciation in the Domestic Currency
medium run factor influencing exchange rates
The Business Cycle
if the domestic economy grows more slowly than foreign economy, how does it affect R?
R Falls: An Appreciation in the Domestic Currency
if the domestic economy grows faster than foreign economy, how does it affect R?
R Rises: A Depreciation in the Domestic Currency
short run factors influencing exchange rates
Interest Parity
Speculation
if home interest rates rise, or foreign rates fall, how does it affect R?
R Falls: An Appreciation in the Domestic Currency
if home interest rates fall, or foreign rates rise, how does it affect R?
R Rises: A Depreciation in the Domestic Currency
if there are expectations of a future appreciation, how does it affect R?
R Falls: An Appreciation in the Domestic Currency
if there are expectations of a future depreciation, how does it affect R?
R Rises: A Depreciation in the Domestic Currency
what is more important, what your currency is worth in another currency, or the purchasing power you would have with that second currency?
the purchasing power you would have with that second currency
basically, the real exchange rate
The real exchange rate
the market exchange rate adjusted for price differences
nominal exchange rate
real exchange rate formula
[(Nominal exchange rate) · (Foreign price)] / (Domestic price)
= real exchange rate
Rr = Rn · (P*/P)
Rr: Real exchange rate
Rn: Nominal exchange rate
P*: Foreign price
P: Domestic price
purchasing power parity indicates long-run equilibrium or short-run equilibrium?
long-run equilibrium
Fixed exchange rate systems (also called pegged exchange rate systems)
setting the value of a country’s currency in several ways
ways in which we can set the value of a country’s currency in fixed exchange rate systems
giving up their currency altogether and adopt the currency of another country
setting the value of a nation’s money equal to a fixed amount of another country’s currency, or less commonly to a basket of several currencies
the most common way to set the value of a country’s currency in fixed exchange rate systems
setting the value of a nation’s money equal to a fixed amount of another country’s currency
do countries often give up their currency altogether and adopt the currency of another country?
nah
very few countries do so
hard peg
when the exchange rate is not allowed to vary
soft peg
Fixed exchange rates that fluctuate within a set band
can take several forms depending on the amount of variation allowed
the most common exchange rates around the world by the end of the 20th century?
flexible exchange rate systems
one type of fixed exchange rate that the world abandoned in the 1930s during the Great Depression
Gold standards
the first countries to end the gold standard
the first ones to escape the depression
Bretton Woods exchange rate system
1947–1971
a modified gold standard adopted by Western economies after World War II
abandoned in the early 1970s
pure gold standards
highlight a pure form of fixed exchange rate with a hard peg
nations keep gold as their international reserve
Gold is used to settle most international obligations
nations must be prepared to trade it for their own currency whenever foreigners attempt to “redeem” the home currency they have earned by selling goods and services
In this sense, the nation’s money is backed by gold
three rules that countries must follow in order to maintain a gold exchange standard
- they must fix the value of their currency unit in terms of gold to fix the exchange rate
- nations keep the supply of their domestic money fixed in some constant proportion to their supply of gold
–> to ensure that the domestic money supply does not grow beyond the capacity of the gold supply to support it
- nations must stand ready and willing to provide gold in exchange for their home country currency
under the gold standards, what are ways to stop our currency from depreciating against another currency who’s demand increased (shifted right)?
sell gold reserves in exchange for our currency
– > supplying international money (gold) to the market through a sale of some of its gold stock
–> an increase in the supply of gold is equivalent to an increase in the supply of the foreign currency
basically, countries hold gold as a reserve instead of foreign currencies and sell their gold reserves in exchange for their own currency
increases the supply of gold (which is international money) and offsets the pressure on the home currency to depreciate
two possibilities for the home country when selling its gold reserves
the demand for gold is satisfied and the pressure on its currency eases
or
it begins to run out of gold
what happens when a country is running out of gold when trying to stop the depreciation of their currency against another currency?
the home country may be forced into a devaluation
basically, changing the gold price of its currency
each ounce of gold sold by the home country buys back a greater quantity of its currency than before
difference between gold standards and pegged exchange rates
instead of gold, another currency is used to “anchor” the value of the home currency
potential sources of problems with a pegged currency
why are they it a problem?
the home currency’s value is synchronized with its peg
–> changes between the peg and a third-party currency are identical for the home currency and the third party currency
significant difference in inflation rates between the home country and its peg
–> real exchange rates play a greater role in determining trade patterns than nominal rates
how to avoid pegging our home currency’s value with another currency?
how is this a solution?
what currencies do countries usually pick?
peg our currency to a group of currencies
it reduces the importance of any single country’s currency in the determination of the home country’s currency value
the currencies of their most important trading partners
The most common technique for dealing with the significant difference in inflation rates between the home country and its peg
the adoption of a crawling peg
crawling pegs
soft pegs that are fixed but periodically adjusted
the goal of crawling pegs?
offset any differences in inflation (changes in P) through regular adjustments in Rn
P: Domestic price
Rn: Nominal exchange rate
are purely fixed or purely flexible exchange rate arrangements rare or common?
rare bruv
Smithsonian Agreement
December 1971
the major industrialized countries agreed to devalue the gold content of the dollar
according to economists, if the goal is to find the system that helps minimize negative shocks to an economy, what determines whether a more flexible or more fixed system should be adopted?
the source of the shock
if the shock that shocks the economy comes from the monetary sector, according to economists, which rate is better to dealing with it?
ex: a central bank that goes overboard in printing new money
a fixed rate is better
in the example, the fixed rate imposes discipline on the central bank
if the shock that shocks the economy comes from outside of the monetary sector, according to economists, which rate is better to dealing with it?
ex: a sudden change in the price of imported oil
more flexibility in the exchange rate enables the country to adapt to the changes more easily
Dollarization
the term given to the adoption of another country’s currency
not the same as a monetary union such as the euro zone
difference between dollarization and a monetary union
a union has a common central bank that issues the currency and carries out monetary policy
a country’s bank that adopts another currency has no ability to issue money
–> they have no control over monetary policy since they cannot expand or contract the money supply
the four monetary unions in the world
the European Monetary Union (EMU)
the Eastern Caribbean Currency Union (ECCU)
the West African Economic and Monetary Union (WAEMU)
the Central African Economic and Monetary Community (CEMAC)
the two oldest monetary unions
what currency do they use?
the West African Economic and Monetary Union (WAEMU)
the Central African Economic and Monetary Community (CEMAC)
they use the CFA franc
the European Monetary Union (EMU) exchange rate system
Flexible
the West African Economic and Monetary Union (WAEMU) exchange rate system
Fixed to euro
the Central African Economic and Monetary Community (CEMAC)exchange rate system
Fixed to euro
the Eastern Caribbean Currency Union (ECCU) exchange rate system
Fixed to dollar
four potential reasons why a group of countries might want to share a common currency
a single currency eliminates the need to convert each other’s money and thereby reduces transaction costs in a number of ways
a single currency eliminates price fluctuations caused by changes in the exchange rate
the elimination of exchange rates through the adoption of a single currency can help increase political trust between countries seeking to increase their integration
the adoption of a common currency may give developing countries’ exchange rate system greater credibility
costs of giving up a country’s national money?
getting rid of strong political symbolism
the country no longer has its own money supply as a tool for managing its economic growth
the theory of optimal currency areas
started by Robert Mundell
four conditions for deciding whether the gains of area are greater than the costs:
- the business cycle must be synchronized and national economies must enter recessions and expansions at more or less the same time
- a high degree of labor and capital mobility between the member countries
- regional policies capable of addressing the imbalances that may develop
- The nations involved must be seeking a level of integration that goes beyond simple free trade
The most important rule for a country’s exchange rate system
it it be credible
Optimal currency areas
geographical regions within which it is optimal for countries to adopt the same currency
