Foreign Exchange Rates and Markets • Is foreign money needed to Foreign carry out internationalExchange transactions. • Is the price measured in oneExchange country’s currency of buying one unit of another country’s currency. Rate
Changes in Tastes Relative Income Changes Relative Price-Level Relative Interest Rate Speculation
Determinants of Foreign Exchange• Any change in consumer tastes or preferences for the products of foreign country may alter the demand for that nation’s currency and change its exchange rate.
Determinants of Foreign Exchange• A nation’s currency is likely to depreciate if its growth of national income is more rapid than that of other countries.
Determinants of Foreign Exchange• Changes in relative price levels of two nations may change the demand and supply of currencies and alter the exchange rate between the two nation’s currencies.
Determinants of Foreign Exchange• Changes in relative interest rates between two countries may alter their exchange rate.
Determinants of Foreign Exchange• It can cause changes in exchange rates.
The Foreign Exchange MarketExchange rate D S Peso/$ Supply of Dollars by people who want pesos Demand for Dollars by people who have pesos Foreign exchange (dollars) 10
Currency Appreciation and Depreciation • It is an increase in the number of units of a particular currency needed Currency to purchase one unit of foreignDepreciation exchange. • It is an decrease in the number of units of a particular currency Currency needed to purchase one unit ofAppreciation foreign exchange.
Changes in the Equilibrium Exchange Rate Supply of DollarsExchange rate D S by people who Peso/$ S’ want pesos$ -depreciationPeso- appreciation Demand for Dollars by people who have pesos Foreign exchange (dollars) 12
Arbitrageurs and Speculators • Someone who takes advantage of temporary geographic differences in the exchange rate by simultaneously purchasing a currency in one market andArbitrageur selling it in another market. • Someone who buys or sells foreign exchange in hopes of profiting from fluctuations in the exchange rateSpeculator over time.
Exchange Rates Regimes 1)Flexible Exchange Rate• Rate determined in foreign exchange markets by the markets by the forces of demand and supply without the government intervention.
Exchange Rates Regimes 2)Fixed Exchange Rate• Rate of exchange between currencies pegged within a narrow range and maintained by the central banks’ ongoing purchases and sales of currencies .
Exchange Rates Regimes a) Currency Devaluation • Is an increase in the official pegged price of foreign exchange in terms of domestic currency. b) Currency Revaluation• Is a reduction in the official pegged price of foreign exchange in terms of domestic currency.
Exchange Rates Regimes 3) Manage Float Exchange Rate• Attempt to influence exchange rates by buying and selling currencies.
Purchasing Power Parity Theory(PPP) is a theory, which establishes thefact that the exchange rates between currencies are in equilibrium in the event of equality in the purchasing power of each of the countries. It is more of a long run predictor than a day to day indicator of therelationship between changes in the price level and the exchange rate.
Purchasing Power Parity Theory(PPP) the “law of one price” applies to individual commodities whereas PPP applies to the general price level • price of similar products to two countries should be “Law of one price” equal when measured in a common currency.
Example: American steel $100 per ton, Japanese steel 10,000 yen per tonIf E = 50 yen/$ then prices are: American Steel Japanese SteelIn U.S. $100 $200In Japan 5000 yen 10,000 yenIf E = 100 yen/$ then prices are: American Steel Japanese SteelIn U.S. $100 $100In Japan 10,000 yen 10,000 yenLaw of one price E = 100 yen/$
Anexample of one measure of the law of one price, which underlies purchase power parity, is the Big Mac Index
Range and quality of goods Trade barriers and nontradables Differences in price level measurement
Interest Rate ParityIt assumes that a countrys currencyexchange rate and risk-free interest rateare correlated, and that an arbitrageinvestor cannot profit through therelationship.• Interest rate parity is a financial theory that connects forward exchange rates, spot exchange rates, and nations individual interest .
Interest Rate Parity Difference between Forward Exchange Rate and Spot Exchange Rate = Difference between the interest rates of two countriesThe Forward exchange rates are when an investor agrees to exchange a currency at a specified rate at a specified future date.A spot exchange rate is what the trader can get for his currency right now.
The Dollar and Interest Rates While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced 26
Past Exchange Rate Regimes 1. 2. Gold standard Bretton Woods•Fixed exchange rates System•No control over Fixed exchange ratesmonetary policy using U.S. dollar as•Influenced heavily by reserve currencyproduction of gold and International Monetarygold discoveries Fund (IMF)
Past Exchange Rate Regimes (cont’d) 3. 4. Bretton Woods European Monetary System (cont’d) System•World Bank •Exchange rate•General Agreement on mechanismTariffs and Trade (GATT)•World TradeOrganization
The Current System : Managed FloatManaged float regime is the current internationalfinancial environment in which exchange rates fluctuate fromday to day, but central banks attempt to influencetheir countries exchange ratesby buying and selling currencies. It is also known as a dirtyfloat.In an increasingly integrated world economy, the currencyrates impact any given countrys economy through the tradebalance. In this aspect, almost all currenciesare managed since central banks or governments interveneto influence the value of their currencies.
The International Monetary Fund The organizations The IMFs stated Countries contribute stated objectives are togoal was to stabilize promote international money to a pool economic cooperation,exchange rates and through a quota international trade, assist the system from which employment, andreconstruction of the countries with payment exchange rate stability,world’s international imbalances can including by making financial resources payment borrow funds available to member system post-World countries to War II. temporarily. meet balance of payments needs