10 The Determination of Exchange Rates
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The document discusses exchange rates and is divided into chapters. Chapter 10 covers the determination of exchange rates. It describes the International Monetary Fund (IMF) and its role in establishing exchange rates. Countries can choose between hard peg, soft peg, or floating exchange rate arrangements. It also discusses how the European Monetary System established exchange rate stability in Europe and how the euro became the currency of the Eurozone. The major determinants of exchange rates are also identified, such as demand for a country's goods and currency. Managers use fundamental and technical analysis to forecast exchange rate movements. Exchange rate changes influence business decisions in areas like marketing, production, and finance.
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10 The Determination of Exchange Rates
- 1. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-1 Chapter 10 The Determination of Exchange Rates
- 2. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-2 Learning Objectives To describe the International Monetary Fund and its role in the determination of exchange rates To discuss the major exchange-rate arrangements that countries use To explain how the European Monetary System works and how the euro became the currency of the euro zone To identify the major determinants of exchange rates To show how managers try to forecast exchange- rate movements To explain how exchange rate movements influence business decisions
- 3. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-3 Introduction Learning Objective 1: To describe the International Monetary Fund and its role in the determination of exchange rates
- 4. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-4 The International Monetary Fund The goals of the International Monetary Fund (IMF) are to ensure stability in the international monetary system promote international monetary cooperation and exchange-rate stability facilitate the balanced growth of international trade provide resources to help members in balance- of-payments difficulties or to assist with poverty reduction
- 5. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-5 The International Monetary Fund The Bretton Woods Agreement established a par value, or benchmark value, for each currency initially quoted in terms of gold and the U.S. dollar The dollar became the world benchmark for trading currencies and continues in that role today
- 6. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-6 The IMF Today The Quota System every member contributes a quota Assistance Programs the IMF lends money to ease balance-of- payments difficulties Special drawing rights (SDRs) the IMF’s unit of account
- 7. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-7 The Global Financial Crisis and the IMF The global crisis in 2008-2009 raised concerns over global liquidity prompted the G20 to inject huge amounts of cash into the IMF Greece’s 2010-2011 financial crisis required assistance from the IMF and the EU the IMF required Greece to adopt very unpopular austerity measures
- 8. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-8 Evolution to Floating Exchange Rates The Smithsonian Agreement 8% devaluation of the dollar revaluation of other currencies widening of exchange rate flexibility The Jamaica Agreement provided greater exchange rate flexibility eliminated the use of par values
- 9. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-9 Exchange Rate Arrangements Under the Jamaica Agreement countries selected and maintained their own exchange rate arrangements The IMF monitors the exchange rate policies of countries to see if they are acting openly and responsibly
- 10. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-10 Exchange Rate Arrangements Exchange Rate Arrangements and Anchors
- 11. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-11 Three Choices: Hard Peg, Soft Peg, or Floating Learning Objective 2: To discuss the major exchange rate arrangements that countries use
- 12. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-12 Three Choices: Hard Peg, Soft Peg, or Floating The IMF classifies currencies into three categories Hard peg 12.2% of total value is locked into something and does not change dollarization currency boards Soft peg 45.7% of total more flexible than hard peg Floating 42.1% of total floating or freely floating
- 13. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-13 The Euro Learning Objective 3: To explain how the European Monetary System works and how the euro became the currency of the euro zone
- 14. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-14 The Euro The European Monetary System (EMS) established to create exchange rate stability within the European Community European Monetary Union (EMU) outlined the criteria for euro applicants the U.K., Sweden, and Denmark opted not to adopt the euro The European Central Bank (ECB) sets monetary policy for the adopters of the euro
- 15. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-15 Determining Exchange Rates Learning Objective 4: To identify the major determinants of exchange rates
- 16. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-16 Determining Exchange Rates Currency in a floating rate world demand for a country’s currency is a function of the demand for that country’s goods and services and financial assets
- 17. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-17 Determining Exchange Rates The Equilibrium Exchange Rate and How it Moves
- 18. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-18 Determining Exchange Rates Currency in a fixed rate or managed floating rate world Role of central banks reserve assets intervening in the market attitudes toward intervention The Bank for International Settlements (BIS) the central banks’ bank coordinates central bank intervention
- 19. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-19 Black Markets A black market closely approximates a price based on supply and demand for a currency instead of a government controlled price
- 20. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-20 Foreign Exchange Convertibility and Controls Hard currencies U.S. dollar, euro, British pound, Japanese yen Soft currencies developing countries Countries can control convertibility through licenses multiple exchange rate systems advance import deposits quantity controls
- 21. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-21 Exchange Rates and Purchasing Power Parity Purchasing power parity (PPP) a change in relative inflation between two countries must cause a change in exchange rates to keep the prices of goods in the countries fairly similar The Big Mac Index
- 22. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-22 Exchange Rates and Interest Rates The Fisher Effect links inflation and interest rates The International Fisher Effect (IFE) links interest rates and exchange rates Other Factors in Exchange Rate Determination confidence information
- 23. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-23 Forecasting Exchange Rate Movements Learning Objective 5: To show how managers try to forecast exchange-rate movements
- 24. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-24 Fundamental and Technical Forecasting Forecasting exchange rates Fundamental forecasting uses trends in economic variables to predict future rates Technical forecasting uses past trends in exchange rates to spot future trends Biases can skew forecasts Timing, direction, and magnitude of exchange rate movements are important to consider
- 25. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-25 Fundamental Factors to Monitor Monitor The institutional setting Fundamental analyses Confidence factors Events Technical analyses
- 26. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-26 Business Implications of Exchange Rate Changes Learning Objective 6: To explain how exchange rate movements influence business decisions
- 27. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-27 Business Implications of Exchange Rate Changes Marketing Decisions when the value of a country’s currency rises, exporting becomes more difficult as the product becomes more expensive in foreign markets Production Decisions might locate production in a weak currency country because the initial investment is cheap and it will make a good base for exports Financial Decisions currency rates influence sourcing, cross-border remittance of funds, and the reporting of financial results
- 28. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-28 The Future: The Dollar, The Euro, The Yen, The Yuan Europe the euro should take market share away from the dollar as the prime reserve asset assuming the problems in Greece and other countries are controlled Asia China is moving forward to establish the yuan as a major world currency Latin America emerging market currencies should strengthen as commodity prices recover
- 29. Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 10-29 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.
Editor's Notes
- Chapter 10: The Determination of Exchange Rates
- The Learning Objectives for this chapter are To describe the International Monetary Fund and its role in the determination of exchange rates To discuss the major exchange-rate arrangements that countries use To explain how the European Monetary System works and how the euro became the currency of the euro zone To identify the major determinants of exchange rates To show how managers try to forecast exchange-rate movements To explain how exchange rate movements influence business decisions To describe the International Monetary Fund and its role in the determination of exchange rates To discuss the major exchange-rate arrangements that countries use To explain how the European Monetary System works and how the euro became the currency of the euro zone To identify the major determinants of exchange rates To show how managers try to forecast exchange-rate movements To explain how exchange rate movements influence business decisions
- Learning Objective 1: To describe the International Monetary Fund and its role in the determination of exchange rates.
- The IMF, which was created in 1945, was formed to promote exchange rate stability and facilitate the international flow of currencies. The IMF monitors the global economy and also the economies of individual nations and provides recommendations as needed. Most recently, the IMF has been involved in the crisis in Greece for example.
- Under the Bretton Woods system of par values, the dollar was fixed at $35 per ounce of gold. This became the benchmark against which all other currencies were valued. Under the agreement, currencies could fluctuate within a one percent band of their par value.
- The IMF relies on a quota system to generate funds to lend to countries in need. Quotas, which are based on the relative size of a country within the global economy, are important because they influence the voting power of each country. The larger the quota, the higher the voting power. The quota system was reformed in 2010 giving more quota shares to emerging markets. So, while the United States retained its top position, China now holds the number 3 spot, and the BRIC countries are among the largest shareholders in the Fund. Special drawing rights are an international reserve asset given to each country to help increase its reserves. They are also the unit of account in which the IMF keeps its financial records. Currencies making up the SDR basket are the U.S. dollar, the euro, the Japanese yen, and the British pound.
- The G20, mindful of the global financial crisis, voted to significantly increase reserves available to the IMF to help countries in distress. Greece has been a beneficiary of IMF funds, but continues to be quite unstable.
- In the early 1970s, the United States was in trouble. The country’s large balance-of-trade deficit made it difficult to maintain the fixed exchange rate system prompting then President Richard Nixon to abandon the Bretton Woods system in 1971. A new system, the Smithsonian Agreement was then established, followed by the Jamaica Agreement in 1976.
- The IMF requires countries to identify how they base their exchange rate mechanism.
- The Table shows different exchange rate arrangements and anchors.
- Learning Objective 2: To discuss the major exchange-rate arrangements that countries use.
- What type of arrangement do countries choose? There are three possibilities: hard peg, soft peg, or floating. Countries can adopt a currency in place of their own. Countries that use the dollar as an exchange arrangement with no separate legal tender are practicing dollarization of the currency. Another option for countries with a hard peg is the currency board. A currency board is an organization generally separate from a country’s central bank. Its responsibility is to issue domestic currency that is typically anchored to a foreign currency. If it does not have deposits on hand in the foreign currency, it cannot issue more domestic currency. Most countries following a soft peg arrangement use a conventional fixed-peg arrangement, whereby a country pegs its currency to another currency or basket of currencies and allows the exchange rate to vary plus or minus one percent from that value. It’s more similar to the original fixed exchange-rate system used by the IMF. Floating regimes include floating systems that change according to market forces but may be subject to market intervention, or freely floating systems where intervention is rare. Because countries can change their systems, it’s important for managers to monitor exchange regimes in each country.
- Learning Objective 3: To explain how the European Monetary System works and how the euro became the currency of the euro zone.
- The EU countries agreed to political and monetary union with the Treaty of Maastricht in 1992. As part of this agreement the countries decided to replace individual currencies with a single currency, the euro. The Growth and Stability Pact provides the criteria that must be met to be part of the EMU. It includes measures of deficits, inflation, debt, interest rates, and exchange rate stability. Today, 17 of the 27 EU countries have adopted the euro, and others are working toward meeting the criteria. The new currency required companies to update their systems, but should also provide greater price transparency, and eliminate foreign exchange costs and risks. During the global financial crisis, investors fled to dollars as a safe-haven currency and only returned to euros when they were willing to incur more risk. Currently, the financial crisis in Greece is threatening the future of the euro. Moreover, instability in Spain, Portugal, and Italy could also be problematic.
- Learning Objective 4: To identify the major determinants of exchange rates.
- In a free float system, currencies are determined by supply and demand without government intervention.
- This Figure shows the equilibrium exchange rate in the market and then a movement to a new equilibrium level as the market changes.
- Fixed exchange rates do not automatically change in value according to supply and demand. Instead, they are regulated by central banks like the Federal Reserve in the United States and the European Central Bank in the EU. While central banks maintain reserve assets in gold, foreign exchange reserves, and IMF-related assets, the vast majority of reserve assets is foreign exchange. Central banks use these reserves as they intervene in markets by buying and selling currency to influence its price. Keep in mind that governments vary in their intervention policies by country and by administration.
- Black markets often exist in countries that strictly regulate and control the convertibility of their currencies.
- Fully convertible currencies can be purchased in unlimited amounts by both residents and nonresidents of a country. Hard currencies are usually fully convertible and strong or relatively stable in value compared to other currencies. In contrast, soft currencies aren’t fully convertible. Soft currencies are sometimes called weak currencies. Governments might try to conserve scarce foreign exchange by imposing exchange restrictions. Licensing occurs when a government requires that all foreign exchange transactions be regulated and controlled by it. Governments can also use multiple exchange rate systems to set different rates for different types of transactions. Governments might also demand advance import deposits prior to releasing foreign exchange to pay for imports. Finally, quantity controls can be used to limit the amount of foreign currency that can be used in a specific transaction.
- Relative rates of inflation, differences in real rates of inflation, and confidence in the government’s ability to manage the political and economic environment all influence exchange rates. The Big Mac Index can be used to test PPP. The theory suggests that the price of a burger should be the same from country to country after exchange rates. If prices aren’t the same, then the foreign currency is undervalued or overvalued relative to the dollar. Note that if the domestic inflation rate is lower than that in the foreign country, the domestic currency should be stronger than that of the foreign currency.
- Interest rate differentials can have an important effect on exchange rates especially in the short term. The Fisher Effect suggests that the nominal interest rate is the real interest rate plus inflation. Because the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation. According to the International Fisher Effect, the currency of the country with the lower interest rate will strengthen in the future. In other words, interest rate differentials are unbiased predictors of future changes in spot rates. In addition to interest rates and inflation, exchange rates can be affected by confidence and technical factors.
- Learning Objective 5: To show how managers try to forecast exchange-rate movements.
- It’s hard to know what will happen to currencies in the future. There are two main approaches to forecasting exchange rates: fundamental forecasting and technical forecasting. Keep in mind that neither approach works well – in fact, all forecasting tends to be imprecise making it difficult for multinationals to develop operating strategies.
- Firms can try to monitor certain fundamental factors as a way to gain some insight as to what might happen with currencies in the future. For freely floating exchange rates, the best predictor of future exchange rates are interest rates for short-term movements, inflation rates for medium-term movements, and current account balances for long-term movements. However, since most currencies are managed at least to some degree, there are other factors to consider as well. Firms should consider the institutional setting and whether, for example, the currency floats or is managed, and how intervention is handled. Fundamental analyses can provide insight as to whether the currency is overvalued or undervalued in terms of PPP. Confidence factors can give some indication about market expectations. It’s also important to consider whether there any national or international events or crises that could impact a currency’s value. Finally, technical analyses can provide information about what trends might be emerging.
- Learning Objective 6: To explain how exchange rate movements influence business decisions.
- Why do firms need to bother trying to predict exchange rate changes? Well, they can dramatically affect operating strategies and profits. Exchange rates changes can affect marketing, production, and financial decisions.
- The dollar, the euro, the yen, and the yuan will all play a role in the global economy in the future. At this point it is difficult to say just what will happen though. The dollar will probably maintain its position as a benchmark currency in the world, especially given that the euro continues to be a question mark given the problems in Greece and some of the other unstable EU countries like Spain, Portugal, Ireland, and Italy. The Japanese yen will probably not have as much power as the dollar or the euro, but remains one of the most widely traded currencies in the world. However, the yuan could become a major currency. While it’s still not floating freely, it’s going through a significant liberalization process, and could become influential in the future. Similarly, the Brazilian real is emerging as a key currency in Latin America.