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Exchange Rates
The theory of relativity applied to
international trade
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Exchange Rates
Before diving into something that sounds reallycomplicated (but actually isnt) determiningthe relative value of different currencieslets
start with something simple.
Think of the $ (or Euro, Peso, or any othercurrency) as a commodity.
What determines the price of any commodity ina free market system?
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Floating Exchange Rates
Yes, we are back to supply and demand.
In a free market system, the relative value ofcurrencies float up and down based on the
forces of supply and demand.
These are known as floating exchange rates.
Floating exchange rates move continuously inresponse to market forces, unless (or until)government intervenes
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Basic Exchange Rate Movements
If demand for a currency goes up (or supplygoes down)the currency appreciates (orstrengthens)
If supply increases (or demand decreases)thecurrency depreciates (weakens)
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Factors that Impact Exchange Rates
Change in Income
Change in Relative Prices
Change in Relative Investment Prospects Speculation
Use of Foreign Reserves
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Change in Income
U.S. income goes up
U.S. consumption increasesdemand forEuropean imports goes up
Supply of US$ goes up, demand for Euro goesup
Both forces act to depreciate the US$ relative tothe Euro (takes fewer Euros to buy a US$)
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A Graphical Example
D
S1
S2
Q of $
E/$
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Change in IncomeIn Reverse
EU income goes up
Demand for U.S. imports increases
Euros flood the currency market, in order toexchange for US$
Demand for US$ goes up
US$ appreciates relative to the Euro (US$ isworth more in Euros)
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Back to the Graph
D1
SE/$
Q of $
D2
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Change in Relative Prices
Change in relative prices = relative rates ofinflation
Higher rates of domestic inflation in the U.S.make imports relatively cheaperdemand forEuropean imports goes up.
Higher inflation in the U.S. also make exportsless competitiveexports to Europe go down
Both factors act to weaken the US$
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Change in Relative Prices
Rememberit is the relative rate of inflationthat counts.
5% inflation in the U.S. will not cause the US$to weaken relative to the Euro if the inflationrate within the EU is running at 8%.
But, 3% inflation in the U.S. will cause the US$to depreciate relative to the Euro if inflation isonly 1% in the EU.
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Relative Investment Prospects
Currency values change in response to relativeinvestment opportunities
US investors see more attractive risk adjustedinvestment opportunities in India versus in thedomestic marketdemand for Indian Rupeesgoes up, and supply of US$ goes up
US$ depreciates relative to the Rupee
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Relative Investment Prospects
New government elected in India based on aplatform of increased regulation andprotectionist policies
Perceived risk of investing in India increases,reducing the relative attractiveness of investingin India versus the U.S.
Demand for US$ goes upUS$ appreciatesrelative to the Rupee
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Relative Interest Rates
In a global market, investors always have choicesin terms of where (and in what form) to investtheir money.
Relative interest rates have a significant impactin determining the relative attractiveness ofholding investments in one currency or another.
Increasing interest rates in the U.S. (on a relativebasis) provide an incentive for investors to holdUS$ denominated financial instruments
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Relative Interest Rates
An increase in demand for US$ denominatedinstruments (think U.S. Treasuries) increasesdemand for US$ -- US$ strengthens
When interest rates in the U.S. decline on arelative basis, demand for US$ denominatedinstruments goes downand the US$
depreciates.
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Speculation
It just wouldnt be a market without speculation.
All markets (including currency markets) aredriven by expectations of future performance
The past and present are relevant only to theextent that they can help predict where marketsare going in the future.
Expectations of future changes that will impactthe value of a currency will be factored into thecurrent market price of the currency
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Speculation
Expectations regarding
Relative rates of inflation
Which impact relative interest rates
Which will impact economic performance andincome
Which can change views on investment
prospects Impact currency markets in a never ending
circular loop of profit motivated speculation
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Speculation
The goal?
Buy currencies (or investments denominated incurrencies) that you think are undervalued
Sell currencies that you think are overvalued
Of course, these speculative trades create market
movements that reduce or eliminate theperceived over or under valuation.
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Use of Foreign Reserves
Use of foreign reservesotherwise known asgovernment intervention
Governments can buy or sell their own (oranother) currency in order to stabilize or changethe relative value of their currency
When governments intervene in the currencymarkets = dirty float
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Do these Factors Really Move
Markets?
Lets take a look
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Exchange Rates Meet BOP
The same factors that impact exchange rates alsoimpact balance of payments.
Change in income
Increase in income
Increased demand for imports
Net exports decline (Current Account goes down)
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Exchange Rates and BOP
Change in Relative Prices
High relative inflation
Imports up; exports down
Net exports decline (Current Account goes down)
Relative Investment Prospects
Strong investment prospects attract flows of capital
from foreign investors
Improves the Capital Account
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Exchange Rates and BOP
Relative Interest Rates
Increase in domestic U.S. interest rates will increasedemand for US$ denominated instruments
When foreign investors buy U.S. financialinstrumentsCapital Account improves
Speculation
Speculative buying and selling of impacts the CapitalAccount and market exchange rates
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Exchange Rates and BOP
Use of Foreign Reserves
If the Fed buys US$ -- positive impact on value ofUS$
But, negative impact on Capital Account (reductionin reserves)
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Everything is Related
Economic growth and income, balance ofpayments and exchange rates are all related
Y = C + I + G + (X-M)
Changes in net exports (X-M) cause changes inGDP (Y)
Changes in economic growth (income) and net
exports drive changes in exchange rates, whichin a circular fashion impact net exports andnational income
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A Self-Correcting System
A floating exchange rate system is self-correcting
Balance of payments will adjust (or shouldadjust) automatically based on changes inexchange rates
A country that runs a large trade deficit willdevalue its currency, making its exports cheaper
to the rest of the world
Exports riseself-correcting the BOP problem
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Your Assignment
1. Pick a currency (anything except the US$).
2. Summarize the exchange rate changes for thiscurrency over the last 12 months.
3. Explain the underlying causes of theseexchange rate movements.
4. Predict where this currency will trade over thenext 12 monthsand support your prediction.
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Your Assignment (Contd)
5. Required work product: 12 page paper summarizing your analysis and support
for your predictions (due at the beginning of next class)
Short (5 minutes or less) presentation of your analysisand conclusions
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Exchange Rates (Continued)
Agenda:
Floating versus fixed exchange rates
Advantages and disadvantages of floating andfixed exchange rate systems
Managed exchange rates
Purchasing power parityTerms of trade
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Floating vs. Fixed Exchange Rates
Floating exchange rate systems allow exchangerates to move based on supply and demanddynamics in the market.
In fixed exchange rate systems the exchange rateis pegged or locked in to a specific, fixed rate ofexchange.
Floating and fixed systems have some important(and fairly obvious) advantages anddisadvantages
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Fixed Exchange Rates
Advantages:
Certainty
Fixed exchange rates take the risk of currency fluctuations
out of business transactions (usually) Increased trade
If the greater certainty of fixed exchange rates leads to anincrease in trade, this would create a net economic benefit
Experience over the last 30 years does not support thiscorrelation
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Fixed Exchange Rates
Advantages:
Reduced speculation No opportunity to profit from day to day changes in the
exchange rate
Huge opportunity to take positions in expectation ofdevaluations or revaluations of a fixed exchange rate
Government discipline Without the self-correcting mechanisms of a floating
exchange rate, governments (theoretically) should be forcedto exercise more disciplined in the management of fiscal andmonetary policy
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Fixed Exchange Rates
Disadvantages:
Reserves
Governments must have sufficient reserves of gold and
foreign currency to support frequent intervention in themarket
Loss of control over monetary policy
If exchange rates are fixed, money supply and interest rates
must float based on flow of trade and investment
No auto-correction mechanism
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Floating Exchange Rates
Advantages:
Self-correcting
No reserves required for market intervention Control over fiscal and monetary policy
Governments can adjust fiscal and monetary policyand allow changes in the exchange rate to adjust forchanges in the balance of payments (let the self-correcting mechanism do its thing)
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Floating Exchange Rates
Advantages:
No large jumps Exchange rates move constantly, but usually in very
small daily increments No major jumps from devaluations or revaluations
Reduction in speculation (maybe)
In theory offsetting trades may cancel each other outand reduce the net impact of speculation on themarket
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Floating Exchange Rates
Disadvantages:
Less certainty
Floating rates add an additional element ofuncertainty (risk) to international transactions
This risk can be mitigated by hedging in forwardcurrency markets
Difficult to hedge long-term investments
Increased speculation (probably)
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Floating Exchange Rates
Lack of discipline
Adjustments in exchange rates can mute (or at leastdelay) the impact of irresponsible economic policies
on the part of government, businesses or labor. Example: Government adopts inflationary monetary
and fiscal policy; inflation increases; currencydecreases in value, which helps offset the negativeimpact of higher prices on exports
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Managed Exchange Rates
Managed exchange rate systems fall between the twoextremes of perfectly fixed and pure floating ratesystems
Two types of managed systems: Adjustable peg
Government pegs a target exchange rate
Manages based on a preset band around this target rate
Dirty float
Floating system with some government intervention
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Exchange Rate Management Tools
Buy or sell currency (ex: buy to appreciate currency)
Manipulate interest rates (ex: lower to depreciatecurrency)
Adopt protectionist policies (use of tariffs or exportsubsidies to protect value of currency)
Violates WTO agreement
Adjustments to exchange rate can have the same effect
Expenditure switching
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Exchange Rate Management Tools
Use fiscal and monetary policy to drive changesin GDP/national income Expenditure changing
Reductions in national income reduce spending onimports, which decreases the supply of currency onthe marketcurrency appreciates and balance ofpayments improves
Tradeoff between manging balance of payments anddomestic economic and political considerations(internal versus external balance)
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Purchasing Power Parity
Based on law of one price
Asserts that a good must sell for the same pricein all locations
Under this theory, each currency should havethe same purchasing power in its home
market, and
Nominal exchange rates should reflect the pricelevels in different countries
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Purchasing Power Parity
If the theory of purchasing power parity holds,the currency adjusted price of like products(think Big Mac) should be the same when
benchmarked against a single currency (like thedollar)
Why wouldnt this theory hold in practice?
Many goods are not easily traded Even goods that are easily traded are often not
perfect substitutes (product differentiation)
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Terms of Trade
What will happen to the volume of trade as the termsof trade improve or worsen?
Depends on the elasticity of demand for exports and
importsthe sensitivity of demand to changes in price If demand for exports and imports is elastic (highly
sensitive to price changes), an improvement in terms oftrade (export prices rising faster than import prices) will
worsen the balance of payments (as demand for exportsfalls more than imports)