Chapter 10
Understanding
Foreign
Exchange
Introduction
• The volume of international exchange has
grown tremendously since World War II
• Whenever an exchange takes place between
residents of different countries, one kind of
money has to be exchanged for another
• Foreign exchange rate between two
currencies is determined by supply and
demand established in the foreign exchange
market consisting of a network of foreign
exchange dealers (Figure 10.1)
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Figure 10.1 Supply of and demand for
foreign exchange and foreign exchange rates
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What Determines Foreign
Exchange Rates
• Imports of a country give rise to a
demand for foreign exchange and a
supply of U.S. dollars
• Exports result in a supply of foreign
exchange and a demand for U.S.
dollars
• Therefore, trade of the U.S. will be a
primary contributor to the demand and
supply of dollars and foreign currency
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10-4
What Determines Foreign
Exchange Rates (Cont.)
• Balance of Payments
– A summary of payments to foreigners for imports
and receipts from foreigners for exports
– Deficit
• Paying out more abroad than we are taking in (imports >
exports—trade deficit)
• Demand for foreign currency is greater than supply
• As a result, the price of foreign currency will rise—the
foreign currency will appreciate relative to the U.S. dollar
and the U.S. dollar will depreciate
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What Determines Foreign
Exchange Rates (Cont.)
• Balance of Payments (Cont.)
– Surplus
• Receiving more from abroad than we are spending
(exports > imports—trade surplus)
• This will result in an appreciation of the U.S. dollar and a
depreciation of the foreign currency
– When exchange rates freely react to supply and
demand for foreign currency, a new equilibrium
exchange rate will tend to eliminate balance of
payments and bring trade into balance (exports =
imports)
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10-6
What Determines Foreign
Exchange Rates (Cont.)
• Balance of Payments (Cont.)
– Deficit
• Result in a depreciation of the U.S. dollar
• Encourages exports and discourages imports
• Eventually the trade balance is in equilibrium at the new
exchange rate
– Surplus
• Appreciation of the U.S. dollar
• Discourages exports and encourages imports
• The trade will be balanced at the new exchange rate
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10-7
What Determines Foreign
Exchange Rates (Cont.)
• Why Do Exchange Rates Fluctuate
– Figure 10.2 shows that the exchange rate
between the U.S. dollar and other major
currencies varies considerably over time
– Figure 10.4 and 10.5 demonstrates that anything
that causes the demand or supply in the foreign
exchange market to shift will change the
equilibrium exchange rate
• U.S. residents buying more or less foreign goods will
shift the demand curve for foreign currency
• Changes in foreigner’s purchase of U.S. goods will shift
the supply curve of foreign currency
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Figure 10.2 Recent exchange rate history between
the U.S. dollar and other major currencies
(a) Canadian dollar per U.S. dollar
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Figure 10.2 Recent exchange rate history between
the U.S. dollar and other major currencies
(b) German mark per U.S. dollar
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Figure 10.2 Recent exchange rate history between
the U.S. dollar and other major currencies
(c) Japanese yen per U.S. dollar
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Figure 10.2 Recent exchange rate history between
the U.S. dollar and other major currencies
(d) British pound per U.S. dollar
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Figure 10.3 A rightward shift in the demand curve for
francs raises the dollar price of francs, implying an
appreciation of the franc and a depreciation of the dollar
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Figure 10.4 A rightward shift in the supply curve of
francs lowers the dollar price of francs, implying a
depreciation of the franc and appreciation of the dollar
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What Determines Foreign
Exchange Rates (Cont.)
• Factors that influence long-run
supply and demand conditions
– Relative prices of U.S. versus foreign
goods
• Relative increase in price of U.S. goods will
encourage more imports
– increase demand for foreign currency
– tends to depreciate the value of the U.S. dollar or an
appreciation of the foreign currency
• Relative decrease in price of U.S. goods will
result in an appreciation of the U.S. dollar
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What Determines Foreign
Exchange Rates (Cont.)
• Factors that influence long-run supply and
demand conditions (Cont.)
– Productivity
• Increased productivity in U.S. will lower price of American
goods
• Increased demand for U.S. goods internationally
• Increased supply of foreign currency will appreciate the
value of the dollar while foreign currency depreciates
– Tastes for U.S. versus foreign goods
• Increased tastes for U.S. goods
• Increased demand for U.S. goods and increased supply
of foreign currency
• Dollar appreciates relative to foreign currency
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What Determines Foreign
Exchange Rates (Cont.)
• How Global Investors Cause
Exchange Rate Volatility
– Changes in the factors described above
occur slowly over time, so they cannot
explain the often violent short-term
movement in exchange rates
– Figure 10.5 shows the considerable dayto-day movement of U.S. dollar exchange
rates versus major foreign currencies
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Figure 10.5 Daily fluctuations on foreign exchange
rates can be quite volatile (2003)
(a) U.S. dollar per British pound
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Figure 10.5 Daily fluctuations on foreign exchange
rates can be quite volatile (2003)
(b) Japanese yen per U.S. dollar
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Figure 10.5 Daily fluctuations on foreign exchange
rates can be quite volatile (2003)
(c) German mark per U.S. dollar
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Figure 10.5 Daily fluctuations on foreign exchange
rates can be quite volatile (2003)
(d) Canadian dollar per U.S. dollar
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What Determines Foreign
Exchange Rates (Cont.)
• How Global Investors Cause Exchange
Rate Volatility (Cont.)
– International capital mobility
• Funds flow freely across international borders and
investors can purchase U.S. or foreign securities
• U.S. investors compare the expected return on
domestic securities versus foreign securities to determine
which are the most attractive
• Therefore, changes in preferences of U.S. versus foreign
securities will result in a change in demand and supply of
foreign currency and a change in the exchange rate
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What Determines Foreign
Exchange Rates (Cont.)
• How Global Investors Cause Exchange
Rate Volatility (Cont.)
– International capital mobility (Cont.)
• In this case, expectations of future exchange rates play a
central role in the decision process
• When considering investing in foreign securities to take
advantage of a higher yield, must consider the expected
movement of future exchange rates
• In order to invest in foreign securities, must first purchase
foreign currency and eventually re-purchase U.S. dollars
to bring currency back to U.S.
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10-23
What Determines Foreign
Exchange Rates (Cont.)
• How Global Investors Cause
Exchange Rate Volatility (Cont.)
– International capital mobility (Cont.)
• It is possible that a change in the future
exchange rate will offset any increased yield by
holding foreign securities
• In fact, the international mobility of capital
will often cause the change in future
exchange rates that was anticipated—selffulfilling prophesy
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10-24
What Determines Foreign
Exchange Rates (Cont.)
• How Global Investors Cause
Exchange Rate Volatility (Cont.)
– This suggests that the equilibrium foreign
exchange rate is sensitive to investor
expectations of future movement in
exchange rates
– Since these expectations might be quite
unstable and susceptible to change, this
may cause considerable short-term
volatility in the actual exchange rates
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10-25
Fixed Versus Floating Exchange
Rates
• Volatility in foreign exchange rates
represents a cost of doing business
internationally and imposes
considerable risk on investments
overseas
• Historically governments tried to avoid
this cost by fixing exchange rates at
some predetermined level
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Fixed Versus Floating Exchange
Rates (Cont.)
• Fixed exchange rate system
– This was the system maintained globally
from 1944 until the early 1970s.
– It came under the supervision of the
International Monetary Fund (IMF)
– After the collapse of the fixed exchange
rate system, it was resurrected with a more
limited scope in 1979 for the major
European countries
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Fixed Versus Floating Exchange
Rates (Cont.)
• Fixed exchange rate system (Cont.)
– The most recent example of a fixed exchange rate
is the introduction of the Euro as the common
currency of the 12 members of the European
Monetary Union
• This new monetary union sets the exchange rate
between the Euro and the member countries’ national
currencies at a fixed rate
• Individual member countries are expected to maintain
domestic economic conditions that will not cause these
agreed upon exchange rates to change
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Fixed Versus Floating Exchange
Rates (Cont.)
• How Fixed Rates Are Supposed to
Work
– The correction process under a floating
exchange rate system
• Country runs a balance-of-payments deficit
• Supply of its currency offered on world financial
markets exceeds the demand
• The currency will be depreciated in value
relative to other markets
• This adjustment brings the international
payments into equilibrium
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Fixed Versus Floating Exchange
Rates (Cont.)
• How Fixed Rates Are Supposed to Work
(Cont.)
– However, under a fixed exchange rate system
these fluctuations are prevented from occurring
through government intervention
– Figure 10.6(a) (Floating Rate System)
• The supply curve of British Pounds shifts to the right
because British tastes have shifted toward increased
purchases of American goods
• This increased supply of pound would put downward
pressure on the value of the Pound
• Under a floating rate system the new lower equilibrium
point would be reached where quantity supplied of
pounds equals the quantity demanded of pounds
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Fixed Versus Floating Exchange
Rates (Cont.)
• How Fixed Rates Are Supposed to Work
(Cont.)
– Figure 10.6(b) (Fixed Rate System)
• Under this system, the British government would
intervene in the foreign exchange market and purchase
the excess pounds available at the predetermined fixed
(pegged) rate
• Britain’s international reserves are used to purchase the
excess pounds which prevents the exchange rate from
falling below the pegged rate
• Traditionally these international reserves consist of gold,
U.S. dollars, other major currencies, and now the Euro
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10-31
Figure 10.6 In
(a), with floating
rates, the pound
depreciates; in
(b), with pegged
rates, the British
central bank
prevents the
decline by buying
up the excess
supply of pounds
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International Financial Crises
• Major problem with a fixed rate system is that
it contains no self-correcting exchange rate
mechanism to eliminate a country’s persistent
balance-of-payment deficit
• A continual balance-of-payment deficit
suggests domestic economic structural
problems relative to the rest of the world
• Eventually the country will run out of
international reserves and be forced to
devalue which will eliminate the deficit
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International Financial Crises
(Cont.)
• The expectation of a devaluation will cause
the international financial community to take
actions that will increase the likelihood of the
anticipated devaluation
– Individuals will sell the threatened currency in the
international market
– This increases the supply of the currency which
increases the downward pressure on the value
– This capital flight will further deplete the country’s
international reserve and speed up the
devaluation
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International Financial Crises
(Cont.)
• Currently industrialized countries practice a
managed float system
– The exchange rate is permitted to vary within a
predetermined band
– If foreign exchange markets attempt to push the
value of the currency outside the band (both
above or below), central bank will intervene
– However, if the central bank is intervening an
excessive amount, it is likely that country will be
forced to devalue or revalue its currency to
recognize structural changes in local economy
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