Econ 141 Fall 2013
Slide Set 1
Introduction to exchange rates and exchange rate regimes
Defining the Exchange Rate
• The exchange rate is the price of a unit of one currency in terms of
another currency.
• For example, the U.S. dollar exchange rate for euros is
E$/€ =dollars/one euro
This is currently E$/€ = 1.35 dollars per euro.
The euro exchange rate for U.S. dollars is E€/$ = 0.74 euros per dollar
E$/¥ = 0.0102 dollars per yen and E¥/$ = 98.08 yen per dollar
E$/£ = 1.62 dollars per pound and E£/$ = 0.62 dollars per pound
Defining the Exchange Rate
• Notice that
E$/€
1
=
E €/$
1
1.35 =
0.74
• We need to be explicit about how we are expressing the relative price
of one currency in terms of the other.
• We will use the convention that we express exchange rates as the
number of units of the home currency that exchange for one unit of
foreign.
Appreciations and Depreciations
• If one currency buys more of another currency, we say it has
experienced an appreciation – its value has risen, appreciated or
strengthened.
• If a currency buys less of another currency, we say it has experienced
a depreciation – its value has fallen, depreciated, or weakened.
Appreciations and Depreciations
• For the U.S. dollar,
 When the U.S. exchange rate E$/€ rises, more dollars are needed to
buy one euro. The price of one euro goes up in dollar terms, and the
U.S. dollar experiences a depreciation.
 When the U.S. exchange rate E$/€ falls, fewer dollars are needed to
buy one euro. The price of one euro goes down in dollar terms, and
the U.S. dollar experiences an appreciation.
Appreciations and Depreciations
Similarly, for the euro,
 When the Eurozone exchange rate E€/$ rises, the price of one dollar
goes up in euro terms and the euro experiences a depreciation.
 When the Eurozone exchange rate E€/$ falls, the price of one dollar
goes down in euro terms and the euro experiences an
appreciation.
Appreciations and Depreciations
• At the beginning of January 2011, the dollar value of the euro was
E$/€ =1.32
• At the beginning of May 2011, it was E$/€ =1.47
• Over this period, the dollar depreciated against the euro by the
amount ∆E$/€ = 1.47 - 1.32 = 0.15
• The percentage depreciation was
∆E$/€/ E$/€ x 100 = (0.15 / 1.32) x 100 = 11%
The annual rate of depreciation over these four months was 38%.
Multilateral Exchange Rates
• To aggregate different trends in bilateral exchange rates into one measure, we
can calculate multilateral exchange rate changes for baskets of currencies using
trade weights to construct an average of all the bilateral changes for each
currency in the basket.
• The resulting measure is called the change in the effective exchange rate.
Eeffective E1 Trade 1 E2 Trade 2
EN Trade N



Eeffective
E1 Trade
E2 Trade
E N Trade

Trade - weightedaverage of bilateral nominal exchange rate changes
Exchange rates and relative prices of goods.
• Suppose you wanted to buy a Belgian chocolate bar selling for 1 euro:
The cost of the bar in dollars will be 1 euro x E$/€ dollars/euro.
On Jan 2, 2011, it would cost $1.32
But on May 1, 2011, you would pay $1.47
• Suppose BMW sold a car in L.A. for $35,000 in 2011. Once it
exchanged its receipts to euros, BMW would receive €26,515 in
January but only €23,810 in May.
 Changes in the exchange rate cause changes in prices of foreign



goods expressed in the home currency.
Changes in the exchange rate cause changes in the relative prices of
goods produced in the home and foreign countries.
When the home country’s exchange rate depreciates, home exports
become less expensive as imports to foreigners, and foreign exports
become more expensive as imports to home residents.
When the home country’s exchange rate appreciates, home export
goods become more expensive as imports to foreigners, and foreign
export goods become less expensive as imports to home residents.
Exchange Rate Regimes: Fixed Versus Floating
• Fixed (or pegged) exchange rate regimes are those in which a
country’s exchange rate fluctuates in a narrow range (or not at all)
against some base currency over a sustained period, usually a year or
longer. A country’s exchange rate can remain rigidly fixed for long
periods only if the government intervenes in the foreign exchange
market in one or both countries.
• Floating (or flexible) exchange rate regimes are those in which a
country’s exchange rate fluctuates in a wider range, and the
government makes no attempt to fix it against any base currency.
Appreciations and depreciations may occur from year to year, each
month, by the day, or every minute.
Floating exchange rates
• The major currencies of the world, float against one another.
For example, the U.S. dollar is allowed to float against the euro, the
pound, the yen, as well as many smaller country currencies (for
example, the Danish krone, Canadian dollar (loonie) or New Zealand
dollar (kiwi)).
Developing Country Exchange Rates
• Exchange rates in developing countries can be much more volatile
than those in developed countries.
• India is an example of a middle ground, somewhere between a fixed
rate and a free float, called a managed float (also known as dirty
float, or a policy of limited flexibility.
• Dramatic depreciations, such as those of Thailand and South Korea in
1997, are called exchange rate crises and they are more common in
developing countries than in developed countries.
Green line shows a measure volatility of the exchange rate.
Currency Unions and Dollarization
• Under a currency union (or monetary union), there is some form of
transnational structure such as a single central bank or monetary
authority that is accountable to the member nations. The most
prominent example of a currency union is the Eurozone.
• Under dollarization one country unilaterally adopts the currency of
another country. The reasons for this choice can vary. A small size,
poor record of managing monetary affairs, or if people simply stop
using the national currency and switch en masse to an alternative.
Exchange Rate Regimes
• Independently Floating: 25 Countries
• Including the U.S., Canada, Australia, Mexico, United Kingdom, Sweden, South
Korea and even Albania.
• Managed Floating: 44 countries
• Including India, Singapore, Thailand and Kenya (many Latin American, East
Asian and African countries)
• Crawling bands or pegs: 10 countries
• Including China
Exchange Rate Regimes
• Currency boards: 7 countries
• Including Hong Kong
• Other pegs: 60 countries
• Including Argentina and many Central Asian and African countries
• No independent currency: 46 countries
•
•
•
•
The Eurozone
The Central African and Western African CFA Franc Zones
Eastern Caribbean Currency Union
Use another currency: Ecuador, Panama, El Salvador and 7 others (7 use USD)