Exchange Rates and the Euro
Dr. Katie Sauer
Metropolitan State
College of Denver
Presented at the
“Discovering the European Union” Workshop
Sponsored by the Colorado Council for Economic Education
And the Colorado European Union Center of Excellence
August 4th, 2010 Denver, CO
Outline:
I. Currency
II. Foreign Exchange
A. Exchange Rate Basics
B. Exchange Rate Fluctuations:
C. Types of exchange rates
D. Exchange Rate Choice
E. Historical EU Monetary Developments
III. Fun with Exchange Rates: The Economist’s Big Mac Index
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I. Currency
Currency is a unit of exchange. It is exchanged for:
- goods
- services
- other currency
Most countries have control over the supply and production of
their own currency.
Usually Central Banks or Ministries of Finance control the
currency.
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There are about 175 currencies in current circulation.
There are about 195 countries in the world.
- several countries use the same currency
ex: the euro is used by Portugal, Spain, France,
Italy, Ireland, Belgium, Luxembourg, Germany,
Netherlands, Austria, Slovenia, Slovakia, Finland,
Malta, Greece and Cyprus
- some countries declare another country’s currency to be
legal tender
ex: Panama and El Salvador use the US dollar as
legal tender
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Several countries use the same name for their currency:
“dollar”
United States
Belize
Canada
Hong Kong
USD
BZD
CAD
HKD
“peso”
Philippines PHP
Uruguay
UYU
Mexico
MXN
To avoid confusion, the ISO 4217 classification system is
used. (three letter currency code)
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II. Foreign Exchange
When making international transactions (like paying for
imports or buying foreign assets), currencies are exchanged as
well.
A. Exchange Rate Basics
The foreign exchange rate (exchange rate, forex rate, FX rate)
specifies how much one currency is worth in terms of another
currency. (abbreviated “e”)
The current exchange rate is also called the spot rate.
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Example Spot Rates:
You could get
this amount of
this currency
With one of this currency
USD
GBP
EUR
USD
1.0000
1.5421
1.2889
GBP
0.6485
1.0000
0.8357
EUR
0.7759
1.1966
1.0000
July 25,2010
oanda.com
With 1 US dollar you could get how many British pounds?
0.6485
With 1 British pound you could get how many US dollars?
1.5421
(actually just the reciprocal… 1/1.5421 = 0.6485)
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spot exchange rates July 15, 2010
1 currency unit equals ? EUR
Float
Czech Republic
Hungary
Poland
Romania
Sweden
UK
CZK
HUF
PLN
RON
SEK
GBP
koruna
forint
zloty
new lei
krona
pound
0.03892
0.00339
0.23987
0.22801
0.10376
1.19660
BGN
DKK
EEK
LVL
LTL
lev
krone
kroon
lats
litas
0.49698
0.13148
0.06263
1.35712
0.27865
Peg
Bulgaria
Denmark
Estonia
Latvia
Lithuania
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Bulgaria’s pegged exchange rate versus the euro:
0.5152
0.5136
0.5119
0.5103
0.5086
0.5070
4/26
5/11
5/26
6/10
Date
6/25
7/10
7/25
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Using exchange rates to convert prices into another currency:
On June 18, 2007, our meal in Vienna, Austria cost €19.70 and
the exchange rate was 1 USD = 0.73169EUR.
How many US dollars did it cost?
€19.70 x 1$
. = $
0.73169 €
$26.92
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On August 3, 2005 in Nice, France a kilo of peppers cost €2.20.
The exchange rate was 1 EUR = 1.19501 USD.
How much did a kilo of peppers cost in US dollars?
€2.20 x 1.19501$
1€
=
$2.63
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Salzburg, Austria
June 2007
1$ = 0.74270euro
1€ x
1$ = $1.35
0.74270 €
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Prague, Czech Republic
June 2007
1$ = 21.3830 koruna
(CZK)
20kc
x
$1 = $0.94
21.3830kc
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B. Exchange Rate Fluctuations:
When one unit of currency A can buy more of currency B, then
currency A has appreciated versus currency B.
When one unit of currency A can buy less of currency B, then
currency A has depreciated versus currency B.
For example:
7/25/2009
7/25/2010
1 USD = 0.718692 EUR
1 USD = 0.790398 EUR
Has the US dollar appreciated or depreciated versus the euro in
the past year?
dollar has appreciated versus the euro
the euro has depreciated versus the dollar
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Some implications of an appreciating currency:
- import more (currency is strong, buying power is strong)
- export less
- trade balance worsens (more of a deficit, less of a surplus)
- travel abroad is “cheaper”
Some implications of a depreciating currency:
- import less
- export more
- trade balance improves (less of a deficit, more of a surplus)
- travel abroad is “more expensive”
Economists don’t believe that appreciating/depreciating currencies
are inherently good or bad… it depends on the circumstances.
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C. Types of exchange rates
floating (aka flexible): the currency’s value is determined by
market forces
fixed (aka pegged): the currency’s value is set at a fixed value
of another currency
pegged float: the currency’s value is kept within a certain range
of predetermined values with another currency
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The Foreign Exchange Market for British pounds
(exchange rate between $ and £)
Demand for £ for foreign exchange
- investors who have $ and wish to buy £-denominated assets
- investors who are selling $-denominated assets and wish to
convert back to £
- US importers of British goods (have $ but need to pay for the
order in £)
Supply of £ for foreign exchange
- Investors who have £ and wish to buy $-denominated assets
- Investors who are selling £–denominated assets and wish to
convert back to $
- British importers of US goods (have £ but need to pay in $)
- government policy (Central Banks or Ministries of Finance),
and bank practices
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the Foreign Exchange Market for British pounds:
e $/£
The notation e$/£ indicates the
exchange rate in terms of
dollars per pound.
S£
As the value of e$/£ increases,
the £ is appreciating against the
$.
As the value of e$/£ decreases,
the £ is depreciating against the
D£ $.
Q£ for forex
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the Foreign Exchange Market for British pounds:
e $/£
D£ slopes downward
because as the £ depreciates,
it is “cheaper” to buy £
using $ (as the “price” of a
£ falls, the quantity
demanded of it rises).
S£
D£
S£ is vertical because there
is a certain quantity of £
available for foreign
exchange at any given time.
Q£ for forex
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1. Floating Exchange Rates (flexible)
S£
e $/£
The intersection of the
supply and demand for £
determines the exchange
rate.
e*
D£
Q£ for forex
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When supply or demand changes, so does a floating exchange rate.
Suppose that $-denominated
assets are paying a higher
return than £-denominated
assets.
S£
e $/£
- D£ will decrease as
people sell £ assets in
favor of $ assets
e1
e2
D£2
D£1
- the exchange rate falls
(£ depreciates vs the $)
Q£ for forex
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2. Fixed (Pegged) Exchange Rates
Flexible (floating) exchange rates fluctuate with market forces and
may be quite volatile. To reduce the uncertainty associated with a
floating forex rate, a country might choose to peg its currency to a
certain value.
The main benefit of a pegged exchange rate is stability.
- investors are more certain of a return
- import/export transactions have less risk
The drawback of a pegged exchange rate is it causes a lack of
flexibility for other policies.
- the Central Bank / Ministry of Finance has to take steps to
maintain the peg
- need to have reserves of the currency you are
pegging to
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A pegged rate higher than the market rate:
eeuro/kroon
Suppose Estonia pegs the
kroon to the euro at a rate of
e1.
Surplus of kroon
e1
- at e1, Qs > Qd which
means there is a surplus of
kroon in the market
Skroon
Qd
“overvalued”
Qs
Dkroon - normally, the kroon would
depreciate
Qkroon
-the Estonian Central Bank
must intervene to keep the
kroon from depreciating
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The Estonia Central Bank must use its reserve of euros to buy up
the surplus of kroon.
- needs to be willing to do so at the fixed exchange rate
eeuro/kroon
Pull kroon out of the
market
Surplus of kroon
e1
Put euros into the
market
Dkroon
Skroon
Qd
Qs
Qkroon
- The Central Bank ends
up with more kroon
- Depletes reserves of
euros
Implications:
An overvalued currency can lead to a trade deficit:
- decreases exports (they are “more expensive”)
- increases imports (they are “cheaper”)
It benefits imports at the expense of exports
The Central Bank reduces its foreign exchange reserves.
If a currency is overvalued for a long period of time, then a
balance of payments crisis could be on the horizon.
- run out of reserves
- can’t pay for imports
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Options if running out of foreign reserve currency:
- borrow foreign exchange from another central bank or the IMF to
maintain the peg
- re-set the peg to a lower level, more consistent with the market
rate
- allow the exchange rate to depreciate down to the market level
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If investors think that a currency will be devalued, they may sell all
of their assets in that currency.
- the demand for currency falls
- This would put more pressure on the peg.
- the market equilibrium is even further below the peg
- the surplus is larger
- A government may be forced to devalue the currency.
- “self fulfilling prophecy”
The investors could then move back into the currency, but since it has
depreciated, they can buy much more of it.
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A pegged rate lower than the market rate:
Suppose China pegs the
yuan to the US dollar at a
rate of e1.
S¥
e$/¥
- at e1, Qd > Qs which
means there is a shortage
of yuan in the market
shortage of yuan
e1
D¥
Qs
“undervalued”
Qd
- normally, the yuan
would appreciate
Q¥
- to keep the currency
from appreciating, the
central bank must intervene
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The Central Bank must put yuan into the market.
- will be spending yuan to buy up dollars
- needs to be willing to do so at the fixed exchange rate
S¥
Pull dollars out of the
market
e$/¥
shortage of yuan
e1
Put yuan into the
market
D¥
Qs
Qd
- China ends up with more
reserves of dollars
Q¥
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Implications:
An undervalued currency can lead to a trade surplus:
- increases exports
- decreases imports
It benefits exports at the expense of imports
The government will increase its foreign currency reserves.
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If a currency is undervalued for a long time, then the government
may be forced to expand the domestic money supply to get more
domestic currency.
- domestic inflation
If currency speculators think that the government may re-value the
currency, then “hot money” may flow into the country.
- increases demand for the currency
- the peg is now even further below market equilibrium
- more of a shortage
- need more domestic currency
- inflation increases
- the government re-sets the peg higher, or lets the currency
float
- speculators make a profit
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D. Exchange Rate Choice
For the vast majority of countries (except for the very largest
economies), the choice of exchange rate policy is probably their
single most important macroeconomic policy decision.
The Mundell-Fleming Trilemma
aka:
- The Unholy Trinity
- The Incompatible Triangle
- The Irreconcilable/Incompatible Trinity
An economy can only have 2 of the following 3 policies at any
given time:
- fixed exchange rates
- control of monetary policy
- free movement in capital markets
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Suppose a nation decides to fix its exchange rate.
It can either have free capital markets or control over monetary
policy.
If it chooses free capital markets, then monetary policy must be
used to keep the peg stable.
- capital flows in and out freely --- changes the demand for
the currency --- pressure on the peg
If it chooses to keep flexibility in monetary policy, then it has to put
restrictions on capital flows.
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For nations with small or underdeveloped capital markets (most
nations), it is usually impossible to have
- free capital markets
- floating exchange rate
- control of monetary policy
The choice is usually either
- capital restrictions
- floating exchange rates
- control of monetary policy
Or
- free capital markets
- fixed exchange rates
- no control of monetary policy
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Free movement of capital is one of the “Four Freedoms” in the
European Union.
When a nation pegs to the euro and has open capital markets, then
it must give up control monetary policy.
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E. Historical EU Monetary Developments
1870 - 1914: gold standard
- each currency was based on gold
- fixed exchange rates between all currencies
1914 – 1945: great variation
- exchange and capital controls
- floating exchange rates
1946 – 1973: Bretton Woods System
- commitment to keep currencies convertible for
current account transactions
- fixed exchange rates
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1973-1979: EMS/ERM
- European Monetary System creates the ecu
- Exchange Rate Mechanism is a system of quasifixed exchange rates
Belgium, Denmark, Germany, France, Ireland, Italy,
Luxembourg, Netherlands join EMS/ERM
UK joins EMS only
1981 – 1986 Greece, Portugal, Spain join EMS
1987 – 1990 Spain and UK join ERM
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1990 Capital controls abolished in EC
1991 The plan for a European Monetary Union
includes a common currency – will use ERM as an
entry route.
1992 Portugal joins ERM, UK leaves ERM
1995 Austria, Finland join EMS/ERM
Sweden joins EMS
1998 European Central Bank is created
- euro nations freeze exchange rates on Dec 31
Austria, Belgium, Netherlands, Finland, France,
Germany, Ireland, Italy, Luxembourg, Portugal, Spain
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1999 Euro is introduced as unit of account.
Greece, Denmark join ERM
2001 Greece joins euro zone
2004 Estonia, Lithuania, Slovenia join ERM
2005 Cyprus, Latvia, Malta, Slovakia join ERM
2007 Slovenia joins euro zone
2008 Cyprus, Malta join euro zone
2009 Slovakia joins euro zone
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III. Fun with Exchange Rates: The Economist’s Big Mac Index
The index is a lighthearted attempt to gauge how far currencies are
from their fair value.
It is based on the theory of purchasing-power parity (PPP), which
argues that in the long run exchange rates should move to equalize
the price of an identical basket of goods between two countries.
Our basket consists of a single item, a Big Mac hamburger,
produced in nearly 120 countries.
The fair-value benchmark is the exchange rate that leaves burgers
costing the same in America as elsewhere.
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The price you’d
see on the menu
board.
The price
converted into US
dollars.
The exchange rate
that would make
the foreign price
equal to the US
price.
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Big Mac Prices
actual
in local
price in implied PPP exchange rate
currency US$
of the US$
per US$
over/under
valued vs
the US$
US
$3.73
$3.73
….
….
….
Czech 67.6kr
$3.43
18.1
19.7
-8
Rep_____________________________________________________
To calculate the price in US$:
Multiply the local price by the actual exchange rate.
67.6kr x
1$
19.7kr
=
$3.43
If you bought a Big Mac in the Czech Republic, it would cost you
67.6kr . Which means it really costs you $3.43.
- It is more expensive to buy a Big Mac in the US than Czech..
Big Mac Prices
actual
in local
price in implied PPP exchange rate
currency US$
of the US$
per US$
over/under
valued vs
the US$
US
$3.73
$3.73
….
….
….
Czech 67.6kr
$3.43
18.1
19.7
-8
Rep_____________________________________________________
To calculate the implied PPP of the US$:
Divide the local price in the foreign country by the local price in the US
PPP rate = 67.6 / 3.73 = 18.1
Big Mac Prices
actual
in local
price in implied PPP exchange rate
currency US$
of the US$
per US$
over/under
valued vs
the US$
US
$3.73
$3.73
….
….
….
Czech 67.6kr
$3.43
18.1
19.7
-8
Rep_____________________________________________________
Compare the PPP rate to the actual exchange rate to see if the currency
is over or undervalued versus the US$.
To calculate how much the real is overvalued by:
(PPPrate – actual exchange rate) / actual exchange rate x 100
(18.1 – 19.7) / 19.7
x 100 = -8.12
Because the koruna is undervalued vs the dollar, we expect the koruna
to appreciate vs the dollar in the future.
Given the price in
local currency and
the actual exchange
rate, you can
calculate
- price in dollars
- implied PPP rate
- over/under
valuation
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Summary:
The exchange rate is also called the spot rate.
Countries can choose to have a pegged exchange rate or a
floating exchange rate.
If a nation pegs its exchange rate to another currency, it must be
prepared to buy and sell currency as needed to maintain the peg.
The EU has a long history of both fixed and floating exchange
rates.
The Big Mac Index is a way of predicting currency appreciations
and depreciations.
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