Personal Finance
The Federal Reserve and Exchange Rates
1
Gold Standard


1876 – 1913
Values of currency set against precious
metals


2
Each country set own conversion rate
Must maintain adequate reserves (Fort Knox) for
redemption
Gold Standard


Gold standard implied fixed XR
Limited growth of money supply for any
country


3
Need enough gold
WWI limited free movement of gold
1920s and 1930s


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Some countries reverted to gold standard
Some abandoned
Some pegged to dollar or pound
Period of instability

4
International trade declined
Bretton Woods Agreement


International agreement in 1944
Fixed exchange rates




5
All currencies pegged to dollar
Dollar set at $35/ounce of gold
Intervention to prevent fluctuation of > 1%
Lasted until 1973
Floating Exchange Rates



By 1971, dollar had depreciated
Concerns about U.S. ability to convert dollars
to gold
March 1973


6
U.S. allows dollar to float
Other major currencies float as well
Countries with Floating XRs
7
Countries with Pegged XRs
8
Floating Exchange Rates


Determined by supply and demand
Factors affecting demand

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
9
Demand for nation’s product
Demand for nation’s stocks and bonds
Inflation expectations
Government stability
Floating Exchange Rates
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

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10
Supply is determined by monetary policy of
central bank
U.S. central bank is the Federal Reserve
Too much supply – inflation
Not enough supply - recession
Federal Reserve

U.S. Central Bank


11
Established in 1913
12 federal reserve banks
Federal Reserve

Board of Governors
•
Seven members



12
Appointed by President and confirmed by congress
14-year term
Chairman’s term is four years
Federal Reserve

FOMC

Chief policymaking committee



All 7 governors
President of NY fed bank
Four other fed presidents
–

All votes are equal

13
All fed presidents attend meetings
Chairman has much influence
Federal Reserve

FOMC determines monetary policy

Supply of money



14
Purchase or sell fixed income assets
Influences short-term rates
Impacts XR
Federal Reserve

Mission




Goals may conflict

15
Maximum employment
Stable prices
Moderate long-term interest rates
XR is not explicit goal
Foreign Exchange Market



Spans the globe
Operates 24 hours/day
Major exchanges

16
Singapore, Hong Kong, Tokyo, Bahrain, London,
New York, San Francisco, Sydney
Foreign Exchange Market
25,000
20,000
15,000
10,000
5,000
0
1
2
3
4
5
6
10 AM
Lunch Europe
In Tokyo In Tokyo opening
17
7
8
9
Asia
closing
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Americas London
open
closing
Afternoon
in America
6 pm Tokyo
In NY opens
Exchange Rates
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
18
Spot Rate – the price of a currency in terms
of another currency for trade today
Forward Rate – The price of a currency in
terms of another currency for a trade agreed
upon today but to be executed at a specified
date in the future (usually 30, 60,90, 180 or
360 days from today)
Exchange Rates
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
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19
Direct Quote – the number of dollars needed
to buy one unit of the foreign currency. Dollar
is in the numerator
Indirect Quote – the number of units of a
foreign currency needed to buy one dollar.
Dollar is in the denominator
Direct and Indirect Quotes are reciprocals of
each other
Exchange Rates
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20
Which is a better deal – bananas being sold
at 50 cents per pound, or two pounds of a
dollar?
1.23 $/€ is the same as .813 €/$
Price of a dollar: €.813
Price of a euro: $1.23
Currency in the denominator is being priced
Exchange Rates
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21
Suppose you have $5.00 and want to convert
to euros.
You are both selling dollars and buying
euros
If XR is quoted at 1.23 $/€, do you multiply or
divide?
Suppose you have €30 and want dollars?
Exchange Rates

There are always two exchange rates

The ask and the bid
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22
Ask > Bid
The spread is the dealer’s profit
The dealer buys at the bid and sells at the ask
You are not the dealer, so you sell at the bid and buy at
the ask
Exchange Rates

Suppose you observe direct quotes of:



You have $150 you want to convert to yen.
How many yen will you receive?
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23
Ask: .0091 $/¥
Bid: .0090 $/¥
Which currency’s price is being quoted?
Are you buying or selling that currency?
Do you buy or sell at the bid, or the ask?
Exchange Rates – Cross Rates
Dollar
24
Euro
Pound
SFranc
Peso
Yen
CdnDlr
Canada
1.2134
1.3591
1.8655
1.3097
0.08
0.01
...
Japan
119.87
134.276
184.299
129.397
7.904
...
98.795
Mexico
15.166
16.988
23.3167
16.3707
...
0.127
12.499
Switzerland
0.9264
1.0377
1.4243
...
0.061
0.008
0.7635
U.K.
0.6504
0.7286
...
0.7021
0.043
0.005
0.5361
Euro
0.8927
...
1.3725
0.9637
0.059
0.007
0.7358
U.S.
...
1.1202
1.5375
1.0794
0.066
0.008
0.8242
Is the Dollar Rising or Falling?
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25
The dollar can only rise or fall in relation to
another currency
If the dollar increases in value (vs that
currency), that other currency must be
decreasing in value (vs the dollar)
It is certainly possible for the dollar to rise in
value vs one currency but fall in value vs a
different currency
Is the Dollar Rising or Falling?
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26
Example: Yesterday, one euro was worth
$1.12
Today, one euro is worth $1.10
Since a euro will buy fewer dollars, the euro
dropped in value
Since it takes fewer dollars to buy a euro, the
dollar increased in value
Is the Dollar Rising or Falling?
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
27
A strong dollar is good for importers because
they can buy more foreign-made product with
a dollar
A weak dollar is good for exporters because
their customers can buy more U.S.-made
goods with their foreign currency
Is the Dollar Rising or Falling?
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
28
A strong dollar is good for you if you plan to
travel overseas because your dollar will buy
more
A weak dollar is good for U.S. businesses
who cater to foreign travelers who come to
the U.S. because their customers can
purchase more