Exchange rates and exchange rate systems

Paul Krugman – Maurice Obsfeld: International
Economics. Theory and Practice. Chapter
13.

 Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.
– How much can be exchanged for one dollar?
– How much can be exchanged for one HUF?
 Exchange rate allow us to denominate the cost or price of a good or service in a common currency.

Nominal bilateral exchange rate
 Direct quotation: value of a unit of foreign currency in terms of the units of domestic currency
 Indirect quotation: value of a unit of domestic currency in terms of the units of foreign currency

Real Bilateral Exchange Rate
Nominal exchange rate between the currencies of the two countries that takes into account the prices in the two countries
Nominal Effective Exchange Rate
The unadjusted weighted average value of a country's currency relative to all major currencies being traded within an index or pool of currencies. The weights are determined by the importance a home country places on all other currencies traded within the pool, as measured by the balance of trade.
The NEER represents the relative value of a home country's currency compared to the other major currencies being traded (U.S. dollar,
Japanese yen, euro, etc.). A higher NEER coefficient (above 1) means that the home country's currency will usually be worth more than an imported currency, and a lower coefficient (below 1) means that the home currency will usually be worth less than the imported currency. The NEER also represents the approximate relative price a consumer will pay for an imported good.

Real effective exchange rate
 The weighted average of a country's currency relative to an index or basket of other major currencies adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country's currency, with each other country within the index.
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This exchange rate is used to determine an individual country's currency value relative to the other major currencies in the index, as adjusted for the effects of inflation. All currencies within the said index are the major currencies being traded today: U.S. dollar, Japanese yen, euro, etc.
This is also the value that an individual consumer will pay for an imported good at the consumer level. This price will include any tariffs and transactions costs associated with importing the good.
It reflects the competitiveness of the country

 Devaluation is a decrease in the value of a currency relative to another currency.
– A devalued currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.
 Appreciation is an increase in the value of a currency relative to another currency.
– An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.

 A devalued currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency.
 A devalued currency means that imports are more expensive and domestically produced goods and exports are less expensive.
 A devalued currency lowers the price of exports relative to the price of imports.

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An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency.
An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive.
An appreciated currency raises the price of exports relative to the price of imports.
 Expected economic impact of devaluation and appreciation.

The participants:
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Commercial banks and other depository institutions: transactions involve buying/selling of bank deposits in different currencies for investment.
Non bank financial institutions (pension funds, insurance funds) may buy/sell foreign assets.
Private firms: conduct foreign currency transactions to buy/sell goods, assets or services.
Central banks: conduct official international reserves transactions.

 Buying and selling in the foreign exchange market are dominated by commercial banks.
– Central banks sometimes intervene, but the direct effects of their transactions are usually small and transitory.
– Trading occurs mostly in major financial centres: London, New York, Tokyo, Frankfurt,
Singapore.

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Computers transmit information rapidly and have integrated markets.
The integration of markets implies that there is no significant arbitrage between markets.
– if dollars are cheaper in New York than in London, people will buy them in New York and stop buying them in London.
The price of dollars in New York rises and the price of dollars in London falls, until the prices in the two markets are equal.

 Spot rates are exchange rates for currency exchanges “on the spot”, or when trading is executed in the present.
 Forward rates are exchange rates for currency exchanges that will occur at a future (“forward”) date.
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– forward dates are typically 30, 90, 180 or 360 days in the future.
rates are negotiated between individual institutions in the present, but the exchange occurs in the future.

Factors that Influence Exchange Rate Changes
– Exchange rate changes as a result of changes in the Balance-of-Payments Accounts.
– Exchange rate changes as a result of changes in particular macroeconomic indicators

Exchange rate changes as a result of changes in the Balance-of-Payments Accounts
Systematic analysis of the influences on the exchange rate determination and changes, caused by changes in particular types of economic transactions in the balance-of payments
– current account, capital and financial account of the balance-of-payments and international monetary reserves:
 ex. relative increase in domestic prices
 domestic goods less competitive
 increased imports & increased demand for foreign currencies

Exchange rate changes as a result of changes in particular macroeconomic indicators
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Differences in the rates of inflation:
 increase in the domestic rate of the level of prices
 devaluation of the domestic currency
 exchange rate reflects the relative purchasing power
Differences in the interest rates:
 higher domestic interest rates
 appreciation of the domestic currency
Differences in the level of income:
 higher domestic income
 depreciation of the domestic currency
Expectations
Other factors (political and psychological factors)

Pure Fixed Exchange Rate System:
– the government determines the value of the domestic currency – it determines official exchange rate
– the government must intervene on the foreign currency market to keep the exchange rate within the allowed interval

– The government establishes neither the official exchange rate nor the interval within which the exchange rate can be
– its intervantion on this market is completely discretionary:
 it will intervene on the foreign exchange market when it estimates that the exchange rate is not changing in accordance with its expectations/wishes

Reasons for Government Intervention on the
Foreign Currency Market
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Reduction of oscillations in the exchange rate movement
Determining implicit borders of the exchange rate movement
Reaction in exceptional circumstances:
– for the neutralisation of the potential exchange rate changes because of speculations
Interventions usually do not have a long-term effect on the exchange rate changes

Direct interventions:
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– additional supply/demand of foreign currencies:
“unsterilized” interventions:
 CB does not react to the changes in the quantity of money, which is a result of its intervention on the foreign currencies market
“sterilized” interventions:
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CB intervenes on the foreign exchange market in such a way that the intervention in combination with economic policy measures does not cause (it sterilizes) changes in the quantity of money the size of the intervention to prevent the devaluation of the domestic currency is bounded by the foreign reserves availability the size of the intervention to prevent the apreciation of the domestci currency is bounded by the size of the stock

Indirect interventions:
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Monetary policy:
 open market operations (increasing/decreasing the interest rate)
 directly related to the change in the quantity of money, and, consequently, to the change in prices in the country
Fiscal policy:
 changes in the level of government spending and the taxation of the residents, as well as the size of the government suficit/deficit
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 restrictive fiscal policy expansive fiscal policy
Other forms of intervention:
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 various forms of public communication between the CB representatives and the government credibility?

Arguments For and Against a Particular
Pure Exchange Rate System
Purely Flexible Exchange Rate System
– balance-of-payments balance achieved automatically
– stabilizing speculations
– higher economic stability
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– monetary autonomy insurance against external shocks

Arguments For and Against a Particular
Pure Exchange Rate System
Purely fixed exchange rate
 higher stability in international relations:
– lower uncertainty for exporters and importers
– more direct investments and other long-term investments
 better discipline in macroeconomic policy implementation:
– it forces the countries into inflation rate lowering
 destabilizing speculations less likely

Even after the government intervention is proven to be necessary, its form, size and duration need to be exactly specified
Pegged arrangements:
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– geographically smaller countries open economies countries with a lower rate of production and export diversification countries with geographically concentrated international trade countries whose rate of inflation is similar to the world rate of inflation high rate of flexibility of the production factor markets, low credibility of the economic policy makers, etc.

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M ost regimes come from the “hybrid” exchange rate system
Pegged arrangements:
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A country establishes the par value of the domestic currency
A country determines the limits within which the exchange rate can change or within which it will keep the exchange rate by intervening in the foreign exchange market difference: how long is the exchange rate pegged at the same level and how wide are the limits within which it can change

Currency board
– A country promises to exchange the domestic currency for a foreign currency at a fixed exchange rate, and that domestic money emission will occur only if it is fully covered by foreign currency
– Possibly successful in countries in which a high rate of fiscal discipline can be achieved, with relatively stable banking system and possibility of flexibility of price and wage movements in both directions

Permanent peg
– par value irrevocably fixed or unchanged in the long run
Adjustable peg
– built-in possibility of occasional par value changes
– the currency is devalued/revalued – it contributes to the elimination of the balance-ofpayments imbalance – deficit/surplus

– par value changes in regular intervals, for example every month or every two months, that are known in advance, and each time the change in par value is relatively small

CB intervenes discretionary which gives it more flexibility in leading the monetary policy
Managed floating the monetary authorities determine the appropriate exchange rate for the country on the basis of their own analyses and estimates
Independent floating
CB interventions on the foreign exchange market are in principle short and not intended to establish the exchange rate; rather, they are mostly intended to alleviate its unnecessarily big oscillations that occasionally happen because of speculating forces on the currency

The eighties
– large oscillations in the movement of the exchange rates of the currencies of the economically most important countries in the world
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– large increase in the rates of inflation in most developing countries decline in the economic growth of industrialized countries in the first half of the decade, deterioration in terms of trade for developing countries and the effects of the debt crisis

The nineties:
– huge increase in the number of countries whose currencies became convertible in transactions on the current account of the balance-of-payments
– increasing tensions between two crucial macroeconomic goals – low rate of inflation and high international competitiveness of the country
– capital flows liberalization, the effect of which is highly increased rate of capital mobility