Exchange Rates

1
Exchange Rates

• Reading Siklos Chapter 8

2
The Foreign Exchange Market

• Definitions
• 1. Spot exchange rate
• 2. Forward exchange rate
• 3. Appreciation
• 4. Depreciation
• Currency appreciates, countrys goods prices ?
  abroad and foreign goods prices ? in that country
• 1. Makes domestic businesses less competitive
• 2. Benefits domestic consumers

3

• FX traded in over-the-counter market
• Trade is in bank deposits denominated in
  different currencies

4
Notation

• E foreign currency price of 1 unit of home
  currency (Canadian dollar)
• Appreciation increase in E
• Depreciation decrease in E
• e home currency price (Canadian dollar) of a 1
  unit of foreign currency
• Appreciation decrease in e
• Depreciation increase in e
• Ef or ef forward exchange rate
• Es or es spot exchange rate

5
Law of One Price

• Example Canadian steel 100 per ton, Japanese
  steel 10,000 yen per ton
• If E 50 yen/ then prices are
• Canadian Steel Japanese Steel
• In Canada 100 200
• In Japan 5000 yen 10,000 yen
• If E 100 yen/ then prices are
• Canadian Steel Japanese Steel
• In Canada 100 100
• In Japan 10,000 yen 10,000 yen
• Law of one price ? E 100 yen/

6
Exchange Rate Systems

• Fixed or Pegged
• Flexible or Floating
• Managed or dirty float
• Target zone

7
Fixed Exchange Rate Systems

• Bretton Woods
• 1. Fixed exchange rates
• 2. Other central banks keep exchange rates fixed
  to is reserve currency
• 3. convertible into gold for central banks only
  (35 per ounce)
• 4. International Monetary Fund (IMF) sets rules
  and provides loans to deficit countries
• 5. World Bank makes loans to developing countries

8
Fixed Exchange Rate Systems contd

• European Monetary System
• 1. Value of currency not allowed outside snake
• 2. New currency unit ECU
• 3. Exchange Rate Mechanism (ERM)
• Key weakness of fixed rate system
• Asymmetry pressure on deficit countries losing
  international reserves to ? M, but no pressure on
  surplus countries to ? M

9
Monetary Policy International Considerations

• 1. Direct effects of FX market
• When intervene, MB changes
• 2. Balance of payments considerations
• When B of P is in deficit need Ms ?
• 3. Exchange rate considerations
• When want lower E (raise e), need Ms ?

10
Exchange Rate Determination

• Demand for foreign exchange (foreign currency)
• foreign trade and capital flows
• Supply of Foreign exchange
• foreign trade, capital flows and exchange rate
  systems
• Equilibrium

11
Floating Exchange Rate Determination
E(CAN per US)
Depn
S0supply of US
E0
1.45
D0demand for US
Appn
12
Fixed Exchange Rate Determination
E(CAN per US)
Depn
S0supply of US
E0
1.45
D0demand for US
Appn
13
Balance of Payments

• Like a balance sheet for a firm the BOP records
  international financial transactions
• Divide into the CURRENT and CAPITAL accounts
• In theory the BOP0 since current account and
  capital account balances should offset each other
  except for a statistical discrepancy
• The Current account reflect trade in goods and
  services the capital account reflects
  cross-border financial flows

14
Foreign Exchange Intervention

• Central banks intervene in the foreign exchange
  market to influence the value of the currency.
  They believe the currency is over or under-valued
• Does it work? In the very short-run, yes. Over
  sustained periods, no
• Some intervention is prompted by monetary policy
  such as the buying/selling of government bonds
• In the absence of sterilization domestic
  monetary/fiscal policies can lead to unwanted or
  undesirable effects

15
Exchange Rate Equilibrium
16

• Overvalued exchange rate
• 1. Central bank sells international reserves to
  buy domestic currency
• 2. MB ?, Ms ?, iD ?,
• 3. If dont do this, have to devalue
• Undervalued exchange rate
• 1. Central bank sells domestic currency and buys
  international reserves
• 2. MB ?, Ms ?, iD ?,
• 3. If dont do this, have to revalue

17
The Twin Deficit

• Deficits in the governments budget can have
  consequences for the balance of payments
• The twin deficits arises from the National
  Income accounting relation
• ycig(x-im)? if ?i?s, ?(t-g)?(x-im)
• An excess of government spending leads to a
  current account deficit, but the empirical
  evidence is mixed

18
Loanable Funds in an Open Economy

• Loanable funds and the open economy Opening up
  the economy makes the supply of loanable funds
  more elastic

19
Loanable Funds with International Borrowing and
Lending A. Total Supply of Loanable Funds
20
Loanable Funds with International Borrowing and
LendingB. Equilibrium with International Lending
and Borrowing
21
Purchasing Power Parity

• Absolute version
• Relative Version
• floating case
• fixed case
• Real exchange rate
• a fall (appn) means loss of competitiveness
• a rise (depn) means a rise in competitiveness

22
PPP contd

• PPP ? Domestic price level ? 10, domestic
  currency ? 10
• 1. Application of law of one price to price
  levels
• 2. Works in long run, not short run
• Problems with PPP
• 1. All goods not identical in both countries
  Toyota vs Chevy
• 2. Many goods and services are not traded e.g.
  haircuts

23
Factors Affecting E in Long Run

• Domestic Price Level
• Trade Barriers
• Import Demand
• Export Demand
• Productivity

24
International Linkages in Interest Rates

• Capital mobility means that domestic and foreign
  rates will be linked via the exchange rate
• For a given maturity we would expect

Return C Return in C x Implicit
invested abroad forward

exchange
rate
OR R Rf (eexp es)/es
25
Summary

• The exchange rate reflects the relative value of
  currencies
• There exist a wide variety of exchange rate
  systems depending on the how unfettered the
  market for foreign exchange is
• Purchasing Power Parity can explain inflation
  differentials between countries
• The real exchange rate is a useful indicator of a
  countrys competitiveness