Exchange Rates

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Exchange Rates

• The theory of relativity applied to international
  trade

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Exchange Rates

• Before diving into something that sounds really
  complicated (but actually isnt) determining
  the relative value of different currencies
  lets start with something simple.
• Think of the (or Euro, Peso, or any other
  currency) as a commodity.
• What determines the price of any commodity in a
  free market system?

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Floating Exchange Rates

• Yes, we are back to supply and demand.
• In a free market system, the relative value of
  currencies float up and down based on the
  forces of supply and demand.
• These are known as floating exchange rates.
• Floating exchange rates move continuously in
  response to market forces, unless (or until)
  government intervenes

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Basic Exchange Rate Movements

• If demand for a currency goes up (or supply goes
  down) the currency appreciates (or strengthens)
• If supply increases (or demand decreases) the
  currency depreciates (weakens)

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Factors that Impact Exchange Rates

• Change in Income
• Change in Relative Prices
• Change in Relative Investment Prospects
• Speculation
• Use of Foreign Reserves

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Change in Income

• U.S. income goes up
• U.S. consumption increases demand for European
  imports goes up
• Supply of US goes up, demand for Euro goes up
• Both forces act to depreciate the US relative to
  the Euro (takes fewer Euros to buy a US)

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A Graphical Example
S1
E/
S2
D
Q of
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Change in Income In Reverse

• EU income goes up
• Demand for U.S. imports increases
• Euros flood the currency market, in order to
  exchange for US
• Demand for US goes up
• US appreciates relative to the Euro (US is
  worth more in Euros)

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Back to the Graph
S
E/
D2
D1
Q of
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Change in Relative Prices

• Change in relative prices relative rates of
  inflation
• Higher rates of domestic inflation in the U.S.
  make imports relatively cheaper demand for
  European imports goes up.
• Higher inflation in the U.S. also make exports
  less competitive exports to Europe go down
• Both factors act to weaken the US

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Change in Relative Prices

• Remember it is the relative rate of inflation
  that counts.
• 5 inflation in the U.S. will not cause the US
  to weaken relative to the Euro if the inflation
  rate within the EU is running at 8.
• But, 3 inflation in the U.S. will cause the US
  to depreciate relative to the Euro if inflation
  is only 1 in the EU.

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Relative Investment Prospects

• Currency values change in response to relative
  investment opportunities
• US investors see more attractive risk adjusted
  investment opportunities in India versus in the
  domestic market demand for Indian Rupees goes
  up, and supply of US goes up
• US depreciates relative to the Rupee

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Relative Investment Prospects

• New government elected in India based on a
  platform of increased regulation and
  protectionist policies
• Perceived risk of investing in India increases,
  reducing the relative attractiveness of investing
  in India versus the U.S.
• Demand for US goes up US appreciates relative
  to the Rupee

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Relative Interest Rates

• In a global market, investors always have choices
  in terms of where (and in what form) to invest
  their money.
• Relative interest rates have a significant impact
  in determining the relative attractiveness of
  holding investments in one currency or another.
• Increasing interest rates in the U.S. (on a
  relative basis) provide an incentive for
  investors to hold US denominated financial
  instruments

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Relative Interest Rates

• An increase in demand for US denominated
  instruments (think U.S. Treasuries) increases
  demand for US -- US strengthens
• When interest rates in the U.S. decline on a
  relative basis, demand for US denominated
  instruments goes down and the US depreciates.

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Speculation

• It just wouldnt be a market without speculation.
• All markets (including currency markets) are
  driven by expectations of future performance
• The past and present are relevant only to the
  extent that they can help predict where markets
  are going in the future.
• Expectations of future changes that will impact
  the value of a currency will be factored into the
  current market price of the currency

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Speculation

• Expectations regarding
• Relative rates of inflation
• Which impact relative interest rates
• Which will impact economic performance and income
  
• Which can change views on investment prospects
• Impact currency markets in a never ending
  circular loop of profit motivated speculation

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Speculation

• The goal?
• Buy currencies (or investments denominated in
  currencies) that you think are undervalued
• Sell currencies that you think are overvalued
• Of course, these speculative trades create market
  movements that reduce or eliminate the perceived
  over or under valuation.

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Use of Foreign Reserves

• Use of foreign reserves otherwise known as
  government intervention
• Governments can buy or sell their own (or
  another) currency in order to stabilize or change
  the relative value of their currency
• When governments intervene in the currency
  markets dirty float

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Do these Factors Really Move Markets?

• Lets take a look

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Exchange Rates Meet BOP

• The same factors that impact exchange rates also
  impact balance of payments.
• Change in income
• Increase in income
• Increased demand for imports
• Net exports decline (Current Account goes down)

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Exchange Rates and BOP

• Change in Relative Prices
• High relative inflation
• Imports up exports down
• Net exports decline (Current Account goes down)
• Relative Investment Prospects
• Strong investment prospects attract flows of
  capital from foreign investors
• Improves the Capital Account

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Exchange Rates and BOP

• Relative Interest Rates
• Increase in domestic U.S. interest rates will
  increase demand for US denominated instruments
• When foreign investors buy U.S. financial
  instruments Capital Account improves
• Speculation
• Speculative buying and selling of impacts the
  Capital Account and market exchange rates

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Exchange Rates and BOP

• Use of Foreign Reserves
• If the Fed buys US -- positive impact on value
  of US
• But, negative impact on Capital Account
  (reduction in reserves)

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Everything is Related

• Economic growth and income, balance of payments
  and exchange rates are all related
• Y C I G (X-M)
• Changes in net exports (X-M) cause changes in GDP
  (Y)
• Changes in economic growth (income) and net
  exports drive changes in exchange rates, which in
  a circular fashion impact net exports and
  national income

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A Self-Correcting System

• A floating exchange rate system is
  self-correcting
• Balance of payments will adjust (or should
  adjust) automatically based on changes in
  exchange rates
• A country that runs a large trade deficit will
  devalue its currency, making its exports cheaper
  to the rest of the world
• Exports rise self-correcting the BOP problem

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Your Assignment

1. Pick a currency (anything except the US).
2. Summarize the exchange rate changes for this
   currency over the last 12 months.
3. Explain the underlying causes of these exchange
   rate movements.
4. Predict where this currency will trade over the
   next 12 months and support your prediction.

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Your Assignment (Contd)

• Required work product
• 1 2 page paper summarizing your analysis and
  support for your predictions (due at the
  beginning of next class)
• Short (5 minutes or less) presentation of your
  analysis and conclusions

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Exchange Rates (Continued)

• Agenda
• Floating versus fixed exchange rates
• Advantages and disadvantages of floating and
  fixed exchange rate systems
• Managed exchange rates
• Purchasing power parity
• Terms of trade

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Floating vs. Fixed Exchange Rates

• Floating exchange rate systems allow exchange
  rates to move based on supply and demand dynamics
  in the market.
• In fixed exchange rate systems the exchange rate
  is pegged or locked in to a specific, fixed rate
  of exchange.
• Floating and fixed systems have some important
  (and fairly obvious) advantages and disadvantages

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Fixed Exchange Rates

• Advantages
• Certainty
• Fixed exchange rates take the risk of currency
  fluctuations out of business transactions
  (usually)
• Increased trade
• If the greater certainty of fixed exchange rates
  leads to an increase in trade, this would create
  a net economic benefit
• Experience over the last 30 years does not
  support this correlation

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Fixed Exchange Rates

• Advantages
• Reduced speculation
• No opportunity to profit from day to day changes
  in the exchange rate
• Huge opportunity to take positions in expectation
  of devaluations or revaluations of a fixed
  exchange rate
• Government discipline
• Without the self-correcting mechanisms of a
  floating exchange rate, governments
  (theoretically) should be forced to exercise more
  disciplined in the management of fiscal and
  monetary policy

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Fixed Exchange Rates

• Disadvantages
• Reserves
• Governments must have sufficient reserves of gold
  and foreign currency to support frequent
  intervention in the market
• Loss of control over monetary policy
• If exchange rates are fixed, money supply and
  interest rates must float based on flow of
  trade and investment
• No auto-correction mechanism

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Floating Exchange Rates

• Advantages
• Self-correcting
• No reserves required for market intervention
• Control over fiscal and monetary policy
• Governments can adjust fiscal and monetary policy
  and allow changes in the exchange rate to adjust
  for changes in the balance of payments (let the
  self-correcting mechanism do its thing)

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Floating Exchange Rates

• Advantages
• No large jumps
• Exchange rates move constantly, but usually in
  very small daily increments
• No major jumps from devaluations or revaluations
• Reduction in speculation (maybe)
• In theory offsetting trades may cancel each other
  out and reduce the net impact of speculation on
  the market

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Floating Exchange Rates

• Disadvantages
• Less certainty
• Floating rates add an additional element of
  uncertainty (risk) to international transactions
• This risk can be mitigated by hedging in forward
  currency markets
• Difficult to hedge long-term investments
• Increased speculation (probably)

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Floating Exchange Rates

• Lack of discipline
• Adjustments in exchange rates can mute (or at
  least delay) the impact of irresponsible economic
  policies on the part of government, businesses or
  labor.
• Example Government adopts inflationary monetary
  and fiscal policy inflation increases currency
  decreases in value, which helps offset the
  negative impact of higher prices on exports

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Managed Exchange Rates

• Managed exchange rate systems fall between the
  two extremes of perfectly fixed and pure floating
  rate systems
• Two types of managed systems
• Adjustable peg
• Government pegs a target exchange rate
• Manages based on a preset band around this target
  rate
• Dirty float
• Floating system with some government intervention

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Exchange Rate Management Tools

• Buy or sell currency (ex buy to appreciate
  currency)
• Manipulate interest rates (ex lower to
  depreciate currency)
• Adopt protectionist policies (use of tariffs or
  export subsidies to protect value of currency)
• Violates WTO agreement
• Adjustments to exchange rate can have the same
  effect
• Expenditure switching

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Exchange Rate Management Tools

• Use fiscal and monetary policy to drive changes
  in GDP/national income
• Expenditure changing
• Reductions in national income reduce spending on
  imports, which decreases the supply of currency
  on the market currency appreciates and balance
  of payments improves
• Tradeoff between manging balance of payments and
  domestic economic and political considerations
  (internal versus external balance)

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Purchasing Power Parity

• Based on law of one price
• Asserts that a good must sell for the same price
  in all locations
• Under this theory, each currency should have the
  same purchasing power in its home market, and
• Nominal exchange rates should reflect the price
  levels in different countries

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Purchasing Power Parity

• If the theory of purchasing power parity holds,
  the currency adjusted price of like products
  (think Big Mac) should be the same when
  benchmarked against a single currency (like the
  dollar)
• Why wouldnt this theory hold in practice?
• Many goods are not easily traded
• Even goods that are easily traded are often not
  perfect substitutes (product differentiation)

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Terms of Trade

• Ratio of average export prices to average import
  prices
• If export prices rise faster than import prices
  terms of trade improve
• If import prices rise more than export prices
  terms of trade worsen

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Terms of Trade

• What will happen to the volume of trade as the
  terms of trade improve or worsen?
• Depends on the elasticity of demand for exports
  and imports the sensitivity of demand to
  changes in price
• If demand for exports and imports is elastic
  (highly sensitive to price changes), an
  improvement in terms of trade (export prices
  rising faster than import prices) will worsen the
  balance of payments (as demand for exports falls
  more than imports)