Transcript Chapter 10 Understanding Foreign Exchange Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Learning Objectives • Measure and determine foreign exchange rates • Understand the equilibrium.

Chapter 10
Understanding
Foreign
Exchange
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Learning Objectives
• Measure and determine foreign exchange rates
• Understand the equilibrium connection between
balance of payments and exchange rate
movements
• Analyze fixed and floating rate exchange
systems and their impact on trade balances and
financial crises
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Introduction
• The volume of international exchange has grown
tremendously since World War II
• Whenever an exchange takes place between residents of
different countries, one kind of money has to be
exchanged for another
• Foreign exchange rate between two currencies is
determined by supply and demand established in the
foreign exchange market consisting of a network of
foreign exchange dealers (Figure 10.1)
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FIGURE 10.1 Supply of and demand for
foreign exchange and foreign exchange rates.
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What Determines Foreign Exchange
Rates
• Imports of a country give rise to a demand for
foreign exchange and a supply of U.S. dollars
• Exports result in a supply of foreign exchange
and a demand for U.S. dollars
• Therefore, trade of the U.S. will be a primary
contributor to the demand and supply of dollars
and foreign currency
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What Determines Foreign Exchange
Rates (Cont.)
• Balance of Payments
– A summary of payments to foreigners for imports and
receipts from foreigners for exports
• Current Account—international transactions involving trade
• Capital Account—international transactions involving financial
assets
– Deficit
• Paying out more abroad than we are taking in (imports > exports—
trade deficit)
• Demand for foreign currency is greater than supply
• As a result, the price of foreign currency will rise—the foreign
currency will appreciate relative to the U.S. dollar and the U.S. dollar
will depreciate
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What Determines Foreign Exchange
Rates (Cont.)
• Balance of Payments (Cont.)
– Surplus
• Receiving more from abroad than we are spending (exports >
imports—trade surplus)
• This will result in an appreciation of the U.S. dollar and a depreciation
of the foreign currency
– When exchange rates freely react to supply and demand for
foreign currency, a new equilibrium exchange rate will tend
to eliminate balance of payments and bring trade into balance
(exports = imports)
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What Determines Foreign Exchange
Rates (Cont.)
• Balance of Payments (Cont.)
– Deficit
• Result in a depreciation of the U.S. dollar
• Encourages exports and discourages imports
• Eventually the trade balance is in equilibrium at the new exchange
rate
– Surplus
• Appreciation of the U.S. dollar
• Discourages exports and encourages imports
• The trade will be balanced at the new exchange rate
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What Determines Foreign Exchange
Rates (Cont.)
• Why Do Exchange Rates Fluctuate
– Figure 10.2 shows that the exchange rate between the U.S.
dollar and other major currencies varies considerably over
time
– Figure 10.4 and 10.5 demonstrates that anything that causes
the demand or supply in the foreign exchange market to shift
will change the equilibrium exchange rate
• U.S. residents buying more or less foreign goods will shift the demand
curve for foreign currency
• Changes in foreigner’s purchase of U.S. goods will shift the supply
curve of foreign currency
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FIGURE 10.2 Recent exchange rate history
between the U.S. dollar and other major
currencies.
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FIGURE 10.2 Recent exchange rate history
between the U.S. dollar and other major
currencies. (Cont.)
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FIGURE 10.2 Recent exchange rate history
between the U.S. dollar and other major
currencies. (Cont.)
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FIGURE 10.2 Recent exchange rate history
between the U.S. dollar and other major
currencies. (Cont.)
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FIGURE 10.3 A rightward shift in the demand curve for
pesos raises the dollar price of pesos, implying an
appreciation of the peso and a depreciation of the dollar.
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FIGURE 10.4 A rightward shift in the supply curve of pesos
lowers the dollar price of pesos, implying a depreciation of
the peso and an appreciation of the dollar.
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What Determines Foreign Exchange
Rates (Cont.)
• Factors that influence long-run supply and
demand conditions
– Relative prices of U.S. versus foreign goods
• Relative increase in price of U.S. goods will encourage
more imports
– increase demand for foreign currency
– tends to depreciate the value of the U.S. dollar or an appreciation
of the foreign currency
• Relative decrease in price of U.S. goods will result in an
appreciation of the U.S. dollar
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What Determines Foreign Exchange
Rates (Cont.)
• Factors that influence long-run supply and demand
conditions (Cont.)
– Productivity
• Increased productivity in U.S. will lower price of American goods
• Increased demand for U.S. goods internationally
• Increased supply of foreign currency will appreciate the value of the
dollar while foreign currency depreciates
– Tastes for U.S. versus foreign goods
• Increased tastes for U.S. goods
• Increased demand for U.S. goods and increased supply of foreign
currency
• Dollar appreciates relative to foreign currency
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What Determines Foreign Exchange
Rates (Cont.)
• How Global Investors Cause Exchange Rate
Volatility
– Changes in the factors described above occur slowly
over time, so they cannot explain the often violent
short-term movement in exchange rates
– Figure 10.5 shows the considerable day-to-day
movement of U.S. dollar exchange rates versus
major foreign currencies
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FIGURE 10.5 Daily fluctuations in foreign
exchange rates can be quite volatile (2008).
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FIGURE 10.5 Daily fluctuations in foreign
exchange rates can be quite volatile (2008).
(Cont.)
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FIGURE 10.5 Daily fluctuations in foreign
exchange rates can be quite volatile (2008).
(Cont.)
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FIGURE 10.5 Daily fluctuations in foreign
exchange rates can be quite volatile (2008).
(Cont.)
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What Determines Foreign Exchange
Rates (Cont.)
• How Global Investors Cause Exchange Rate
Volatility (Cont.)
– International capital mobility
• Funds flow freely across international borders and investors can
purchase U.S. or foreign securities
• U.S. investors compare the expected return on domestic securities
versus foreign securities to determine which are the most attractive
• Therefore, changes in preferences of U.S. versus foreign securities
will result in a change in demand and supply of foreign currency and a
change in the exchange rate
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What Determines Foreign Exchange
Rates (Cont.)
• How Global Investors Cause Exchange Rate
Volatility (Cont.)
– International capital mobility (Cont.)
• In this case, expectations of future exchange rates play a central role
in the decision process
• When considering investing in foreign securities to take advantage of
a higher yield, must consider the expected movement of future
exchange rates
• In order to invest in foreign securities, must first purchase foreign
currency and eventually re-purchase U.S. dollars to bring currency
back to U.S.
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What Determines Foreign Exchange
Rates (Cont.)
• How Global Investors Cause Exchange Rate
Volatility (Cont.)
– International capital mobility (Cont.)
• It is possible that a change in the future exchange rate will
offset any increased yield by holding foreign securities
• In fact, the international mobility of capital will often
cause the change in future exchange rates that was
anticipated—self-fulfilling prophesy
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What Determines Foreign Exchange
Rates (Cont.)
• How Global Investors Cause Exchange Rate
Volatility (Cont.)
– This suggests that the equilibrium foreign exchange
rate is sensitive to investor expectations of future
movement in exchange rates
– Since these expectations might be quite unstable and
susceptible to change, this may cause considerable
short-term volatility in the actual exchange rates
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Fixed Versus Floating Exchange
Rates
• Volatility in foreign exchange rates represents a
cost of doing business internationally and
imposes considerable risk on investments
overseas
• Historically governments tried to avoid this cost
by fixing exchange rates at some predetermined
level
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Fixed Versus Floating Exchange
Rates (Cont.)
• Fixed exchange rate system
– This was the system maintained globally from 1944
until the early 1970s.
– It came under the supervision of the International
Monetary Fund (IMF)
– After the collapse of the fixed exchange rate system,
it was resurrected with a more limited scope in 1979
for the major European countries
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Fixed Versus Floating Exchange
Rates (Cont.)
• Fixed exchange rate system (Cont.)
– The most recent example of a fixed exchange rate is the
introduction of the Euro as the common currency of the 12
members of the European Monetary Union
• This new monetary union sets the exchange rate between the Euro and
the member countries’ national currencies at a fixed rate
• Individual member countries are expected to maintain domestic
economic conditions that will not cause these agreed upon exchange
rates to change
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Fixed Versus Floating Exchange
Rates (Cont.)
• How Fixed Rates Are Supposed to Work
– The correction process under a floating exchange
rate system
• Country runs a balance-of-payments deficit
• Supply of its currency offered on world financial markets
exceeds the demand
• The currency will be depreciated in value relative to other
markets
• This adjustment brings the international payments into
equilibrium
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Fixed Versus Floating Exchange
Rates (Cont.)
• How Fixed Rates Are Supposed to Work (Cont.)
– However, under a fixed exchange rate system these
fluctuations are prevented from occurring through
government intervention
– Figure 10.6(a) (Floating Rate System)
• The supply curve of British Pounds shifts to the right because
British tastes have shifted toward increased purchases of
American goods
• This increased supply of pound would put downward pressure
on the value of the Pound
• Under a floating rate system the new lower equilibrium point
would be reached where quantity supplied of pounds equals the
quantity demanded of pounds
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Fixed Versus Floating Exchange
Rates (Cont.)
• How Fixed Rates Are Supposed to Work (Cont.)
– Figure 10.6(b) (Fixed Rate System)
• Under this system, the British government would intervene in the
foreign exchange market and purchase the excess pounds available at
the predetermined fixed (pegged) rate
• Britain’s international reserves are used to purchase the excess pounds
which prevents the exchange rate from falling below the pegged rate
• Traditionally these international reserves consist of gold, U.S. dollars,
other major currencies, and now the Euro
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FIGURE 10.6 In (a), with floating rates, the pound
depreciates; in (b), with pegged rates, the British central
bank prevents the decline by buying up the excess supply
of pounds.
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FIGURE 10.6 In (a), with floating rates, the pound
depreciates; in (b), with pegged rates, the British central
bank prevents the decline by buying up the excess supply
of pounds. (Cont.)
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International Financial Crises
• Major problem with a fixed rate system is that it
contains no self-correcting exchange rate mechanism to
eliminate a country’s persistent balance-of-payment
deficit
• A continual balance-of-payment deficit suggests
domestic economic structural problems relative to the
rest of the world
• Eventually the country will run out of international
reserves and be forced to devalue which will eliminate
the deficit
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International Financial Crises (Cont.)
• The expectation of a devaluation will cause the
international financial community to take actions that
will increase the likelihood of the anticipated
devaluation
– Individuals will sell the threatened currency in the
international market
– This increases the supply of the currency which increases the
downward pressure on the value
– This capital flight will further deplete the country’s
international reserve and speed up the devaluation
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International Financial Crises (Cont.)
• Currently industrialized countries practice a managed
float system
– The exchange rate is permitted to vary within a
predetermined band
– If foreign exchange markets attempt to push the value of the
currency outside the band (both above or below), central bank
will intervene
– However, if the central bank is intervening an excessive
amount, it is likely that country will be forced to devalue or
revalue its currency to recognize structural changes in local
economy
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