unit 11 review
Exchange rates play a crucial role in the global economy, affecting international trade, investment, and economic policies. They represent the value of one currency in terms of another, influenced by factors like inflation, interest rates, and economic growth.
Understanding exchange rates is essential for businesses, investors, and policymakers. Different exchange rate systems, such as fixed, floating, and pegged, have varying impacts on economic stability and flexibility. Theories like Purchasing Power Parity and Interest Rate Parity help explain exchange rate movements.
Key Concepts
- Exchange rate represents the value of one currency in terms of another currency
- Nominal exchange rate refers to the rate quoted in the foreign exchange market without adjusting for inflation
- Real exchange rate adjusts the nominal exchange rate for differences in inflation rates between countries
- Appreciation occurs when a currency increases in value relative to another currency
- Depreciation happens when a currency decreases in value relative to another currency
- Fixed exchange rate system maintains a constant exchange rate between currencies through central bank intervention
- Floating exchange rate system allows the exchange rate to be determined by market forces of supply and demand
Exchange Rate Basics
- Exchange rates are typically quoted as the price of one currency in terms of another (USD/EUR, JPY/GBP)
- Bilateral exchange rate involves the exchange between two currencies
- Multilateral exchange rate involves the exchange among multiple currencies
- Spot exchange rate refers to the current exchange rate for immediate delivery
- Forward exchange rate is an agreed-upon rate for a future transaction
- Currency pairs are often quoted in terms of a base currency and a quote currency (EUR/USD, GBP/JPY)
- Cross rates are exchange rates between two currencies derived from their respective exchange rates with a third currency
Types of Exchange Rate Systems
- Fixed exchange rate system maintains a constant exchange rate through central bank intervention in the foreign exchange market
- Central banks buy or sell foreign currency reserves to maintain the fixed rate
- Examples include the Bretton Woods system (1944-1971) and the European Exchange Rate Mechanism (ERM) prior to the introduction of the euro
- Floating exchange rate system allows the exchange rate to be determined by market forces of supply and demand
- Clean float occurs when the central bank does not intervene in the foreign exchange market
- Dirty float or managed float involves occasional central bank intervention to influence the exchange rate
- Pegged exchange rate system ties the value of a currency to another currency or a basket of currencies
- Currency board arrangement is a strict form of a pegged system where the domestic currency is backed by foreign currency reserves
- Crawling peg system allows for gradual adjustments in the exchange rate based on a predetermined schedule
Factors Affecting Exchange Rates
- Inflation rate differentials between countries impact exchange rates
- Higher inflation in a country typically leads to a depreciation of its currency
- Interest rate differentials influence exchange rates through capital flows
- Higher interest rates attract foreign capital, leading to an appreciation of the currency
- Economic growth and productivity differences affect exchange rates
- Stronger economic growth and higher productivity can lead to currency appreciation
- Balance of payments, which includes the current account and capital account, impacts exchange rates
- A current account surplus (deficit) can lead to currency appreciation (depreciation)
- Capital inflows (outflows) can lead to currency appreciation (depreciation)
- Political stability and economic policies influence investor confidence and exchange rates
- Speculation and market sentiment can cause short-term fluctuations in exchange rates
Exchange Rate Theories
- Purchasing Power Parity (PPP) theory suggests that exchange rates should adjust to equalize the prices of goods and services across countries
- Absolute PPP states that the exchange rate between two currencies should equal the ratio of the price levels in the two countries
- Relative PPP focuses on the change in the exchange rate and the inflation rate differential between countries
- Interest Rate Parity (IRP) theory posits that the difference in interest rates between two countries should equal the expected change in the exchange rate
- Covered Interest Rate Parity (CIRP) involves the use of forward contracts to hedge against exchange rate risk
- Uncovered Interest Rate Parity (UIRP) assumes that the expected future spot rate is an unbiased predictor of the actual future spot rate
- Monetary approach to exchange rates emphasizes the role of money supply and demand in determining exchange rates
- An increase in the domestic money supply relative to the foreign money supply leads to a depreciation of the domestic currency
Impact on International Trade
- Exchange rates affect the relative prices of exports and imports
- An appreciation of a country's currency makes its exports more expensive and imports cheaper
- A depreciation of a country's currency makes its exports cheaper and imports more expensive
- Exchange rate volatility can increase the risk and uncertainty in international trade transactions
- Hedging techniques, such as forward contracts and currency options, can be used to manage exchange rate risk
- The Marshall-Lerner condition states that a currency depreciation will improve a country's trade balance if the sum of the absolute values of the export and import demand elasticities is greater than one
- The J-curve effect suggests that a currency depreciation may initially worsen a country's trade balance before improving it in the long run
- The initial worsening is due to the time lag in the response of export and import volumes to price changes
Policy Implications
- Exchange rate policy is an important tool for macroeconomic management
- Countries may choose to maintain a fixed, floating, or managed exchange rate system based on their economic objectives and circumstances
- Monetary policy actions, such as changes in interest rates, can influence exchange rates
- Higher interest rates typically lead to currency appreciation, while lower interest rates lead to depreciation
- Fiscal policy decisions, such as government spending and taxation, can affect exchange rates through their impact on economic growth, inflation, and capital flows
- Central bank intervention in the foreign exchange market can be used to stabilize exchange rates or achieve specific exchange rate targets
- Sterilized intervention involves offsetting the impact of foreign exchange transactions on the domestic money supply
- Non-sterilized intervention allows the money supply to change as a result of the intervention
- Capital controls can be used to manage capital flows and mitigate the impact of exchange rate fluctuations
- Examples include taxes on capital inflows, restrictions on capital outflows, and foreign exchange regulations
Real-World Applications
- Multinational corporations use exchange rate forecasts and risk management strategies to minimize the impact of exchange rate fluctuations on their operations and financial performance
- Hedging techniques, such as forward contracts, options, and swaps, are commonly used to manage exchange rate risk
- Investors consider exchange rate movements when making international portfolio investment decisions
- Diversifying investments across currencies can help reduce the overall risk of a portfolio
- Central banks monitor exchange rate developments and may intervene in the foreign exchange market to achieve their policy objectives
- The Swiss National Bank has intervened in the foreign exchange market to prevent excessive appreciation of the Swiss franc
- Exchange rate fluctuations can impact the competitiveness of a country's exports and the cost of its imports
- The depreciation of the Chinese yuan in 2015 raised concerns about the competitiveness of exports from other countries
- Currency crises, such as the Asian financial crisis (1997-1998) and the Argentine peso crisis (2001-2002), highlight the importance of sound exchange rate policies and the potential consequences of exchange rate misalignments