🏦Business Macroeconomics Unit 13 – Exchange Rates & Currency in Global Markets

Key Concepts

• Exchange rate represents the value of one currency in terms of another currency
• Floating exchange rates are determined by market forces of supply and demand
• Fixed exchange rates are set and maintained by a country's central bank
• Currency appreciation occurs when a currency increases in value relative to another currency
• Currency depreciation happens when a currency decreases in value compared to another currency
• Nominal exchange rate is the unadjusted rate at which one currency can be exchanged for another
• Real exchange rate adjusts the nominal exchange rate for differences in inflation between countries
• Purchasing Power Parity (PPP) theory suggests that exchange rates should equalize the prices of goods and services across countries

Exchange Rate Basics

• Exchange rates play a crucial role in international trade and investment
• Quoted as the price of one currency in terms of another (e.g., 1 USD = 0.85 EUR)
• Spot exchange rate refers to the current exchange rate for immediate delivery
• Forward exchange rate is an agreed-upon rate for a future transaction
• Exchange rates can be expressed as direct or indirect quotations
  • Direct quotation states the price of a foreign currency in terms of the domestic currency
  • Indirect quotation states the price of the domestic currency in terms of a foreign currency
• Cross rates involve the exchange between two currencies, neither of which is the official currency in the country where the quote is provided
• Bid-ask spread represents the difference between the buying and selling prices of a currency

Types of Exchange Rate Systems

• Exchange rate systems can be classified into three main categories: floating, fixed, and managed
• Floating exchange rates are determined by market forces without government intervention
  • Clean float occurs when exchange rates are determined entirely by market forces
  • Dirty float happens when central banks intervene to influence exchange rates
• Fixed exchange rates are set and maintained by the government or central bank
  • Currency board system involves fixing the exchange rate to a major currency (USD) and backing the domestic currency with foreign reserves
  • Dollarization occurs when a country adopts a foreign currency (USD) as its official currency
• Managed exchange rates involve government intervention to keep rates within a desired range
• Crawling peg system allows for gradual adjustments to the exchange rate over time
• Target zone or band system maintains the exchange rate within a specific range

Factors Influencing Exchange Rates

• Interest rates affect currency values, with higher rates typically attracting foreign investment and increasing demand for the currency
• Inflation rates impact exchange rates, as countries with lower inflation tend to have stronger currencies
• Economic growth and stability influence investor confidence and currency demand
• Political stability and government policies can impact currency values
• Balance of trade and current account balances affect supply and demand for currencies
  • Trade surpluses increase demand for a country's currency
  • Trade deficits lead to increased supply of a country's currency
• Speculation and market sentiment can cause short-term fluctuations in exchange rates
• Central bank interventions, such as open market operations or interest rate changes, can influence exchange rates

Currency Markets and Trading

• Foreign exchange (forex) market is the largest financial market in the world
• Operates 24 hours a day, five days a week across major financial centers
• Main participants include commercial banks, central banks, hedge funds, and multinational corporations
• Spot market involves the immediate exchange of currencies at the current rate
• Forward market allows for the exchange of currencies at a predetermined future date and rate
• Currency futures are standardized contracts traded on exchanges, specifying the exchange of currencies at a future date and rate
• Currency options give the holder the right, but not the obligation, to buy or sell a currency at a specific rate and date
• Forex trading involves speculating on currency price movements to generate profits
  • Long positions benefit from currency appreciation
  • Short positions profit from currency depreciation

Exchange Rates and International Trade

• Exchange rates directly impact the competitiveness of a country's exports and imports
• Currency appreciation makes exports more expensive and imports cheaper, potentially reducing trade competitiveness
• Currency depreciation makes exports cheaper and imports more expensive, potentially boosting trade competitiveness
• Exchange rate volatility can create uncertainty for international businesses and impact trade flows
• J-curve effect describes the delayed impact of currency depreciation on a country's trade balance
  • Initially, trade balance worsens due to higher import prices
  • Over time, exports become more competitive, and the trade balance improves
• Marshall-Lerner condition states that currency depreciation will improve the trade balance if the sum of export and import price elasticities is greater than one

Exchange Rate Policies and Interventions

• Governments and central banks may intervene in foreign exchange markets to manage exchange rates
• Exchange rate policies aim to achieve various economic objectives, such as price stability, economic growth, or trade competitiveness
• Sterilized intervention involves buying or selling foreign currency while simultaneously conducting open market operations to offset the impact on the money supply
• Unsterilized intervention affects the money supply and can have inflationary or deflationary effects
• Capital controls are measures designed to limit the flow of foreign capital in and out of a country
  • Can be used to manage exchange rate volatility and prevent speculative attacks
  • May include taxes on foreign investments, restrictions on currency convertibility, or limits on capital outflows
• Competitive devaluation occurs when countries deliberately weaken their currencies to gain a trade advantage, potentially leading to "currency wars"
• International coordination, such as the Plaza Accord (1985) and Louvre Accord (1987), can help manage global exchange rate stability

Global Economic Impacts

• Exchange rates influence global trade patterns, investment flows, and economic growth
• Currency fluctuations can affect the profitability and competitiveness of multinational corporations
• Exchange rate risk is the potential for financial losses due to unfavorable currency movements
  • Hedging techniques, such as forward contracts or currency options, can help mitigate exchange rate risk
  • Natural hedges involve matching foreign currency revenues and expenses to minimize exposure
• Global imbalances, such as persistent trade surpluses or deficits, can create pressure on exchange rates and lead to economic instability
• International monetary cooperation, through institutions like the International Monetary Fund (IMF), helps promote global financial stability and manage exchange rate crises
• Currency crises, such as the Asian Financial Crisis (1997) or the Argentine Peso Crisis (2001), can have severe economic and social consequences
• Exchange rates play a crucial role in the transmission of economic shocks across countries and the global business cycle