chapter - 4 & 6 (exchange rate determination & goverment influence on exchange rate)

Exchange Rate Determination and Government Influence on Exchange Rate

Exchange Rate Determination and Government Influence on Exchange Rate

33 Chapter Chapter

Learning Objectives

• To explain how exchange rate movements are measured;

• To describe the exchange rate systems used by various governments;

• To explain how the equilibrium exchange rate is determined;

• To examine the factors that affect the equilibrium exchange rate; and

• To explain how governments can use direct and indirect intervention to influence exchange rates;

Exchange Rate

Exchange Rate:

An exchange rate measures the value of one currency in units of

another currency.

• When a currency declines in value, it is said to depreciate. When it

increases in value, it is said to appreciate.

• If currency A can buy you more units of foreign currency, currency

A has appreciated and foreign currency depreciated

• If currency A can buy you less units of foreign currency, currency

A has depreciated and foreign currency appreciated.

To compare a foreign currency’s spot rate at two specific points in

time, the following equation can be used,

Percentage change (% ) in foreign currency value =

Where, S denotes the recent spot rate at time t

denotes the earlier spot rate at time t

• A positive % represents appreciation of the foreign currency, while a negative % represents depreciation.

• On the days when some currencies appreciate while others depreciate against the dollar, the dollar is said to be “mixed in trading.”

Measuring Exchange Rate Movements, Cont.

1001

1

t

t

S

SS

1tS

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Exchange Rate System

• Exchange rate systems can be classified according to the degree to which the rates are controlled by the government.

• Exchange rate systems normally fall into one of the following categories:

¤ Fixed

¤ Freely floating

¤ Managed float

¤ Pegged

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Fixed Exchange Rate System:

In a fixed exchange rate system, exchanges rates are either held

constant or allowed to fluctuate only within very narrow boundaries.

A fixed exchange rate would be beneficial to a country for the

following reasons:

• Exporters and importers could engage in international trade

without concern about exchange rate movements of the currency to

which their local currency is linked.

• Firm could engage in direct foreign investment, without concern

about exchange rate movements of that currency.

Exchange Rate System, Cont..

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• Investors would be able to invest funds in foreign countries, without concern that the foreign currency denominating their investment might weaken over time.

Pros:

Work becomes easier for the MNCs.

Cons:

• Governments may revalue their currencies. In fact, the dollar was devalued more than once after the U.S. experienced balance of trade deficits.

• Each country may become more vulnerable to the economic conditions in other countries.


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Freely Floating Exchange Rate System:

In a freely floating exchange rate system, exchange rate values are

determined by market forces without intervention by Governments. A

freely floating exchange rate system allows complete flexibility. A

freely floating exchange rate adjust on a continual basis in response to

demand and supply conditions for that currency.


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Pros:

• Each country may become more insulated against the economic problems in other countries.

• Central bank interventions that may affect the economy unfavorably are no longer needed.

• Governments are not restricted by exchange rate boundaries when setting new policies.

• Less capital flow restrictions are needed, thus enhancing the efficiency of the financial market.

Cons:

• MNCs may need to devote substantial resources to managing their exposure to exchange rate fluctuations.

• The country that initially experienced economic problems (such as high inflation, increasing unemployment rate) may have its problems compounded.


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Managed Float Exchange Rate System:

In a managed (or “dirty”) float exchange rate system, exchange

rates are allowed to move freely on a daily basis and no official

boundaries exist. However, governments may intervene to prevent

the rates from moving too much in a certain direction.

Cons:

• A government may manipulate its exchange rates such that its own country benefits at the expense of others.


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Pegged Exchange Rate System:

In a pegged exchange rate system, the home currency’s value is

pegged to a foreign currency or to some unit of account, and moves

in line with that currency or unit against other currencies.

Some Government peg their currency’s value to that of a stable

currency, because that forces the value of their currency to be

stable.


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For Example:

A country may peg their currency’s value to dollar. So their

currency exchange rate with the dollar to be fixed and the currency

will move against non-dollar currencies by the same degree as the

dollar. Since the dollar is more stable than most currency, it will

make their currency more stable than most currencies.


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An exchange rate represents the price of a currency. Like any other

products sold in market, the price of a currency is determined by the

demand for that currency relative to the supply for that currency.

The concept of an Equilibrium Exchange Rate will help us to

understand, how currencies exchange rates are determined.

For each possible price of a currency, there is a corresponding demand

for that currency, and corresponding supply of that currency for sale.

At any point in time, that currency should exhibit the price at which

the demand for the currency is equal to supply, and that point is

represents the equilibrium exchange rate.

Exchange Rate Determination

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We will use British pound and US dollar to explain exchange rate

equilibrium.

Demand for a Currency:

This exhibit shows the quantity of pounds that would be demanded at

various exchange rates at specific point in time. The demand schedule

is down word sloping.

Exchange Rate Equilibrium

Val

ue

of

£

Quantity of £

D: Demand for £

$1.55$1.50

$1.60

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Supply of a Currency for Sale:

This exhibit shows the quantity of pounds for sale corresponding to

each possible exchange rate at a given point in time. There is

positive relationship between the value of the pound and the

quantity of pounds for sale.

Exchange Rate Equilibrium, Cont..

Val

ue

of

£

Quantity of £

$1.55

$1.50

$1.60 S: Supply of £

Val

ue

of

£

Quantity of £

D: Demand for £

$1.55

$1.50

$1.60S: Supply of £

Equilibrium Exchange Rate

Exchange Rate Equilibrium, Cont..

Equilibrium:

The demand and supply schedule for pound are combined in the

following exhibit. According to exhibit the equilibrium exchange rate

is $1.55 because this rate equates the quantity of pounds demanded

with the supply of pounds for sale.

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The equilibrium exchange rate will change over time as supply and

demand schedules change. The factors that causes currency supply

and demand schedule to change are:

• Relative Inflation Rates

• Relatives Interest Rates

• Relative Income Levels

• Government Controls

• Expectation

Factors that Influence Exchange Rates

$/£

Quantity of £

S0

D0

r0

U.S. inflation U.S. demand for British goods,

and hence £.

British desire for U.S. goods, and hence the supply of £.

D1

r1

S1

Relative Inflation Rates:

Changes in relative inflation rates can affect international trade

activity, which influences the demand for and supply of currencies

and therefore influences exchange rates.

Factors that Influence Exchange Rates, Cont..

$/£

Quantity of £

r0

S0

D0

S1

D1

r1

U.S. interest rates U.S. demand for British

bank deposits, and hence £. British desire for U.S. bank

deposits, and hence the supply of £.

Relative Interest Rates:

Changes in relative interest rates affect investment in foreign

securities, which influences the demand for and the supply of

currencies and therefore influences exchange rates.


• Though A relatively high interest rate may attract foreign inflows, the relatively high interest rate may reflect expectations of relatively high inflation, which discourages foreign investment.

• Because high inflation can place down ward pressure on the local currency, for this reason, it is helpful to consider the Real Interest Rate, which is adjusts the nominal interest rate for inflation:

Real Interest Rate Nominal Interest Rate – Inflation Rate

This relationship is sometimes called the Fisher effect.


$/£

Quantity of £

S0

D0

r0

U.S. income level U.S. demand for British

goods, and hence £. No expected change for the

supply of £.D1

r1

Relative Income Levels:

A third factor affecting exchange rates is relative income levels.

Because income can affect the amount of imports demanded, it can

affect exchange rates.

Changing income can also affect exchange rates indirectly through

effects on interest rates.


Government Controls:

The Governments of foreign countries can influence the

equilibrium exchange rate in many ways, including:

¤ Imposing foreign exchange barriers,¤ Imposing foreign trade barriers,¤ Intervening (buying and selling currencies) in the foreign

exchange market, and¤ Affecting macro variables such as inflation, interest rates,

and income levels.


Expectations:

A fifth factor affecting exchange rates is market expectations of

future exchange rates. Like other financial markets, foreign

exchange markets react to any news that may have a future effect.

News of a potential surge in US inflation may cause currency traders

to sell dollars, anticipating a future decline in the dollar’s value. This

response places immediate down ward pressure on the dollar.

• Institutional investors often take currency positions based on anticipated interest rate movements in various countries.

• Because of speculative transactions, foreign exchange rates can be very volatile.


Trade-Related Factors 1. Inflation Differential 2. Income Differential 3. Gov’t Trade Restrictions

Financial Factors1. Interest Rate Differential2. Capital Flow Restrictions

How Factors Can Affect Exchange Rates

U.S. demand for foreign goods, i.e. demand for

foreign currency

Foreign demand for U.S. goods, i.e. supply of

foreign currency

U.S. demand for foreign securities, i.e. demand

for foreign currency

Foreign demand for U.S. securities, i.e. supply of

foreign currency

Exchange rate

between foreign

currency and the dollar

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Each country has a government agency (called the central bank) that

may intervene in the foreign exchange market to control the value of

the country’s currency. In particular, they attempt to control the

growth of the money supply in their respective countries in a way

that will favorably affect economic conditions.

Reasons for Government Intervention

Central banks commonly manage exchange rates for three reasons:¤ to smooth exchange rate movements,¤ to establish implicit exchange rate boundaries, and/or¤ to respond to temporary disturbances.

Government Intervention

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Direct Intervention:

To force the dollar to depreciate, the government can intervene

directly by exchanging dollars that it holds as reserves for other

foreign currencies in the foreign exchange market.

If the government desires to strengthen the dollar, it can exchange

foreign currencies for dollars in the foreign exchange market,

thereby putting upward pressure on the dollar.

Government Intervention, cont..

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Quantity of £

S1

D1

D2

Valueof £

V1

V2

Fed exchanges $ for £to strengthen the £

Quantity of £

S2

D1

Valueof £

V2

V1

Fed exchanges £ for $to weaken the £

S1

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Non-Sterilized Vs. Sterilized Intervention:

When a central bank intervenes in the foreign exchange market without

adjusting for the change in money supply, it is said to engaged in

non-sterilized intervention.

For example: if the government exchanges dollars for foreign

currencies in the foreign exchange markets in an attempt to strengthen

foreign currencies (weaken the dollar), the dollar money supply

increases.

In a sterilized intervention, the government intervenes in the foreign

market and Treasury securities are purchased or sold at the same

time to maintain the money (dollar) supply.


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Federal Reserve

Banks participatingin the foreign

exchange market

$ C$To Strengthen

the C$:

Federal Reserve


exchange market

$ C$To Weaken the C$:

Non-Sterilized Intervention

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Federal Reserve


exchange market

$ C$

Federal Reserve


exchange market

$ C$

$

Financialinstitutionsthat invest

in Treasurysecurities

T- securities

Financialinstitutionsthat invest

in Treasurysecurities

$

T- securities

To strengthen

The C$

To Weaken the C$

Sterilized Intervention

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Indirect Intervention:

Central banks can also engage in indirect intervention

influencing the factors that determine the value of a currency.

• Inflation Rates

• Interest Rates

• Income Levels

• Government Controls

• Expectation

For example: the Fed may attempt to increase interest rates (and

hence boost the dollar’s value) by reducing the U.S. money supply.

• Note that high interest rates adversely affects local borrowers.


Impact of Exchange Rates on an MNC’s Value

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = weighted average cost of capital of the parent

Inflation Rates, Interest Rates,Income Levels, Government Controls,

Expectations

chapter - 4 & 6 (exchange rate determination & goverment influence on exchange rate)

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