Changes in Exchange Rate

10 Key excerpts on "Changes in Exchange Rate"

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  eBook - ePub

  Applied International Economics

  • W. Charles Sawyer, Richard L. Sprinkle(Authors)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  CHAPTER 14

  Exchange rates and their determination

  A basic model

  The exchange rate is determined from day to day by supply and demand of home currency in terms of foreign currency. Each transaction is two-sided, and sales are equal to purchases. Any change in the conditions of demand or of supply reflects itself in a change in the exchange rate, and at the ruling rate the balance of payments balances from day to day, or from moment to moment.

  Joan Robinson

  INTRODUCTION

  T he international value of a country’s currency has become an inescapable part of the daily flow of economic information. Most of us are aware that a country’s exchange rate is important, but many of us do not have a clear idea of why the exchange rate matters or what causes it to change. As the chapter’s opening quote indicates, the familiar tools of supply and demand analysis can be used to determine a country’s exchange rate. In this chapter, you will learn why the supply and demand model works in analyzing exchange rates—in the same manner, in fact, that it works in analyzing the price of gasoline or pizza, for one dollar or one yen or one gallon of gasoline is indistinguishable from another. By the end of this chapter you should have a good grasp of why exchange rates are important and what factors cause them to change over the long run. Finally, it is obvious to even a casual observer that exchange rates change frequently. These changes, or volatility, are a source of aggravation for individuals, businesses, and governments. The chapter explains what economists know about the effects of exchange rate volatility on international trade and how Changes in Exchange Rates affect the prices of the goods and services we purchase. The final part of the chapter deals with the underlying value of a currency. While the exchange rate we observe in the market often differs from that value, it is very useful to know what that value is.

  EXCHANGE RATES

  Suppose that a U.S. importer is purchasing British Jaguars. To purchase the Jaguars, the importer needs to obtain British pounds by exchanging dollars for pounds. The demand for foreign currency is derived from individuals demanding foreign goods and services. This relationship can be applied in reverse. As individuals in the U.K. demand U.S. products, there is an increased demand for dollars. However, this raises the question of how many dollars must be exchanged to obtain the requisite number of pounds, or vice versa? In this example, the relevant exchange rate is the U.S. dollar–U.K. pound exchange rate. In general, the exchange rate is the price of one country’s currency in terms of another. The demand for British pounds relative to the supply of pounds will determine the exchange rate, just as the demand for gasoline relative to the supply of gasoline determines the price of gasoline. Exchange rates fluctuate considerably over time. However, unlike the price of gasoline, changes in the exchange rate are expressed as changes in the value of the domestic country’s currency. An increase in the value of a currency is referred to as appreciation. Analogously, a decline in the value of the currency is referred to as depreciation

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  Exchange Rate Regimes

  Fixed, Flexible or Something in Between?

  • I. Moosa(Author)
  • 2006(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The second problem is that the equilibrium values of the exchange rate are ranked differently by the two countries involved in the bilateral exchange rates. For example, one country may prefer E 1 while the other prefers E 3 . A situation like this could lead to conflict in the economic policies of the two countries. The third problem is that speculation as well as balance of payments disturbances may cause sharp fluctuations in the exchange rate, which lead to an unnecessary and wasteful reallocation of resources. For E 3 E 2 E 1 Q E S D Figure 2.11 Multiple equilibria in the foreign exchange market The Role of the Exchange Rate in the Economy 43 example, if the exchange rate rises slightly above E 1 , speculators will start buying the foreign currency, thinking that it will rise further. The exchange rate will rise beyond the unstable level E 2 , all the way to the stable level E 3 . When it reaches E 3 , speculators sell the foreign currency, causing the exchange rate to fall all the way to E 1 . The effect of a balance of payments disturbance is illustrated in Figure 2.12. A fall in the demand for foreign exchange is represented by a shift in the demand curve, and the equilibrium exchange rate falls from E 1 to E 2 . This big drop is caused by the backward-bending nature of the supply curve. Changes in the exchange rate would be less dramatic under a normal upward-sloping supply curve. The effect of the exchange rate on the current account of the balance of payments emanates from the effect of changes in the exchange rate on prices and, therefore, the demand for domestic and foreign goods (exports and imports). When the exchange rate rises (the domestic currency depreciates), prices of exports in foreign currency terms fall while prices of imports in domestic currency terms rise.

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  Exchange Rate Alignments

  • J. Mills(Author)
  • 2012(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  32 Exchange Rate Alignments to persuade that they have been aiming at precisely the wrong objective for all their working lives. All these sentiments are wrapped up in the widely used rhetoric of exchange rates. When a currency’s value is high, it is strong. When low, it is weak. When it depreciates, its value falls. When it appreciates, it rises. Loaded terms colour everyone’s perceptions. The reality, however, is different. If a country’s currency is too strong, its exports wither, its manufacturing declines, investment and the savings to pay for it fall, living standards for most people stagnate, life chances deteriorate, the foreign exchange and fiscal balances tend to go into deficit, and its rela- tive power and position in the world falls away. This is a terrible price to pay for misconceptions which need to be exposed and which ought not to prevail. Finally, it is surprisingly difficult to disentangle all the existing empir- ical evidence on the impact of exchange rates on economic perform- ance. Table 2.1 sets out some telling statistics, which show how far from being clear-cut and obvious the evidence is. It is clear that between 2000 and 2010 exchange rates and the proportion of the economy devoted to manufacturing were not alone in determining growth rates. Russia and Saudi Arabia did very well out of high oil prices. Greece, Spain and Ireland benefited hugely, for a while at least, from the Eurozone. India, Brazil and the USA were helped by positive demographics. Japan was hindered by a high exchange rate, and Germany by the hangover from unification. Towards the end of the decade, the West was hit much harder than the East by the financial crisis. Disentangling the critical impact of exchange rates is therefore not easy. The really crucial point is that all the other factors which have clearly had an impact on the growth rates in Table 2.1 are largely if not wholly beyond any govern- ment’s capacity to influence.

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  Country Analysis

  Understanding Economic and Political Performance

  • David M. Currie(Author)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  explain the factors that influence the value of a currency; 6. explain the difference between fixed and floating exchange rate regimes; 7. explain the risk in a currency transaction caused by appreciation or depreciation of either currency. What is an Exchange Rate? An exchange rate is simply a price that tells you how much a currency is worth in terms of another currency. Because this book is intended for a US audience, most of the discussion will be in terms of how much a US dollar is worth, but the same reasoning applies to any other currency: how much a UK pound is worth in terms of euros, or how much a euro is worth in terms of Japanese yen. Any currency can be stated relative to another currency, and the price is its exchange rate. The exchange rate can be established in two ways: by the government of a country, or by the international currency market. In the old days, before the Second World War, governments set exchange rates that initially were based on the gold content of each country’s coins. When that system ran into complications, rates were set by agreements between governments in what was known as the Bretton Woods system. When the Bretton Woods system failed in the 1970s, most governments left it to markets to determine exchange rates. With a few notable exceptions, today most exchange rates are determined on the currency market. When a government sets an exchange rate and attempts to maintain that value, it is called a fixed exchange rate regime. When governments give up the effort and allow markets to determine exchange rates, it is called a floating exchange rate regime. Between the two extremes are several variations, but those are the choices facing any government: the government can attempt to dictate the exchange rate, or it can leave the decision up to the market

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  Introduction to Foreign Exchange Rates, Second Edition

  • Thomas J. O'Brien(Author)
  • 2016(Publication Date)
  • Business Expert Press

    (Publisher)

  CHAPTER 2 Impact of Foreign Exchange Rate Changes

  Although spot foreign exchange (FX) rates at any moment are known and observable, one does not know ahead of time what future spot FX rates will be. Many try to predict and speculate, but there is always uncertainty about where FX rates will go in the future. Some FX rates are more volatile than others, depending on fundamental supply and demand and whether government policies tend to stabilize or destabilize. This chapter covers some issues related to FX volatility.

  Central Banks and Balance of Payments

  In addition to retail and interbank elements, central banks are important FX market participants. A central bank has an unlimited supply of its own economy’s currency. In addition, a central bank maintains balances of foreign currency reserves (or FX reserves) of other currencies, obtained over time through transactions in the interbank market. In their FX reserves, central banks like to hold currencies that hold value. In 2012, the most prominent reserve currencies were (1) the U.S. dollar (62 percent), (2) the euro (25 percent), (3) the British pound (4 percent), and (4) the Japanese yen (4 percent).

  To see an example of routine interaction between central banks and the private FX market, say the Bank of England has sold British pounds to Crown Materials’ U.S. bank for the U.S. dollars sent to Crown by Belmont. The Bank of England can either hold the U.S. dollars as FX reserves, or trade the U.S. dollars back to the Fed for some of the Fed’s existing FX reserves of British pounds (or for gold or other currency). If Belmont had acquired British pounds from its U.S. bank, which in turn had acquired the pounds from the Fed, the Fed would then be holding fewer British pounds in its FX reserves. If the Fed thinks that the new inventory level of British pounds is too low, the Fed can buy more pounds in the interbank market, or from the Bank of England using gold or U.S. dollars or, for that matter, any other country’s currency that the Fed is holding as FX reserves. If either of the central banks is in the transaction, then there is an increase in the British pound money supply

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  International Finance

  Contemporary Issues

  • Maurice D. Levi, Dilip Das(Authors)
  • 2007(Publication Date)
  • Routledge

    (Publisher)

  7 The conclusion, that with both countries having the same inflation the exchange rate does not change, also follows from PPP. However, PPP does not make predictions about the quantity of currency that is exchanged.

  8 Exchange rates do affect the domestic-currency value of a given amount of foreign-currency receipts or foreign-currency payments. However, this is an effect of translating foreign currency into domestic currency, and is different from the effects of exchange rates on merchandise and services which result from changes in amounts bought and sold.

  9 By high or low global interest rates we are referring to rates around the world, not to interest rates in one country versus another. As we explain in the next section, relative interest rates affect exchange rates by affecting the flows of financial capital between countries.

  10 In all future periods when interest or dividends are paid, or profits and rents are repatriated, there is a supply of the country’s currency.

  11 The reason we can have downward-sloping supply curves for currencies and not for other things is that for currencies we plot values (price X quantity) on the horizontal axis, whereas we normally plot just the quantity.

  12 For a further discussion of the time path see Michael H. Moffett, ‘‘The J-Curve Revisited: An Empirical Examination for the United States,’’ Journal of International Money and Finance, September 1989, pp. 425–44, and David K. Backus, Patrick J. Kehoe, and Finn E. Kydland, ‘‘Dynamics of the Trade Balance and the Terms of Trade: The J-Curve?,’’ American Economic Review, March 1994, pp. 84–103.

  13 The question of whether speculators are likely to stabilize or destabilize exchange rates is addressed in Chapter 23.

  14 Stability conditions can be derived without assuming perfectly elastic supply of exports and imports, but only at the expense of considerable additional complexity. See Miltiades Chacholiades, Principles of International Economics, McGraw-Hill, New York, 1981, pp. 386–7, or Joan Robinson, ‘‘The Foreign Exchanges,’’ in Joan Robinson, Essays in the Theory of Employment

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  Staff Studies for the World Economic Outlook

  • International Monetary Fund(Author)
  • 1986(Publication Date)
  • INTERNATIONAL MONETARY FUND

    (Publisher)

  IV Effects of Exchange Rate Changes in Industrial Countries

  James M. Boughton, Richard D. Haas, Paul R. Masson, and Charles Adams *

  Two questions arise when large changes occur in exchange rates among the currencies of the major industrial countries. First, what are the effects of those changes on other important economic variables both domestically and abroad, including current account balances, output, prices, and interest rates? Second, what policy reactions, if any, should they entail? These questions are particularly timely in view of the large swings in exchange rates that have characterized the floating-rate era and especially the past five or six years. The 23 percent decline in the nominal effective exchange rate of the U.S. dollar and the 47 percent appreciation of the Japanese yen against the dollar from March 1985 through April 1986, and the decision by the five largest industrial countries in September 1985 to encourage changes in their exchange rates, have added to the urgency of developing a clear understanding of the processes that are involved and of their impact.

  The scope of this paper is limited in three important ways. First, it deals only with the large industrial countries that have floating exchange rates. To examine the issues that arise for smaller countries with floating rates, as well as for countries with less flexible exchange rate arrangements or fixed rates, would require a different approach from that taken in this paper; available empirical studies pertain almost exclusively to the largest countries. Second, the paper is not concerned with very short-run fluctuations in exchange rates that are reversed within a few months, nor is it concerned with the problems that might arise from any persistent and long-run misalignment of exchange rates. Although the study addresses certain long-run issues at least peripherally, its main emphasis is on the effects that exchange rate movements have over the first few years following a policy change or other disturbance. This limitation is consistent with its empirical and policy-oriented approach. Third, no attempt is made to assess the extent to which exchange rates might in practice have been misaligned. Although it is important to reach a judgment—even if such a judgment must be to some extent subjective—on whether a given currency is undervalued or overvalued in order to determine the appropriate policy responses to currency movements, such judgments are beyond the scope of this paper.

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  Exchange Rate Theory and Practice

  • John F. Bilson, Richard C. Marston, John F. Bilson, Richard C. Marston(Authors)
  • 2007(Publication Date)
  • University of Chicago Press

    (Publisher)

  Nominal apprecia- tion of the exchange rate in the face of external price increases could also be consistent with private market behavior where agents perceive the de- terioration of the terms of trade as a permanent improvement in international competitiveness. More often, however, at least among smaller European countries, increases in foreign prices have been transmitted to domestic prices through substitution and income effects in consumption or production. This process could even be accompanied by exchange rate depreciation if the rise of internal prices exceeds that of traded goods.4 Finally, changes in nominal exchange rates among hard currencies have led to changes in effec- tive exchange rates which have in turn been transmitted to domestic prices and, in the case of countries with market power, to the foreign currency price of export^.^ Thus real exchange rate movements reflect different economic processes which result from the interaction of private market participants and policy authorities. Even in those cases where real exchange rates have remained roughly constant, it is interesting to analyze the economic forces behind the process of real exchange rate determination. Such analysis can highlight the effectiveness of exchange rate policy and can illuminate the fundamental reasons for alternative targets in the exercise of exchange rate policy. Thus in a country where nominal exchange rate devaluation quickly raises domes- tic prices by the full extent of the devaluation, an active exchange rate pol- icy can only become an instrument of anti-inflation policy rather than bal- ance of payments adjustment. Alternatively, if the speed of adjustment is low, nominal exchange rate policy can potentially become a useful instru- ment of external balance.

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  Foreign Exchange

  A Practical Guide to the FX Markets

  • Tim Weithers(Author)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  Banks, whether commercial, investment, central, or supranational, are intimately involved in the markets for foreign exchange. Commercial banks are sometimes asked to assist their local clients with their foreign exchange risk. Investment banks tend to be more active, but this depends on the reason for their FX trading (facilitating client transactions, hedging their business exposures, cross-border issuance, international mergers and acquisitions, and even proprietary trading). Central bank activity ranges from the management of their foreign reserves through active FX market intervention.

  Of course, if exchange rates never moved (i.e., if they were fixed), then much of the trading activity (whether hedging or implementing views on the market) would cease. Having spelled out the economic rationale for many of the trades undertaken by the FX market participants, we now consider the possible implications of fixed exchange rates.

  FIXED VERSUS FLOATING EXCHANGE RATES

  Economists have long debated the advantages, disadvantages, virtues, shortcomings, merits, costs, and benefits of a fixed exchange rate system versus a floating exchange rate system. “Does the choice of exchange rate regime matter? Few questions in international economics have sparked as much debate and yielded as little consensus.”6

  Fixed Exchange Rates

  The attraction of fixed exchange rates is the presumed stability they provide for those engaging in international transactions. If USD|JPY is fixed at 120.00, then a U.S. software firm can enter into trade agreements in which their product will sell for JPY 6,000 in Japan—comfortable that they will receive USD 50 as a result of that sale. Similarly, a Japanese automobile manufacturer might sleep better knowing that their cars, selling in the United States for USD 20,000, will appear on the bottom line as JPY 2,400,000.

  Sounds good.

  The real problem, though, with fixed exchange rates is that someone must keep them fixed. If the institutions charged with maintaining the exchange rate (which, if it indeed requires active support, is obviously not set at the market clearing rate) are either unable or unwilling to maintain the peg, then there are potentially large impacts associated with formal devaluation (reduction in a currency’s value) or revaluation (appreciation of a currency’s value). As with agricultural price supports, the minimum wage and rent control, any interference with market prices creates inefficiencies, distortions, and influences behavior in a way that may not be desirable.

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  Changes in Exchange Rates in Rapidly Developing Countries

  Theory, Practice, and Policy Issues

  • Takatoshi Ito, Anne O. Krueger, Takatoshi Ito, Anne O. Krueger(Authors)
  • 2007(Publication Date)
  • University of Chicago Press

    (Publisher)

  If the home currency accidentally appreciates, in- dependent of the fundamentals, the residents will find that imported goods are now cheaper-and this will exert downward pressure on the domestic price level. Causality is reversed from the previous case: the exchange rate move- ment is causal to the changes in the fundamentals. For instance, empirical stud- ies by Helkie and Hooper (1988) and Ohno (1990) treat the exchange rate as an explanatory variable that determines domestic prices. In addition, practi- cally all contributions to the literature of exchange rate pass-through treat the exchange rate as an exogenous shock. Because the exchange rate is an asset price dominated by expectations, it could also anticipate future changes in the fundamental variables and move first. Then true causality runs from Japanese monetary policy to the yen-dollar rate-although the time sequence is reversed from the traditional Cassel case. In sum, there are three alternative and mutually exclusive interpretations of the fact that the nominal exchange rate and relative national price levels move in the same direction in the long run: Hypothesis 1. The exchange rate is an “adjusting variable” that passively accommodates changes in the fundamentals (prices, monetary policy, etc.). In this case, the flexibility of the exchange rate-despite short-term volatility-contributes to economic adjustment in the medium to long run. Causality runs from the fundamentals to the exchange rate. Hypothesis 2. The exchange rate is a “forward-looking variable” that antici- pates future autonomous changes in the fundamentals. In this case, the true causality is from the fundamentals to the exchange rate, but the move- ment of the exchange rate precedes the fundamentals in the observed time-series sequence. 358 Ronald I. McKinnon, Kenichi Ohno, and Kazuko Shirono Hypothesis 3.

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