INTRODUCTION
CONTENTS
1.1 What is an exchange rate?
1.2 The market for foreign currency
1.3 The balance of payments
1.4 The DIY model
1.5 Exchange rates since World War II: a brief history
1.1. EXCHANGE RATE
❖ Exchange rate: price of one currency in terms of
another
❖ Foreign exchange market: the financial market
where exchange rates are determined
❖ Appreciation: a currency rises in value relative to
another currency
❖ Depreciation: a currency falls in value relative to
another currency
1.1. EXCHANGE RATE
1.1.1. Bilateral versus trade-weighted exchange rates
❖ The nominal exchange rate is the rate at which one
country’s currency can be exchanged for another
country’s currency.
❖ The real exchange rate is the rate at which domestic
goods can be exchanged for foreign goods.
▪the price of domestic goods relative to the price of
foreign goods denominated in the domestic currency.
The Real Exchange Rate
❖ There is a simple relationship between the real exchange rate
and the nominal exchange rate.
❖ For an espresso in the U.K. (home country) and in U.S.
(foreign country), the real exchange rate:
Real coffee exchange rate
𝐷𝑜𝑙𝑙𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑠𝑝𝑟𝑒𝑠𝑠𝑜 𝑖𝑛 𝑈𝑆 $3.60 × 𝑃𝑜𝑢𝑛𝑑𝑠 𝑝𝑒𝑟 𝑑𝑜𝑙𝑙𝑎𝑟
=
𝑃𝑜𝑢𝑛𝑑𝑟 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑠𝑝𝑟𝑒𝑠𝑠𝑜 𝑖𝑛 𝑈𝐾 (£1.20)
𝐷𝑜𝑙𝑙𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑠𝑝𝑟𝑒𝑠𝑠𝑜 𝑖𝑛 𝑈𝑆 ($3.60)×(£0.50 / $)
=
𝑃𝑜𝑢𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑠𝑝𝑟𝑒𝑠𝑠𝑜 𝑖𝑛 𝑈𝐾 (£1.20)
£1.80
=
£1.20
= 1.5
The Real Exchange Rate
❖This tells us that one cup of Starbucks espresso buys
1.5 cups of British espresso.
❖The real exchange rate has no units of measurement.
Real exchange rate
𝐻𝑜𝑚𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑔𝑜𝑜𝑑𝑠
=
𝐻𝑜𝑚𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑔𝑜𝑜𝑑𝑠
❖Whenever the ratio in this equation is more than
one, domestic products will seem cheap.
The Real Exchange Rate
❖The competitiveness of U.K. exports depends on the
real exchange rate.
❖Appreciation of the real exchange rate makes U.K.
exports seem cheaper to foreigners, improving their
competitiveness.
❖Depreciation of the real exchange rate makes U.K.
exports more expensive to foreigners, reducing their
competitiveness.
1.1.1. Bilateral versus trade-weighted exchange rates
❖ Bilateral Real Exchange Rate (BRER) is the nominal
bilateral exchange rate adjusted for the inflation
differential between the two countries. It is an index that
shows the purchasing power of a domestic currency
compared to a foreign currency.
❖ Multilateral Real Exchange Rate (MRER) depends on the
bilateral real exchange rates of the foreign currencies in
the basket and trade weights.
▪ The effective or trade-weighted exchange rate of currency A is a
weighted average of its exchange rate against currencies B, C, D, E,…
The weights used are usually the proportion of country A’s trade that
involves B, C, D, E,…, respectively.
1.1.2. Spot versus forward rates
❖A cross-exchange rate is the exchange rate between
two currencies that are both valued against a third
currency, mainly the U.S. dollar.
❖Spot rates are the rates for an immediate exchange
(subject to a two-day settlement period).
❖Forward rates are the rates at which foreign
currency dealers are willing to commit to buying or
selling a currency in the future.
1.1.3. Buying versus selling rates
❖The bid rate for currency A in terms of currency B is
the rate at which dealers buy currency A (sell
currency B).
❖The offer (or ask) rate is the rate at which dealers sell
currency A (buy currency B).
❖The (bid/ask) spread is the gap between the offer
and bid rates.
1.2. THE MARKET FOR FOREIGN CURRENCY
❖To explain short-run exchange rates, we turn to an
analysis of supply and demand for currencies.
❖Three agents supply or demand foreign currency:
▪ Exporters & importers
▪ Foreign investors & domestic investors
▪ Speculators
1.2. THE MARKET FOR FOREIGN CURRENCY
1.2. THE MARKET FOR FOREIGN CURRENCY
1.2.1. Floating rates (purely or freely floating, or completely
flexible exchange rate)
▪ The exchange rate is determined exclusively by the
underlying balance of supply and demand for the
currencies involved, with no outside intervention.
1.2. FOREIGN EXCHANGE MARKET
1.2. THE MARKET FOR FOREIGN CURRENCY
1.2.1. Floating rates (purely or freely floating, or completely
flexible exchange rate)
▪ The exchange rate is determined exclusively by the
underlying balance of supply and demand for the
currencies involved, with no outside intervention.
1.2.2. Fixed rates
▪ Exchange rates are either held constant or allowed to
fluctuate only within very narrow boundaries.
▪ These currencies are said to be non-convertible or fully
non-convertible.
1.2.3. Managed floating
▪ Governments sometimes intervene to prevent their
currencies from moving too far in a certain direction.
1.2. FOREIGN EXCHANGE MARKET
❖Exchange rate regimes could be classified by their
implications for the foreign currency reserves:
▪ Pure float: reserves are constant, and the
monetary authority does not need to hold any
reserves at all.
▪ Managed float: reserves fluctuate on a day-to-
day, month-to-month basis, but around a broadly
constant level.
▪ Fixed rate: reserves must carry the full burden of
adjustment to disequilibrium in the currency
markets and can be expected to be more volatile.
1.3. BALANCE OF PAYMENTS
Balance of Payments
Definition:
Summary of transactions between domestic and
foreign residents for a specific country over a
specified period of time.
➔ The balance of payments (BOP) is a statement of
all transactions made between entities in one
country and the rest of the world over a defined
period of time, such as a quarter or a year.
Balance of Payments
❑ Components of the Balance of Payments
Statement:
❖Current Account
❖Capital Account
❖Financial Account
❖Errors and omissions
❖Reserves
Balance of Payments
❑ Components of the Balance of Payments
Statement:
❖Current Account (CA): summary of flow of funds due
to purchases of goods or services or the provision of
income on financial assets.
❖Capital Account (KA): summary of flow of funds
resulting from the sale of assets between one
specified country and all other countries over a
specified period of time.
❖Financial Account (FA): refers to special types of
investment, including DFI and portfolio investment.
Balance of Payments
Errors and omissions and Reserves
❖ Errors and omissions
Measurement errors can occur when attempting to
measure the value of funds transferred into or out of a
country.
reflect the imbalances resulting from imperfections in
source data and compilation of the balance of
payments accounts.
Balance of Payments
Errors and omissions and Reserves
❖ Reserves /International reserves /Foreign
exchange reserves
Reserve assets, which a central bank holds in foreign
currencies: foreign banknotes, bank deposits, bonds,
treasury bills, and other government securities; gold
reserves or Special drawing rights (SDRs).
1.3.1. CURRENT ACCOUNT
❖The current account is simply a record of trade
transactions between people in one country and the
rest of the world.
❖CA covers transactions that create no future claim in
either direction, involving simply an exchange here
and now.
❖Subsets of CA:
▪ Goods balance
▪ Services balance
▪ Primary Income (Factor income)
▪ Secondary income (Transfer payments)
FACTORS AFFECTING CURRENT ACCOUNTS
1. Inflation: Current account decreases if inflation
increases relative to trade partners.
2. National income: Current account decreases if
national income increases relative to other
countries.
3. Exchange rate: Current account decreases if the
home currency appreciates relative to other
currencies.
4. Government policies
J-Curve Effect
J-curve
The J-curve effect describes that after a home currency
depreciation (or devaluation), the trade balance will initially
deteriorate (or worsen) before beginning to improve as normally
expected.
1.3.2. Capital & financial account
Capital Account
❖ Originally included the financial account.
❖ Includes the value of financial assets transferred
across country borders by people who move to a
different country.
❖ Includes natural resources; contracts, leases, and
licenses; marketing assets such as patents and
trademarks, logos; or a liability is forgiven by the
creditor (write off debts).
❖ Relatively minor (in terms of dollar amounts) to the
financial account.
1.3.2. Capital & financial account
Financial Account
❖ Direct foreign investment
▪ Investments in fixed assets in foreign countries.
• According to the IMF and OECD definitions, direct investment
reflects the aim of obtaining a lasting interest by a resident
entity of one economy (direct investor) in an enterprise that
is resident in another economy (the direct investment
enterprise).
1.3.2. Capital & financial account
Financial Account
❖ Direct foreign investment
▪ Investments in fixed assets in foreign countries.
❖ Portfolio investment
▪ Transactions involving long-term financial assets
(such as stocks and bonds) between countries that do
not affect the transfer of control.
❖ Other capital investment
▪ Transactions involving short-term financial assets
(such as money market securities) between
countries.
FACTORS AFFECTING FINANCIAL ACCOUNTS
1. Changes in restrictions
2. Potential economic growth
3. Exchange rates
4. Interest rates
1.4. DIY MODEL
❖ The DIY (do - it - yourself) model of exchange rates includes
the following propositions:
▪ The higher the level of economic activity and/or the more
rapid its growth rate, the lower the value of the domestic
currency and/or the greater the current account deficit
(Chapter 5 and 6).
▪ Devaluation improves the competitiveness of the
devaluing country’s output, thereby increasing its current
account surplus or reducing its deficit (Chapter 5).
▪ The higher interest rates in any country relative to the
ROW, the greater the value of its currency (Chapter 3).
1.5. EXCHANGE RATE SINCE 1945
❖ Bretton Woods 1944–68 US$ fixed at 1 oz gold = $35, all other
currencies fixed to $ with 1% fluctuation bands, devaluations
to correct persistent deficits.
❖ Breakdown 1968–73 as US printed excess $ causing worldwide
inflation and flight into gold, other currencies (DM, Yen).
❖ Floating Era 1973 onward managed floats for most convertible
currencies at first, but later experiments with limited fixed
systems, e.g. ERM in Europe, currency boards in Hong Kong,
Argentina.
❖ EMU 1998 onward response to failure of fixed exchange rates.
❖ Increasing importance of Asian exchange rates 2000 onward,
especially RMB, Won, Rupee (varying degrees of
flexibility/convertibility, increasingly linked to $/€/Yen currency
basket).
1.5. EXCHANGE RATE SINCE 1945
❖ China as world’s 2nd-largest economy – RMB as a
reserve currency?
❖ 2007 credit crunch September 2008 Lehman
bankruptcy and global banking crisis prompting rush out
of risky currencies (especially GBP) into safe havens
(Yen, SwFr, NorKr) and worldwide recession. Banking
problems Government insolvency in Iceland, Ireland.
❖ 2010 Greece slides into bankruptcy, triggering
sovereign debt crisis in Eurozone.
❖ Emergence of cybercurrencies (Bitcoin, etc.) – the shape
of things to come?