MASTER OF INTERNATION AL BUSINESS
SUB-INTERNATIONAL FINANCIAL MANAGEMENT KAVITT ROLL-12
Exchange rate regimes
mibUccms
3/24/2012 klm
kkk
Mechanics of foreign [Link] FOREX market [Link] rates [Link] rate determination Types of exchange rate [Link] regimes [Link] regimes Balance of Payments [Link] a fixed rate regime [Link] a flexible rate regime
Mechanics of Foreign Exchange
People in different countries speak different languages; they also transact business in different currencies ($, , , or ), requiring conversion from one currency to another Foreign exchangeis the currency of another country that is needed to carry out international transactions The market where currencies are exchanged is called the foreign exchange market,or FOREX
The FOREX Market
Not a physical place but a network of telephone/internet connections between all major banks in the world Biggest markets are in New York, London, and Tokyo Volumes traded daily are huge: $1.5 trillionperday(100 times greater than value of trade per day)
Exchange Rates
Price determined in the FOREX market is the exchange rate: the price of one currency measured in terms of another When a currency becomes more valuable relative to another currency it has appreciated$1 buys 120 instead of 110 previously
When a currency becomes less valuable relative to another currency, it has depreciated$1 buys 0 previously
Exchange Rate Determination
What determines the price of foreign exchange? Exchange rates are determined by the equilibrating actions of buyers and sellers of currencies in the FOREX market: demand and supply determine exchange rates .Demand for Swiss francs represents US residents need for francs to buy Swiss goods or financial assets, or when they travel to Switzerland Supply of Swiss francs is a function of Swiss residents need for dollars to consummate transactions with the usa
What causes changes in demand?
Changes in tastes for goods e.g. Americans want more Swiss products Changes in relative national incomes e.g. US economy grows, causing an increase in demand for all goods, including Swiss goods
Changes in relative returns on financial assets e.g. Swiss bonds earn more than US bond
What causes demand changes?
All these forces increase demand for Swiss francs On Panel A of Figure 1, they show up as an upward shift in the demand curve (From D0to D1) If Swiss citizens dont change their preferences for U.S. goods and assets, the value of the Swiss franc will increase (the franc appreciates).
Exchange rate regimes
Nations can choose to let market forces determine exchange rates, as above. This is a floating regime(e.g. U.S.) Or a nation can choose to adopt a fixed regime .Here, the govt sets the price of its currency and maintains that price via policy changes Note: there are many variations of fixed and floating regimes (dirty floats, target zones, crawling pegs, crawling bands, currency boards, currency unions, etc) We focus on fixing and floating
BOP adjustment: floating regimes
Adjustment works via the exchange rate: Swiss franc appreciates , which reduces US demand for Swiss goods and services. Appreciation also increases U.S. exports to [Link] the decline in Swiss exports and the increase in imports from the US reduce BOP surplus Appreciation also makes US financial assets cheaper to Swiss residents, leading to an outflow of capital to the US. These developments eliminate the BOP surplus (the adjustment requires no govt action)
BOP adjustment: floating regimes
Same holds for BOP deficits: Swiss franc depreciates, which increases US demand for Swiss goods and services. Franc depreciation also reduces imports from the US. Both the increase in Swiss exports and the fall in imports help eliminate BOP deficit Depreciation also makes Swiss financial assets cheaper to U.S. residents, leading to an inflow of capital. These processes eliminates the BOP deficit
Fixed Exchange Rates: Benefits and Costs
Benefits Exchange-rate stability promotes globalization more trade and investment. Fixing value of currency to the currency of a low inflation country forces govt to keep prices in line Costs Eliminates domestic policy independence policy cant be used for domestic purposes. Speculative pressures build up and pose a risk of currency crises
Floating Exchange Rates: Benefits and Costs
Benefits Automatic correction of payments imbalances Governments have policy independence -can choose any domestic inflation rate (exchange rate will adjust)
Cost Unstable/uncertain exchange rates reduce globalization Policy independence may be a problem if government cannot control inflation
NEXT PERSON PRESENT YOUR POWER POINT
KAVITT