international economics 5th by gerber ch10 (2)

Chapter 10 Exchange Rates and Exchange Rate Systems Copyright © 2011 Pearson Addison-Wesley All rights reserved Introduction: Fixed, Flexible, or In-Between? • Disagreements related to exchange rates and exchange rate systems • Countries have numerous choices • Exchange rate systems require different policies and respond differently to the pressures of the world economy Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-2 Exchange Rates and Currency Trading • Exchange rate: The price of domestic currency stated in terms of another currency • For US it is dollars per pound, or dollars per yen Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-3 Exchange Rates and Currency Trading • Frequently traded currencies are: - European Union’s euro - Japanese yen - British pound • All three are flexible exchange rates • It doesn’t matter how many of one currency is required to buy another • Can’t use “strong” and “weak” Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-4 Figure 10.1 Dollar Exchange Rates for Commonly Traded Currencies, 1999–2008 Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-5 Exchange Rates and Currency Trading • Appreciation: Less domestic currency is required to buy unit of foreign currency • Depreciation: More domestic currency is required to buy unit of foreign currency Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-6 Reasons for Holding Foreign Currencies Trade and investment Interest rate arbitrage • Borrow money where interest rates are low and sell it where interest rates are high • Capital inflow in high interest countries decreases interest rates • Outflow of capital from low interest rate countries increases interest rates Powerful force in global economy Copyright â 2011 Pearson Addison-Wesley All rights reserved 10-7 Reasons for Holding Foreign Currencies Speculation • speculators sell overvalued currencies and buy undervalued currencies • Help restore equilibrium after currency has become under- or overvalued • Some argue it can be destabilizing by leading to under- or overvalued currency Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-8 Institutions • Four main groups involved in foreign currency markets: – Retail customers: firms and individuals that hold foreign currency – Commercial banks: hold inventories of foreign currencies as part the services to customer; most important of four participants – Foreign exchange brokers: middlemen between buyers (banks) and sellers of foreign currency – Central banks: a country’s bank of banks Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-9 Exchange Rate Risk • Exchange rate risks: currencies are constantly changing in value – Actual payment in a foreign currency will likely be a different domestic currency amount from when the contract was signed – Created mechanisms to deal with problem Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-10 Exchange Rate Risk • Hedging: Use forward market to protect themselves against foreign exchange risk while holding foreign assets – Done by buying forward contract to sell foreign currency at the same time the interest earning asset matures – Covered interest arbitrage: Use of forward market by an interest rate arbitrageur against exchange rate risk Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-12 The Supply and Demand for Foreign Exchange • Currency’s value is determined by its supply and demand – Under a flexible exchange rate system currency appreciates/depreciates based on changes in supply/demand – Under a fixed exchange rate system, the central bank counteracts changes in the market to hold currency’s value constant • Biggest disadvantage: trade-off between supporting the exchange rate and maintaining economic growth Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-13 TABLE 10.1 A Hypothetical Example of the Exchange Rate in the Long Run • Purchasing power parity (PPP): the equilibrium value of an exchange rate is at the level that allows a given amount of money to buy the same quantity of goods abroad as it will buy at home Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-14 Exchange Rates in the Long Run • PPP is underlying tendency of exchange rates in long run, not short or medium run • If currency is over- or undervalued, automatic changes in buying/selling currency and flow of goods will restore PPP • Usually equalization is through exchange rates, not prices • PPP is based on goods arbitrage which fails to acknowledge other costs Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-15 Exchange Rates in the Medium Run and Short Run • Medium run forces: – The country’s economic growth: increases incomes, increases demand for imports and an outward shift in the demand for foreign currency, domestic currency depreciates – Growth abroad: results in an increase of exports from the home country and an increase in the supply of foreign currency, domestic currency appreciates Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-16 Exchange Rates in the Medium Run and Short Run • Short run (a year or less) effects on the exchange rate stem from financial capital flows • These flows are determined by (1) interest rates and (2) expectations of future exchange rates Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-17 Exchange Rates in the Medium Run and Short Run • Interest parity: the difference between any two countries’ interest rates is equal to the expected change in the exchange rate – If i = i*, investors are indifferent – If i > i*, investors prefer home to foreign investment • Best choice is also determined by exchange rate movements during the period Copyright © 2011 Pearson Addison-Wesley All rights reserved 10-18 Exchange Rates in the Medium Run and Short Run • Difference between the forward exchange rate (F) and the spot rate (R) is expected appreciation or depreciation – F > R: home currency expected to depreciate and is selling at a discount – F