copyright © 2009 pearson addison-wesley. all rights reserved. chapter 10 understanding foreign...

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter 10

Understanding Foreign Exchange

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-2

Learning Objectives

• Measure and determine foreign exchange rates

• Understand the equilibrium connection between balance of payments and exchange rate movements

• Analyze fixed and floating rate exchange systems and their impact on trade balances and financial crises


Introduction

• The volume of international exchange has grown tremendously since World War II

• Whenever an exchange takes place between residents of different countries, one kind of money has to be exchanged for another

• Foreign exchange rate between two currencies is determined by supply and demand established in the foreign exchange market consisting of a network of foreign exchange dealers (Figure 10.1)


FIGURE 10.1 Supply of and demand for foreign exchange and foreign exchange rates.


What Determines Foreign Exchange Rates

• Imports of a country give rise to a demand for foreign exchange and a supply of U.S. dollars

• Exports result in a supply of foreign exchange and a demand for U.S. dollars

• Therefore, trade of the U.S. will be a primary contributor to the demand and supply of dollars and foreign currency


What Determines Foreign Exchange Rates (Cont.)

• Balance of Payments– A summary of payments to foreigners for imports and receipts

from foreigners for exports• Current Account—international transactions involving trade• Capital Account—international transactions involving financial assets

– Deficit• Paying out more abroad than we are taking in (imports > exports—trade

deficit)• Demand for foreign currency is greater than supply• As a result, the price of foreign currency will rise—the foreign currency

will appreciate relative to the U.S. dollar and the U.S. dollar will depreciate



• Balance of Payments (Cont.)– Surplus

• Receiving more from abroad than we are spending (exports > imports—trade surplus)

• This will result in an appreciation of the U.S. dollar and a depreciation of the foreign currency

– When exchange rates freely react to supply and demand for foreign currency, a new equilibrium exchange rate will tend to eliminate balance of payments and bring trade into balance (exports = imports)



• Balance of Payments (Cont.)– Deficit

• Result in a depreciation of the U.S. dollar

• Encourages exports and discourages imports

• Eventually the trade balance is in equilibrium at the new exchange rate

– Surplus• Appreciation of the U.S. dollar

• Discourages exports and encourages imports

• The trade will be balanced at the new exchange rate



• Why Do Exchange Rates Fluctuate– Figure 10.2 shows that the exchange rate between the U.S.

dollar and other major currencies varies considerably over time

– Figure 10.4 and 10.5 demonstrates that anything that causes the demand or supply in the foreign exchange market to shift will change the equilibrium exchange rate

• U.S. residents buying more or less foreign goods will shift the demand curve for foreign currency

• Changes in foreigner’s purchase of U.S. goods will shift the supply curve of foreign currency


FIGURE 10.2 Recent exchange rate history between the U.S. dollar and other major currencies.


FIGURE 10.2 Recent exchange rate history between the U.S. dollar and other major currencies. (Cont.)


FIGURE 10.3 A rightward shift in the demand curve for pesos raises the dollar price of pesos, implying an appreciation of the peso and a depreciation of the dollar.


FIGURE 10.4 A rightward shift in the supply curve of pesos lowers the dollar price of pesos, implying a depreciation of the peso and an appreciation of the dollar.



• Factors that influence long-run supply and demand conditions– Relative prices of U.S. versus foreign goods

• Relative increase in price of U.S. goods will encourage more imports

– increase demand for foreign currency– tends to depreciate the value of the U.S. dollar or an appreciation

of the foreign currency

• Relative decrease in price of U.S. goods will result in an appreciation of the U.S. dollar



• Factors that influence long-run supply and demand conditions (Cont.)– Productivity

• Increased productivity in U.S. will lower price of American goods• Increased demand for U.S. goods internationally • Increased supply of foreign currency will appreciate the value of the

dollar while foreign currency depreciates

– Tastes for U.S. versus foreign goods• Increased tastes for U.S. goods• Increased demand for U.S. goods and increased supply of foreign

currency• Dollar appreciates relative to foreign currency



• How Global Investors Cause Exchange Rate Volatility – Changes in the factors described above occur slowly

over time, so they cannot explain the often violent short-term movement in exchange rates

– Figure 10.5 shows the considerable day-to-day movement of U.S. dollar exchange rates versus major foreign currencies


FIGURE 10.5 Daily fluctuations in foreign exchange rates can be quite volatile (2008).


FIGURE 10.5 Daily fluctuations in foreign exchange rates can be quite volatile (2008). (Cont.)



• How Global Investors Cause Exchange Rate Volatility (Cont.)– International capital mobility

• Funds flow freely across international borders and investors can purchase U.S. or foreign securities

• U.S. investors compare the expected return on domestic securities versus foreign securities to determine which are the most attractive

• Therefore, changes in preferences of U.S. versus foreign securities will result in a change in demand and supply of foreign currency and a change in the exchange rate



• How Global Investors Cause Exchange Rate Volatility (Cont.)– International capital mobility (Cont.)

• In this case, expectations of future exchange rates play a central role in the decision process

• When considering investing in foreign securities to take advantage of a higher yield, must consider the expected movement of future exchange rates

• In order to invest in foreign securities, must first purchase foreign currency and eventually re-purchase U.S. dollars to bring currency back to U.S.



• How Global Investors Cause Exchange Rate Volatility (Cont.)– International capital mobility (Cont.)

• It is possible that a change in the future exchange rate will offset any increased yield by holding foreign securities

• In fact, the international mobility of capital will often cause the change in future exchange rates that was anticipated—self-fulfilling prophesy



• How Global Investors Cause Exchange Rate Volatility (Cont.)– This suggests that the equilibrium foreign exchange

rate is sensitive to investor expectations of future movement in exchange rates

– Since these expectations might be quite unstable and susceptible to change, this may cause considerable short-term volatility in the actual exchange rates


Fixed Versus Floating Exchange Rates

• Volatility in foreign exchange rates represents a cost of doing business internationally and imposes considerable risk on investments overseas

• Historically governments tried to avoid this cost by fixing exchange rates at some predetermined level


Fixed Versus Floating Exchange Rates (Cont.)

• Fixed exchange rate system– This was the system maintained globally from 1944

until the early 1970s.– It came under the supervision of the International

Monetary Fund (IMF)– After the collapse of the fixed exchange rate system,

it was resurrected with a more limited scope in 1979 for the major European countries



• Fixed exchange rate system (Cont.)– The most recent example of a fixed exchange rate is the

introduction of the Euro as the common currency of the 12 members of the European Monetary Union

• This new monetary union sets the exchange rate between the Euro and the member countries’ national currencies at a fixed rate

• Individual member countries are expected to maintain domestic economic conditions that will not cause these agreed upon exchange rates to change



• How Fixed Rates Are Supposed to Work – The correction process under a floating exchange

rate system• Country runs a balance-of-payments deficit • Supply of its currency offered on world financial markets

exceeds the demand• The currency will be depreciated in value relative to other

markets• This adjustment brings the international payments into

equilibrium



• How Fixed Rates Are Supposed to Work (Cont.)– However, under a fixed exchange rate system these

fluctuations are prevented from occurring through government intervention

– Figure 10.6(a) (Floating Rate System)• The supply curve of British Pounds shifts to the right because

British tastes have shifted toward increased purchases of American goods

• This increased supply of pound would put downward pressure on the value of the Pound

• Under a floating rate system the new lower equilibrium point would be reached where quantity supplied of pounds equals the quantity demanded of pounds



• How Fixed Rates Are Supposed to Work (Cont.)– Figure 10.6(b) (Fixed Rate System)

• Under this system, the British government would intervene in the foreign exchange market and purchase the excess pounds available at the predetermined fixed (pegged) rate

• Britain’s international reserves are used to purchase the excess pounds which prevents the exchange rate from falling below the pegged rate

• Traditionally these international reserves consist of gold, U.S. dollars, other major currencies, and now the Euro


FIGURE 10.6 In (a), with floating rates, the pound depreciates; in (b), with pegged rates, the British central bank prevents the decline by buying up the excess supply of pounds.


FIGURE 10.6 In (a), with floating rates, the pound depreciates; in (b), with pegged rates, the British central bank prevents the decline by buying up the excess supply of pounds. (Cont.)


International Financial Crises

• Major problem with a fixed rate system is that it contains no self-correcting exchange rate mechanism to eliminate a country’s persistent balance-of-payment deficit

• A continual balance-of-payment deficit suggests domestic economic structural problems relative to the rest of the world

• Eventually the country will run out of international reserves and be forced to devalue which will eliminate the deficit


International Financial Crises (Cont.)

• The expectation of a devaluation will cause the international financial community to take actions that will increase the likelihood of the anticipated devaluation– Individuals will sell the threatened currency in the

international market– This increases the supply of the currency which increases the

downward pressure on the value– This capital flight will further deplete the country’s

international reserve and speed up the devaluation


International Financial Crises (Cont.)

• Currently industrialized countries practice a managed float system– The exchange rate is permitted to vary within a

predetermined band– If foreign exchange markets attempt to push the value of the

currency outside the band (both above or below), central bank will intervene

– However, if the central bank is intervening an excessive amount, it is likely that country will be forced to devalue or revalue its currency to recognize structural changes in local economy

copyright © 2009 pearson addison-wesley. all rights reserved. chapter 10 understanding foreign...

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