the notion and types of exchange rate
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Exchange rates and exchange
rate regimes
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Lecture outline
The notion of the exchange rate
Types of exchange rate regimes
Types of exchange rate
The equilibrium on the currency market
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Exchange rate
The price of one currency expressed in another
currency
Direct quotation the price of the foreigncurrency expressed in domestic currency
Indirect quotation the price of the domestic
currency expressed in foreign currency
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Free floating
A currencys ER may fluctuate free versus other currencies ER
A currencys exchange rate is determined by the demand and
supply
Managed floating- central bank interventions
Examples
the majority of key currencies: EUR, USD, GBP, JPY, CHF
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Crawling band
The ER fluctuates within a band around a central
parity, the band is adjusted periodically at a
preset rate
Examples
CLP (Chile), COP (Columbia) , VEB (Venezuela)
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Fixed band system
The ER may fluctuate within a fixed band around
the central parity
Example:
ERM/ERM II- a system aimed at stabilizing the
ER of euro area candidate countries
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Crawling peg
The ER is fixed at a central parity, the parity is
periodically adjusted at a preset rate
Example:
RMB (China)
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Fixed ER (hard peg)
The ER is pegged to another currency, to a
basket of currencies or to another value e.g.
gold
Example:
RMB (China) till 2005 currency pegged to
USD
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Currency board system
The ER is pegged to a foreign currency at a set and
fixed exchange rate
The domestic monetary base issuance is 100% backed
by reserves of the foreign anchor currency
Examples: LTL (Lithuania), EEK (Estonia) pegged to
EUR
HKD (Hong Kong), BMD (Bermuda) pegged to USD
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Monetary union
Two or more states using the same currency
Unilateral and multilateral monetary union
Unilateral - euroisation, dollarisation
Multilateral- EMU
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De iure and de facto classification
Free floating- mostly developed economies
Peg to the EUR- 40 countries
Peg to the USD- 70 countries
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Advantages and disatvantages of
floating Adjustment of the balance of payments +
Adjustment after shocks +
Volatility concerning foreign trade and
investment
The fear of floating
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Advantages and disatvantages of
pegs Stability concerning foreign trade and
investment +
Possibility to import monetary stability +
Higher risk of speculative attacks
Constraint for the domestic economic policy-
The need of large reserves
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Impossible trinity
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No single currency regimeisright forall countries oratall
times.
J.A. Frankel
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Exchange rate regime choices
Estonia
Argentina
China
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Estonia
Currency board
1992-1999 ER pegged to DEM, since 1999 to
EUR
Reasons for CB introduction in Estonia
Inflation up to 300% in the early 90-ties
Small open economy- outward oriented economic policy
Goal the join the EU (later the euro area)
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Estonia- CPI
8
8(
)
Source: Estonian Central Bank
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Argentina
Currency board
ER pegged to USD 1991- 2002
Reasons for introduction:
Hyperinflation till 1990
Large macroeconomic imbalances
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Argentina
CPI
200
0
200
400
600
00
1000
1200
1400
1600
1990 1991 1992 1993 1994 1995 1996 1997 199
1999 2000 2001 2002
Results:
Monetary stabilityachieved
External shocks-
liquidity crunch-late 90-ties
Overvalued pesodue to wrong peg
Floating since2002-extreme
depreciation of thepeso
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China
Fixed ER
1997-2005 peg against the USD
Export oriented strategy
2005- switching from the USD peg to a basket
crawling peg
Reasons for switching
RMB undervalued
Large global imbalances
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Curre
acc
unt ba ance
50
0
50
100
150
200
250
300
350
400
450
190
192
194
196
19 1990
1992
1994
1996
199
2000
2002
2004
2006
200
b
on
Revaluation of the
RMB
Gradual movement
towards moreflexible ER
Lifting capital
controls
Source: IMF
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Types of exchange rate
Nominal and real ER
Nominal ER- the price of a currency expressed
in a foreign currency
Real ER - the price of commodities of one
country expressed in prices of foreign
commodities -ratio of the domestic price leveland the foreign price level
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Types of ER
Billateral and effective
Billateral- the price of a currency
expressed in a foreign currency
Effective- ER weighted with the shares of
trade partners in the whole foreign trade
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Equlibrium on the currency market
The state of equilibrium is reached when the
supply of a foreign currency equals the demand
for this currency Appreciation / Depreciation
Revaluation / Devaluation
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Depreciation and appreciation
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Demand and supply on the FX
market
Companies involved in foreign trade
Foreign investors
Central banks
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A French investor buys Japanese
stock
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An American company buys
products from the EU
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Factors determining the exchange
rate in the short term
Fundamental economic values
Trends
Events
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Fundamental economic values
GDP growth rate
Interest rates
Prices
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Growth rate
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Interest rate
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The interest rate parity theory
The FX market reaches equilibrium if the
deposits in all currencies command the
same expected rate of return
iUSD=iEUR+ (EReEUR-E
eUSD)/EUSD/EUR
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The interest rate parity theory
Example:
iUSD=10%, iEUR= 6%
Expected % USD depreciation p.a. the
expected rate of return in EUR is 4%
higher than in USD higher demand for
EUR unequlibrium ER changes
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The interest rate parity theory
If iUSD > iEUR USD appreciates
If iUSD < iEUR USD depreciates
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Prices
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Trends
Inflationary path
Fiscal developments
Expectations
Example:
PLN - introduction of direct inflationtargeting appreciation of PLN
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Events
Sudden decisions concerning economic policy
Market psychology Example:
Hungarian ER regime switch depreciation of
HUF + market psychology depreciation of allcurrencies in the region
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Summing up
ER regime choice depends on the
features of the economy
No ER regime is right for all countries or
at all times
Impossible trinity
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Summing up
Equlibrium in the short term depends on
market participants actions
Fundamental values
Trends
Events
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References
P. Krugman, M.Obstfeld, International economics: theory
and policy. Part II, Pearson, Addison Wesley, Boston
2009
A. Budnikowski, Midzynarodowe stosunki gospodarcze,
PWE, Warszawa 2004
J. Frankel, No single currency regime is right for all
countries or at all times, Essays in International Finance,1999.
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