The Exchange Rate Ratna K. Shrestha

1. 26 CHAPTER The Exchange Rate Ratna K. Shrestha

2. Many Monies! • The world’s four big monies are the U.S dollar, the Japanese yen, the U.K. pound and the European euro. • How much these currencies (and many other currencies) can one CAD $ buy? • Why do currency exchange rates fluctuate? • Why does the Canadian dollar fluctuate against the U.S. dollar? • Why isn’t there just one dollar?

3. Currencies and Exchange Rates • To buy goods and services produced in another country we need currency of that country. • Foreign bank notes, coins, and bank deposits are called foreign currency. • Figure 26.1 shows the currencies that Canada uses in its international trade.

4. Currencies and Exchange Rates • A fall in the value of one currency in terms of another currency is called currency depreciation and the rise is called currency appreciation. • Sometimes the central bank of a country can peg the value of its currency relative to another foreign currency. • The Bank of Canada pegged the value of the exchange rate during most of the 1960s. Similarly China had a fixed exchange rate policy until very recently.

5. Currencies and Exchange Rates Figure 26.2 shows the average annual Canadian dollar interms of the U.S. dollar from 1951 to 2005.

6. Currencies and Exchange Rates • The Foreign Exchange Market • Foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. • Foreign Exchange Rates • The price at which one currency exchanges for another is called a foreign exchange rate. • Exchange rate = Number of foreign currency one CAD $ can buy.

7. Currencies and Exchange Rates (Jan 30, 2009) • We can express the value of the Canadian dollar in terms of any other currency, called cross exchange rate.

8. Currencies and Exchange Rates • Figure 26.4 shows how the Canadian dollar has fluctuated against other currencies.

9. The Foreign Exchange Market • The Demand for One Money Is the Supply of Another Money • When people who are holding one money want to exchange it for Canadian dollars, they demand Canadian dollars and they supply the other country’s money. • So the factors that influence the demand for Canadian dollars also influence the supply of U.S. dollars, E.U. euros, U.K. pounds, and Japanese yen. • And the factors that influence the demand for another country’s money also influence the supply of Canadian dollars.

10. The Foreign Exchange Market • Demand in the Foreign Exchange Market • The quantity of Canadian dollars that traders plan to buy in the foreign exchange market during a given period depends on • The exchange rate • World demand for Canadian exports • Interest rates in Canada and other countries • The expected future exchange rate

11. The Foreign Exchange Market • 1. Exchange Rate and The Law of Demand: • The demand for dollars is a derived demand. • People buy Canadian dollars so that they can buy Canadian-made goods and services or Canadian assets. • Other things remaining the same, the higher the exchange rate, the smaller is the quantity of Canadian dollars demanded in the foreign exchange market.

12. The Foreign Exchange Market • There are two sources of the derived demand for Canadian dollars: • Exports effect • Expected profit effect • Exports Effect • The larger the value of Canadian exports, the greater is the quantity of Canadian dollars demanded on the foreign exchange market. • And the lower the exchange rate, the greater is the value of Canadian exports, so the greater is the quantity of Canadian dollars demanded.

13. The Foreign Exchange Market • Expected Profit Effect • The lower the today’s exchange rate, other things remaining the same, the larger is the expected profit from buying Canadian dollars and the greater is the quantity of Canadian dollars demanded today. • Suppose people expect that CAD $ will be worth US $1.00 by the end of the month, then people expect to make profits by holding CAD$ (which is worth US 80c today), which means the demand for CAD $ will be higher.

14. The Foreign Exchange Market • The Demand Curve for Canadian Dollars • Figure 26.5 illustrates the demand curve for Canadian dollars on the foreign exchange market.

15. The Foreign Exchange Market • Supply in the Foreign Exchange Market • The quantity of Canadian dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate. • This quantity depends on many factors such as: • The exchange rate • Canadian demand for imports • Interest rates in Canada and other countries • The expected future exchange rate

16. The Foreign Exchange Market • 1. The Exchange Rate: • Imports Effect • The higher the exchange rate, the greater is the value of Canadian imports, so the greater is the quantity of Canadian dollars supplied. • Expected Profit Effect • For a given expected future Canadian dollar exchange rate, the lower the exchange rate, the greater is the expected profit from holding Canadian dollars, and the smaller is the quantity of Canadian dollars supplied on the foreign exchange market.

17. The Foreign Exchange Market • Supply Curve for Canadian Dollars • Figure 26.6 illustrates the supply curve of Canadian dollars in the foreign exchange market.

18. The Foreign Exchange Market • Market Equilibrium • Figure 26.7 shows how demand and supply in the foreign exchange market determine the exchange rate.

19. The Foreign Exchange Market • If the exchange rate is too high, a surplus of dollars drives it down. • If the exchange rate is too low, a shortage of dollars drives it up. • The market is pulled (quickly) to the equilibrium exchange rate at which there is neither a shortage nor a surplus.

20. Exchange Rate Fluctuations • Changes (shift) in the Demand for Dollars • A change in any influence on the quantity of dollars that people plan to buy, other than the exchange rate, brings a change in the demand for dollars and a shift in the demand curve for dollars. • These other influences are • World demand for Canadian exports • Interest rates in Canada and in other countries • The expected future exchange rate

21. Exchange Rate Fluctuations • World Demand for Canadian Exports • At a given exchange rate, if world demand for Canadian exports increases, the demand for Canadian dollars increases and the demand curve for Canadian dollars shifts rightward. • Interest rates in Canada and in other countries • The Canadian interest rate minus the foreign interest rate is called the Canadian interest rate differential. • If the Canadian interest differential rises, the demand for Canadian dollars increases (due to higher demand for Canadian assets) and the demand curve for Canadian dollars shifts rightward.

22. Exchange Rate Fluctuations • The expected future exchange rate • At a given exchange rate, if the expected future exchange rate for CAD dollars rises, the demand curve for CAD dollars shifts rightward. • Suppose exchange rate is US 80c. If it is expected to be US 90c next month, the demand for CAD $ at the current exchange rate of US 80c will rise.

23. The Foreign Exchange Market • Figure 26.8 shows how the demand curve for Canadian dollars shifts in response to changes in Canadian exports, the Canadian interest rate differential, and expectations of future exchange rates.

24. Exchange Rate Fluctuations • Changes in the Supply of Dollars • A change in any influence on the quantity of Canadian dollars that people plan to sell, other than the exchange rate, brings a change in the supply of dollars and a shift in the supply curve of dollars. • These other influences are • Canadian demand for imports • Interest rates in Canada and in other countries • The expected future exchange rate

25. Exchange Rate Fluctuations • Canadian Demand for Imports • At a given exchange rate, if Canadian demand for imports increases, the supply of Canadian dollars on the foreign exchange market increases and the supply curve of Canadian dollars shifts rightward. • Interest rates in Canada and in other countries • If the Canadian interest differential rises, the supply for Canadian dollars decreases and the supply curve of Canadian dollars shifts leftward.

26. Exchange Rate Fluctuations • The expected future exchange rate • At a given exchange rate, if the expected future exchange rate for Canadian dollars rises, the supply of Canadian dollars decreases and the demand curve for dollars shifts leftward. • Notice that in the case when supply shifts to the left, the effect on the demand side will be just the opposite; the demand for CAD $ will be higher.

27. Exchange Rate Fluctuations • Figure 26.9 shows how the supply curve of Canadian dollars shifts in response to changes in Canadian demand for imports, the Canadian interest rate differential, and expectations of future exchange rates.

28. Exchange Rate Fluctuations • A Depreciating Dollar: 19912002 • During the 1990s, the North American Free Trade Agreement (NAFTA) came into effect and the volume of trade between Canada and the United States increased. • The supply of Canadian dollars increased. • The demand for Canadian dollars would have increased but traders expected the Canadian dollar to depreciate, which offset the factors leading to an increase in demand. • Between 1991 and 2002, the Canadian dollar fell from 87 U.S. cents to 64 U.S. cents.

29. Exchange Rate Fluctuations • Figure 26.10(a) illustrates the depreciation of the Canadian dollar. • The increase in supply with no change in demand lowered the exchange rate and increased the quantity of dollars traded.

30. Exchange Rate Fluctuations • An Appreciating Dollar: 20022005 • During 2004 and 2005, the world demand for resources increased, driven mainly by rapid economic growth in China and India. The large increase in the world demand for Canadian exports increased the demand for the Canadian dollar. • The increase in demand and decrease in supply raised the exchange rate from 64 U.S. cents to 81 U.S. cents in 2005 and most recently (in 2008) to US $1.10.

31. Exchange Rate Fluctuations • The increase in the demand for CAD$ and the decrease in the supply of CAD$ raised the CAD exchange rate. • Changes in D and S at the same time and in opposite directions bring a large change in the exchange rate-a reason behind the volatility of exchange rates.

32. Exchange Rate Fluctuations • Exchange Rate Expectations • The exchange rate changes when it is expected to change. But expectations about the exchange rate are driven by deeper forces. Two such forces are • Purchasing power parity • Interest rate parity

33. Exchange Rate Fluctuations • Purchasing Power Parity • When two quantities of money can buy the same quantity of goods and services, the situation is called purchasing power parity (PPP), which means equal value of money. • For example, if one CAD dollar exchanges for 90 U.S. cents, then PPP is attained when one CAD dollar buys the same quantity of goods and services in Canada as 90 cents buys in the United States. • If PPP does not hold, then one can earn profits by purchasing low in one market and selling high in another—called arbitrage.

34. Exchange Rate Fluctuations • If one Canadian dollar buys more goods and services in Canada than 90 U.S. cents buys in the United States, people will expect that the Canadian dollar will eventually appreciate. • If one Canadian dollar buys less goods and services in the Canada than 90 U.S. cents buys in the United States, people will expect that the Canadian dollar will eventually depreciate.

35. Exchange Rate Fluctuations • The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries. • Suppose, • P = price of a basket of goods in Canada in CAD $. • P* = price of the same basket in Japan in Yen. • e = (Nominal) exchange rate (# of Yen 1 CAD$ buys). • The purchasing power in Canada of $1 = 1/P. • $1 can also buy e Yen, so the purchasing power of $1 in Japan = e/P*. • According to PPP theory, 1/P = e/P* • That is: e = P*/P

36. Limitations of The Purchasing-Power Parity • Two things may keep (nominal) exchange rates from exactly equalizing purchasing power: • 1. Many goods are not easily traded or shipped from one country to another. • Traded goods are not always perfect substitutes. • PPP tends to hold in the long run; but in the short run large variations can occur due to the above reasons.

37. Purchasing Power Parity

38. Exchange Rate Fluctuations • Interest rate parity • The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. When the returns on two currencies are equal, interest rate parity prevails. • Interest rate parity means equal interest rates when exchange rate changes are taken into account. • Market forces achieve interest rate parity very quickly. This is especially true in the case of Canada—a country with a small open economy.

39. Exchange Rate Fluctuations • Canada is a “small” part of the world economy. At the same time there is a “perfect capital mobility” between Canada and the rest of the world. • The Implication of perfect capital mobility is that the real interest rate in Canada should equal the interest rate prevailing in world financial markets. • Limitations: • The risk of default can vary across countries. • Tax treatment of interest income are different across countries. • The financial assets may not be perfect substitutes.

40. Limitation of Interest Rate Parity • The above three reasons can make the real interest rates across countries different. • For example, from 1986-2000 the US average real interest rate was 4.2% whereas that of CAD was 4.7%. The 0.5 % point different was due to a higher default risk and higher tax rates in Canada.

41. Exchange Rate Policy • Four distinct exchange rate policies are • Flexible exchange rate • Fixed exchange rate • Crawling peg • Currency union • Flexible Exchange Rate • A flexible exchange ratepolicy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank. • The Bank of Canada operates a flexible exchange rate.

42. Exchange Rate Policy • Fixed Exchange Rate • A fixed exchange ratepolicy is one that pegs the exchange rate at a value decided by the government or central bank and that blocks the unregulated forces of demand and supply by direct intervention in the foreign exchange market. • The Bank of Canada operated a fixed exchange rate during the 1960s when the dollar was pegged at 92.5 U.S. cents.

43. Exchange Rate Policy • Figure 26.11 shows how the Bank of Canada can directly intervene in the foreign exchange market to keep the exchange rate close to a target rate (90 U.S. cents per dollar in this example). • If demand increases, the Bank sells dollars in the foreign exchange market to increase its supply.

44. Exchange Rate Policy • If demand decreases, the Bank buys dollars to decrease supply. • Persistent intervention on one side of the foreign exchange market cannot be sustained.

45. Exchange Rate Policy • Crawling Peg • A crawling pegexchange rate policy is one that selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. • A crawling peg works like a fixed exchange rate except that the target value changes. China practices this policy. • The idea behind a crawling peg is to avoid wild swings in the exchange rate that might happen if expectations become volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate.

46. Exchange Rate Policy • Currency Union • A currency unionis a merger of the currencies of a number of countries to form a single money and avoid foreign exchange transactions. • How likely is a currency union between Canada and the United States? • The benefits of a currency union are • Transparency and competition • Transactions costs fall • Foreign exchange risk is eliminated • The real interest rate fall.

47. Exchange Rate Policy • Transparency and Competition Improve • A single currency provides a single unit of account, so prices are easily compared across all the members of the currency union. • Transactions Costs Fall • A single currency eliminates foreign exchange transactions costs—the costs of converting Canadian dollars to U.S. dollars or the reverse conversion.

48. Exchange Rate Policy • Foreign Exchange Risk Eliminated • With a single currency, exporters and importers no longer face foreign exchange risk. So elimination of exchange risk greatly simplifies the life of thousands of firms. • Real Interest Rates Fall • The real interest rate is the cost of capital and the return to saving. It includes a premium for risk. One type of risk arises from currency fluctuations and inflation fluctuations. • If a single currency can eliminate or lower this type of risk, it can lower the real interest rate and stimulate saving and investment.

49. Exchange Rate Policy • Two major costs of a currency union are • Shocks that need national monetary policy • Loss of sovereignty • Shocks that Need National Monetary Policy • A single currency means a single monetary policy—in the North American context, one monetary policy for the United States and Canada. • But many economic shocks call for a monetary policy response that is specific to the economy receiving the shock.

50. Exchange Rate Policy • Loss of Sovereignty • If a country joins with another country to form a currency union, each country surrenders some sovereignty—the ability to set its own monetary policy. • In principle, national fiscal policy might be used to pursue national economic policy goals where monetary policy is not available. • But usually, before a currency union can be agreed upon, some limits must also be agreed for the use of fiscal policy. • Is it likely Canada and the United States would adopt a North American dollar?