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Foreign Exchange Rate

Foreign Exchange Rate. What is money?. The “medium of exchange” that is, something widely accepted as means of payment Usually, governments declare certain pieces of paper to be money But people must accept them. Foreign Exchange Terms.

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Foreign Exchange Rate

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  1. Foreign Exchange Rate

  2. What is money? • The “medium of exchange” • that is, something widely acceptedas means of payment • Usually, governments declare certain pieces of paper to be money • But people must accept them

  3. Foreign Exchange Terms • Foreign exchange: money denominated in the currency of another nation or group of nations • Exchange rate: the price of a particular currency relative to another

  4. The Foreign Exchange Market Spot exchange rate: price for immediate exchange. Forward exchange rate: price for an exchange that will take place sometime in the future.

  5. Exchange Rate Systems • Floating exchange rate • Determined by the forces of demand and supply without intervention from governments or central bankers. • Fixed exchange rate • Official authorities stand ready to purchase or sell foreign currency in order to balance the demand and supply at the targeted (fixed) exchange rate. • Floating within a band • Official authorities stand ready to purchase or sell foreign currency if the exchange rate diverges from a predetermined band.

  6. Exchange Rates • Nominal exchange rates • Reflect the relative prices of two currencies • Real exchange rates • Rate at which we trade goods, terms of trade

  7. Exchange Rate Contd.. • Exchange rates are important because they enable us to translate different counties’ prices into comparable terms. • Exchange rates are determined in the same way as other asset prices.

  8. Exchange Rates and International Transactions • An exchange rate can be quoted in two ways: • Direct • The price of the foreign currency in terms of dollars • Indirect • The price of dollars in terms of the foreign currency

  9. Why and when do businesspeople deal with foreign money? • Sell abroad, and may receive payment in foreign currency • Buy abroad, and pay in foreign currency • A foreign direct investment will have to pay expenses in foreign currency

  10. How should you convert money from one currency into another? • Current values of major foreign currencies appear daily in newspapers • the “interbank” values • Businesspeople normally buy from or sell to a bank • The bank gives less than the rates quoted in the newspaper • Banks may vary a lot in how good a deal they give

  11. A business with significant foreign activity creates a stable relationship with one or a few banks • Negotiating with the bank, it can get good rates on foreign exchange • A large business can do its own currency trading • If they trade well, they can get the same rates that appear in the newspaper

  12. How are the values of currencies set? • There are two basic ways • “Fixed” or “Pegged” exchange rates • Governments decide the value of currency • Example: Hong Kong’s government keeps the value of its dollar at roughly US$0.128 (US$1=HK$7.80) • “Floating” exchange rates • Supply and demand sets values • The value of most major currencies “floats” • Euro, Japanese yen, British pound, etc.

  13. Exchange Rates and International Transactions • Domestic and Foreign Prices • If we know the exchange rate between two countries’ currencies, we can compute the price of one country’s exports in terms of the other country’s money. • Example: The dollar price of a £50 sweater with a dollar exchange rate of $1.50 per pound is (1.50 $/£) x (£50) = $75.

  14. Factors that InfluenceExchange Rates e = percentage change in the spot rate INF = change in the relative inflation rate INT = change in the relative interest rate INC = change in the relative income level GC = change in government controls EXP = change in expectations of future exchange rates

  15. Key Foreign-Exchange Terms • Bid: the rate at which traders buy foreign currency • Offer: the rate at which traders sell foreign exchange • Spread: the difference between bid and offer rates; the profit margin for the trader 9-6

  16. Foreign-Exchange Instruments • Spot transactions: involve the exchange of currency the second day after the date on which the two foreign-exchange traders agree • Outright forward transactions: involve the exchange of currency 3 or more days after the date the traders agree • FX swap: involves a swap of one currency for another and then swapped back on a future date 9-5

  17. Foreign-Exchange Convertibility • Fully convertible currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts • “Hard currencies” are fully convertible • “Soft currencies” (or weak currencies) are not fully convertible • Typically from developing countries • Known as “exotic currencies” 9-10

  18. Exchange Rate Arrangements Floating • “Independent Floating”: the category in which the exchange rate is market determined with foreign market interventions of the central bank only admissible when there are unjustifiable fluctuations in the exchange rate. • “Managed Floating”: the central bank intervenes to the level of the exchange rate without announcing or specifying a path for it.

  19. Soft Pegs • “Crawling Bands”: the central bank pre-announces a central rate and adjusts it periodically and does not intervene when the exchange rate fluctuates within a certain margin of that central rate. • “Crawling Pegs”: the central bank adjusts the rates in small amounts at a fixed, pre-announced rate or as a result of changes in certain pre-announced selective quantitative criteria. • “Pegged Rates with Horizontal Bands”: the central bank maintains the pre-announced central exchange rate within margins that may be wider than  1 percent around that rate. • “Other Conventional Fixed Peg Arrangements”: the central bank maintains the pre-announced central exchange rate within a maximum of  1 percent margins.

  20. Hard Pegs • “Currency Board Arrangements”: the central bank refrains from any intervention other than buying and selling the foreign currency and does not allow for any fluctuation in the pre-announced fixed exchange rate. • “Exchange Rate Regimes with No Separate Legal Tender” that may take place in the event of a complete dollarization or membership in a currency union. • Bofinger and Wollmerschaeuser add an additional category to the IMF’s classification, • “Pure Floating”: the exchange rate is completely market determined and under no circumstance does the central bank intervene.

  21. Flexible Exchange rate determined by supply and demand. Characterized by volatility. Creates uncertainty in conducting international business. Changes in value called appreciation and depreciation. Fixed Central bank buys and sells domestic currency at a fixed price. The gold standard was a fixed exchange rate regime. Bretton Woods was another. Provides more certainty in the short run but the system is susceptible to speculative attacks. Changes in value called revaluation and devaluation. Two types of exchange rate regime

  22. Fixed exchange rates have important benefits • They make business predictable • In some very prosperous periods, most major exchange rates have been fixed • The late 19th century • 1945-1971

  23. But a fixed exchange rate requires discipline in the government –and a willingness to create pain • Example: Suppose your nation’s economy is very prosperous • Your people will have money to buy imports • Their demand for foreign currencies will put upward pressure on their exchange rates • Government has to slowthe domestic economy to prevent change in exchange rate • Higher taxes, higher interest rates, lower spending

  24. U.S. abandoned fixed exchange rates when the Vietnam War created strong inflation • It seems that the more complicated an economy, the more difficult it is to maintain fixed exchange rates • Many small countries succeeded • Malaysia, Bangladesh, Fiji • Few propose them for large nations today

  25. Most international business involves currencies with floating rates • Buyers and sellers establish prices in markets like those for tea and wheat • $1,200,000,000,000 in foreign exchange is traded every day • US dollar is most widely traded • involved in 90% of all transactions • London is the main foreign-exchange market

  26. Two open market operations • Open-market operations involve the purchase or sale of domestic assets. • Official transactions in foreign assets is just the open market operations in the foreign asset market. • Any central bank purchase of assets increases money supply, and any central bank sale of assets reduces money supply.

  27. Foreign exchange market equilibrium under a fixed exchange rate When the exchange rate is fixed permanently at E0, Ee=E0; then, the central bank must manipulate money supply by either buying or selling foreign assets.

  28. Monetary policy with a fixed exchange rate • Under a fixed exchange rate, monetary policy can affect international reserves but nothing else; therefore it’s powerless. • The central bank’s commitment to the fixed exchange rate forces it to resist any tendency for the currency to either depreciate or appreciate by sales or purchases of foreign assets.

  29. Changes in the exchange rate • A devaluation occurs when the central bank officially lowers the exchange value of the domestic currency. • A revaluation occurs when the central bank officially raises the exchange value of the domestic currency. • In either case, the central bank announces its willingness to trade domestic against foreign currency, in unlimited amounts, at the new exchange rate.

  30. Exchange Rates and International Transactions • Two types of changes in exchange rates: • Depreciation of home country’s currency • A rise in the home currency prices of a foreign currency • It makes home goods cheaper for foreigners and foreign goods more expensive for domestic residents. • Appreciation of home country’s currency • A fall in the home price of a foreign currency • It makes home goods more expensive for foreigners and foreign goods cheaper for domestic residents.

  31. Exchange rate policy of devaluation • A devaluation increases output and thus money demand. To back up the exchange rate at its new fixed level, the central bank must buy foreign assets and expand the money supply. • Devaluation causes a rise in output, a rise in official reserves, and a monetary expansion.

  32. Why choose a devaluation? • Devaluation allows the government to fight unemployment despite the lack of effective monetary policy. • Devaluation improves the current account and reduces the risk of balance-of-payment crisis. • Devaluation helps accumulate the central bank’s foreign reserves.

  33. The Open Economy

  34. The Balance of Payments Accounts

  35. BALANCE OF PAYMENTS ACCOUNTS These accounts are to summarize payments a country receives from other nations and payments it must make to other nations. They consist of the following five categories: 1. MERCHANDISE OR TRADE BALANCE: (Exports minus imports )

  36. BALANCE OF PAYMENTS ACCOUNTS 2. GOODS AND SERVICES BALANCE: (Just add services) 3. NET UNILATERAL TRANSFERS (Gifts) • U.S. government transfers to foreigners • (E.g., Foreign aid or wheat from U.S. stockpiles) • Private remittances of wages earned abroad, and • Lots of other transfers.

  37. BALANCE OF PAYMENTS ACCOUNTS To here, we are looking at the CURRENT ACCOUNT BALANCE (Net flows of goods, services and gifts). Again: 1. MERCHANDISE OR TRADE BALANCE: 2. GOODS AND SERVICES* BALANCE: 3. NET UNILATERAL TRANSFERS

  38. Balance of Payments There is also a set of asset flows referred to as the CAPITAL ACCOUNT BALANCE 4. NET CHANGES IN FOREIGN HOLDINGS OF U.S. ASSETS Flows of financial assets and similar claims, or Foreign direct and other investments in the U.S., or “Private capital flows.” (Note that we are talking direct and portfolio investments here).

  39. Balance of Payments 5. NET OFFICIAL INTERNATIONAL RESERVE TRANSACTION Foreign official holdings of U.S. assets, U.S. holdings of official reserve (gold and foreign exchange) assets or, “Official asset flows.”

  40. BOP 1. MERCHANDISE OR TRADE BALANCE: 2. GOODS AND SERVICES* BALANCE: 3. NET UNILATERAL TRANSFERS 4. NET CHANGES IN FOREIGN HOLDINGS OF U.S. ASSETS 5. NET OFFICIAL INTERNATIONAL RESERVE TRANSACTION

  41. Balance of Payments • THE BALANCE OF PAYMENTS IS, THEREFORE, THE SUM OF THE CURRENT AND CAPITAL ACCOUNT BALANCES.

  42. Services in the Balance of Payments Note: *Services include travel and tourism, trade transportation, insurance, education, financial, technical, telecommunications and other business and professional services. In addition there are royalties, payments for capital services besides interest, such as dividends, payments for foreign labor, etc.

  43. The current account balance is the difference between domestic saving and domestic investment. If domestic saving falls, the US must borrow from abroad to finance domestic investment… • US foreign indebtedness is not necessarily bad if foreign funds are used towards investment. (p. 231)

  44. Repayment of the debt is potentially a problem if foreign funds are used to purchase consumption goods since future generations will bear the burden of debt.

  45. Balance of Payments • A record of international transactions between residents of one country and the rest of the world • International transactions include exchanges of goods, services or assets • “Residents” means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations

  46. Double-entry Accounting in the BOP • All transactions are either debit or credit transactions • Credit transactions result in receipt of payment from foreigners • Merchandise exports (valued f.o.b.) • Transportation and travel receipts • Income received from investments abroad • Gifts received from foreign residents • Aid received from foreign governments

  47. Double-entry Accounting(Cont’d) • Debit transactions involve to payments to foreigners • Merchandise imports • Transportation and travel expenditures • Income paid on investments of foreigners • Gifts to foreign residents • Aid given by home government • Overseas investments by home country residents • Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance.

  48. Accounts Overview (Level 1) • Current Account (all real transfers) • Merchandise trade • Service trade • Transfers • Capital and Financial Account (transfers of ownership and financial assets and liabilities) • Changes in private assets • Changes in holdings of official international reserves • Statistical Discrepancy

  49. Current Account • The current account is that balance of payments account in which all short-term flows of payments are listed: • Goods and services balance (exports – imports) • Merchandise trade balance (exports – imports) • Services balance (exports – imports) • Net Investment income • Unilateral transfers • Private transfer payments • Governmental transfers

  50. What are Services? • Travel and tourism • Trade transportation • Insurance • Education • Financial, technical, and marketing services • Telecommunication • Use of property rights (royalties) • Other professional and consulting services

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