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CHAPTER 15 EXCHANGE RATES AND THE INTERNATIONAL MONETARY SYSTEM

CHAPTER 15 EXCHANGE RATES AND THE INTERNATIONAL MONETARY SYSTEM. EXCHANGE RATES. BoP a record of economic transactions between US and foreign residents both in goods and assets Double-entry credits: earnings debits: expenditure

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CHAPTER 15 EXCHANGE RATES AND THE INTERNATIONAL MONETARY SYSTEM

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  1. CHAPTER 15EXCHANGE RATES AND THE INTERNATIONAL MONETARY SYSTEM EXCHANGE RATES

  2. BoP a record of economic transactions between US and foreign residents both in goods and assets Double-entry credits: earnings debits: expenditure Current account a record of US merchandise exports and imports as well as trade in services and foreign transfer payments Capital account a record of purchases of US assets by foreign residents (capital inflows) and purchases of foreign assets by US residents (capital outflows) Statistical discrepancy the amount that must be added due to improper recording of transactions Balance of Payments

  3. Foreign exchange a general term to refer to an aggregate of foreign currencies Foreign exchange market the market in which national currencies are traded Demand for foreign exchange ≡ Supply of US Dollars by US residents: when purchasing imports or buy foreign assets Supply of foreign exchange ≡ Demand for US Dollars by foreigners: when purchasing US exports or buy US assets Foreign Exchange

  4. Exchange rate the price of one currency in terms of another Example: the price of Euro in terms of Dollar is Є1 = $0.80 Appreciation increase in value; the appreciation of Euro against the dollar If the exchange rate rises, Є1 = $1 Є appreciated, $ depreciated Deprecation decrease in value; the depreciation of Euro against the dollar If the exchange rate falls, Є1 = $0.6 Є depreciated, $ appreciated Exchange Rate

  5. Foreign exchange rate • Demand for foreign exchange: • foreign expenditures by US residents • negative sloping • Supply for foreign exchange: • domestic expenditure by foreigners • positive sloping • (the higher the exchange rate, foreign exchange is more expensive, less demand and more supply) S 1.00 0.80 Foreign Exchange Market 0.60 Quantity of foreign exchange D

  6. Price of one unit German camera = Є 250 At 0.80 exchange rate  the camera will cost $200. If the exchange rate rises to 1.00  the camera will now cost $250. Euro appreciates, Dollar depreciates, camera more expensive. [The higher the exchange rate, the higher the dollar cost of imported goods, lower demand for foreign exchange.] If the exchange rate falls to 0.60  the camera will now cost $180. Euro depreciates, Dollar appreciates, camera cheaper. [The lower the exchange rate, the lower the dollar cost of imported goods, higher demand for foreign exchange.] Buying a German Camera (Agfa)

  7. French government bond = Є 1000 paying annual interest of Є100 At 0.80 exchange rate  the bond costs $800 paying $80 interest. • If the exchange rate rises to 1.00 •  the bond will now cost $1000, paying annual interest of $100. • Although Euro appreciates, Dollar depreciates, bond more expensive, but the interest paid by the bond is still 10%. • The changes in exchange rate will not have significant effects on the demand for foreign assets. • Similarly, it may not have much effect on transfer payments (i.e. pensions, foreign aid) made in foreign currencies. Buying a French Government Bond

  8. Price of one bushel of American wheat = $4.00 At 0.80 exchange rate  the wheat will cost Є5.00. If the exchange rate rises to 1.00  the wheat will now cost Є4.00. Euro appreciates, Dollar depreciates, wheat cheaper. [The higher the exchange rate, the lower the Euro cost of exported goods, higher demand for Dollars, higher supply of foreign exchange.] If the exchange rate falls to 0.60  the wheat will now cost $6.67. Euro depreciates, Dollar appreciates, wheat more expensive. [The lower the exchange rate, the higher the Euro cost of exported goods, lower demand for Dollars, lower supply of foreign exchange.] Selling / Exporting American Wheat

  9. Price of one bushel of American wheat = $4.00 At 0.80 exchange rate  the wheat will cost Є5.00. If the exchange rate rises to 1.00  the wheat will now earn $4.00. Euro appreciates, Dollar depreciates, wheat cheaper. When the exchange rate rises, Americans lose from Dollar earnings. But when the exchange rate rises, American gain from increase in demand for exported goods. 10% increase in exchange rate + 10% increase in volume of exports = no gain from foreign exchange. US Earnings From Exports

  10. Foreign exchange rate • a.k.a floating exchange rate system: • no central bank intervention • exchange rate is determined by the market • An autonomous increase in the demand for imports (i.e. due to taste/preference) will shift D to the right  new equilibrium at a higher exchange rate  Dollar depreciates. S 1.00 0.80 Flexible Exchange Rates D1 Quantity of foreign exchange D0

  11. Foreign exchange rate • a.k.a. pegged exchange rate system: • central bank intervention • Example: pegging US to Euro at Є0.80 = $1.00 (equals Є1.00 = $1.25) • If the official exchange rate is below market equilibrium: • Euro is undervalued 1.00 0.80 • Dollar is overvalued 1.00 1.25 • the shortage of foreign exchange must be supplied by US/European central bank S 1.00 excess demand = shortage Fixed Exchange Rates 0.80 Quantity of foreign exchange D

  12. When Dollars are overvalued, shortage for Euros: • US central bank intervenes … • use international reserve assets to (i) buy Euros from the ECB (ii) sell Euros back in the foreign exchange market • reduce US official reserve assets • European central bank intervenes … * BWS • directly supplying Euros (i) buy Dollars from the Fed (ii) sell Euros in the foreign exchange market • increase Foreign official assets • US assets ↓ + Foreign assets ↑ = US BoP deficit Central Bank Intervention

  13. A pegged exchange rate system set up at the end of WW2: • international monetary agreements negotiated at Bretton Woods, New Hampshire • International Monetary Fund (IMF) to administer the system • US to set a par value for Dollar in terms of gold [US owned 2/3 of world gold reserves] while other currencies to set parities to Dollar • US to maintain convertibility Dollar to gold at fixed $35 per oz while other currencies to maintain convertibility to Dollar within 1% range Bretton Woods System

  14. Collapsed in 1972: • BWS was an adjustable pegging system with IMF permission; countries with chronic BoP deficits would devalue own currency and countries with persistent BoP surplus would revalue. • devaluation shows failed government policy  loss of confidence • late 1960s: severe inflation (govt. spending > tax returns)  chronic US BoP deficits  1972: devalue Dollar  increase price for Gold from $35 to $38  loss confidence in Dollar • 1973: oil price shock  managed floating exchange rate system Bretton Woods Collapse

  15. Floating or Managed Float a.k.a. Dirty Float (77 countries): • flexible to market forces but the central bank can intervene to prevent undesirable / disruptive exchange rate movements • Fixed peg arrangements (44 countries): • fixed to one currency/composite within 1% margin • Pegged arrangements with bands (14 countries): • fixed exchange rate with wider bands • Exchange rate mechanism (11 countries): • i.e. common currency, monetary union • Crawling pegs (5 countries): • adjusts in relative to a central rate Current Exchange Rate System (2000)

  16. Bahamas - currency: dollar; Symbol: B$; Regime: US-$ (1.0) “the country pegs its currency to the US$ at B$1=US$1” Bulgaria - currency: new lev; Symbol: Lv; Regime: Euro (1.95583) “the official locking rate between the Euro and own currency at Є1=CFAF655.96 Rwanda - currency: franc; Symbol: RF; Regime: SDR “SDR=Special Drawing Right of the International Monetary Fund” Qatar - currency: riyal; Symbol: QR; Regime: US-$ (lim.flex.) “the currency exhibits limited flexibility vis-à-vis the currency named” Malaysia - currency: ringgit; Symbol: RM; Regime: m.float “managed float with central bank interventions” Canada - currency: dollar; Symbol: Can$; Regime: float “completely flexible exchange rates” Bangladesh - currency: taka; Symbol: Tk; Regime: composite “currency pegged to a basket of currencies” http://fx.sauder.ubc.ca/currency_list.html

  17. Currency board - fix values of own currency to a strong currency (i.e. US$) and ready to convert on demand - eliminates domestic inflationary pressure - example: Argentina 1991-2001 Dollarization - adopts a strong currency (i.e. US$) to replace own currency - limits control of own monetary policy - example: Ecuador 15 Sept 2000 Currency Board versus Dollarization

  18. Flexible Exchange Rate Regime: • policymakers can focus on domestic goals, • no conflicts of internal (unemployment, inflation) balance versus external balance (BoP) • insulate domestic economy from foreign shocks • Fixed Exchange Rate Regime: • more stable environment for growth and international trade • increase macroeconomic stability Advantages

  19. BoP is a record of economic transactions between US and foreign residents both in goods and assets. • Foreign exchange is a general term that refers to an aggregate of foreign currencies. Appreciation is when exchange rate increases in value, depreciation is when exchange rate decreases in value. • Flexible exchange rate system is without central bank intervention and exchange rate is determined by the market. Fixed exchange rate system decides an official exchange rate with central bank intervention. Conclusion

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