The Determination of Exchange Rates

1. The Determination of Exchange Rates Chapter Ten

2. The International Monetary Fund International Monetary Fund (IMF): a multi-national institution established in 1945 as part of the Bretton Woods Agreement to maintain order in the international monetary system • Initially the Bretton Woods Agreement estab-lished a system of fixed exchange rates under which each IMF member country set a par value [benchmark] for its currency quoted in terms of gold and the U.S. dollar.

3. Objectives of the IMF • To promote exchange rate stability • To facilitate the international flow of currencies and hence the balanced growth of international trade • To promote international monetary cooperation • To establish a multilateral system of payments • To make resources available to member nations experiencing balance-of-payments difficulties* *IMF loan criteria are designed to help stabilize a country’s economy. However, they are often unpopular with affected constituencies.

4. The IMF Quota IMF Quota: the sum of the total assessments levied on member countries to form the pool of money from which the IMF draws to make loans to member nations • National quotas are based upon countries’ national incomes, monetary reserves, trade balances, and other economic indicators. • Quotas form the basis for the voting power of each member nation—the higher the quota, the greater the number of votes.

5. Special Drawing Rights Special Drawing Rights (SDRs): an artificial international reserve asset created in 1969 to supplement IMF members’ existing reserves of gold and foreign exchange • The SDR is used as the IMF’s unit of account for purposes of financial record-keeping, but it has not assumed the role of gold as a primary reserve asset. • The value of the SDR is based upon the weighted average of a basket of four currencies. Weights as of Dec. 31, 2004 Current U.S. dollar 39% 44% Euro 36% 34% Japanese yen 13% 11% British pound 12% 11%

6. The Evolution to Floating Exchange Rates • The Smithsonian Agreement of 1971: a restructuring of the international monetary system that widened exchange rate flexibility from 1 percent to 2.25 percent from par value • The Jamaica Agreement of 1976: an amendment to the original IMF rules that eliminated the concept of fixed exchange rates and par values in order to accommodate greater exchange rate flexibility via a spectrum of exchange rate regimes

7. Exchange Rate Arrangements: Broad Categories • Peg the exchange rate to another currency or basket of currencies with little or no flexibility [Ecuador, El Salvador, Finland, Niger] • Peg the exchange rate to another currency or basket of currencies with trading occurring within a band [Denmark, Cyprus, Hungary] • Allow the currency to float in value against other currencies, either managed or not managed [Britain, Brazil, India, Norway, Turkey, So. Africa, USA] IMF member countries are permitted to select and maintain their exchange rate regimes, but they must be open and act responsibly with respect to their exchange rate policies.

8. Exchange Rate Regimes: 2004(See Map 10.2) NO. OF REGIMES COUNTRIES Arrangements with no separate legal tender 41 Currency board arrangements 7 Other conventional fixed peg arrangements 41 Pegged exchange rates within horizontal bands 4 Crawling pegs 5 Exchange rates within crawling bands 5 Managed float with no pronounced path 49 Independently floating 35 Total 187 Source: International Monetary Fund, IMF Annual Report, 2004, pp. 118-120.

9. The Role of Central Banks • Each country has a central bank responsible for the policies affecting the value of its currency. [The NY Fed, one of 12 of a system of regional Federal Reserve Banks, intervenes in foreign exchange markets on behalf of both the Federal Reserve and the U.S. Treasury.] • Central banks intervene in currency markets by buying or selling a particular currency in order to affect its price; central banks are primarily concerned with liquidity. [Selling a currency puts downward pressure on its value; buying a currency puts upward pressure on its value.] • Central banks keep their reserve assets in three major forms: gold, foreign exchange, and IMF-related assets (SDRs). [continued]

10. Depending on market conditions, a central bank may: • coordinate its actions with other central banks or go it alone • aggressively enter the market to change attitudes about its views and policies • call for reassuring action to calm markets • intervene to reverse, resist, or support a market trend • be very visible or be very discrete • operate openly or operate indirectly through brokers The Bank for International Settlements (BIS) in Basel, Switzerland, acts as the central bankers’ central bank and also serves as a place to gather to discuss monetary cooperation.

11. The Euro • European Monetary System (EMS): established by the EU (then the EC) in 1979 as a means of creating exchange rate stability within the bloc • European Central Bank: established by the EU on July 1, 1998, to set monetary policy and to admin-ister the euro • Euro: the common European currency established on Jan. 1, 1999 as part of the EU’s move toward monetary union as called for by the Treaty of Maastricht of 1992 • European Monetary Union (EMU): a formal arrangement linking many but not all of the currencies of the EU [continued]

12. The Exchange Rate Mechanism (ERM), i.e., the Stability and Growth Pact that defines the criteria that EU member nations must meet to qualify for adoption of the euro, requires: • an annual government deficit not to exceed 3% of GDP • total outstanding government debt not to exceed 60% of GDP • rates of inflation within 1.5% of the three best performing EU countries • average nominal interest rates within 2% of the average rate in the three countries with the lowest inflation rates • exchange rate stability, i.e., for at least two years, ex-change rate fluctuations within the “normal” margins of the ERM The UK, Sweden, and Denmark are the only members of the initial group of 15 that opted not to adopt the euro.

13. Exchange Rate Determination: Fixed to Floating Regimes Floating rate regimes: currencies float freely, i.e., free from government intervention, in response to demand and supply conditions Managed fixed rate regimes: a nation’s central bank intervenes in the foreign exchange market in order to influence its currency’s relative price • Demand for a country’s currency is a function of the demand for that country’s goods, services, and financial assets. Equilibrium exchange rates are achieved when supply equals demand. [continued]

14. Fig. 10.1: The Equilibrium Exchange Rate

15. The prices of tradable products, when expressed in a common currency, will tend to equalize across countries as a result of exchange rate changes. • If economic policies and intervention are ineffective, governments may be forced to revalue or devalue their currencies. • A currency that is pegged is usually changed on a formal basis. • The G8 group of finance ministers meets often to discuss global economic issues, including exchange rate values and policies. Black markets closely approximate prices based on supply and demand for currencies, rather than government-controlled prices.

16. Purchasing Power Parity: The Concept Purchasing power parity: the number of units of a country’s currency required to buy the same amount of goods and services in the domestic market that one unit of income would buy in another country Purchasing power parity [PPP] is estimated by calculating the value of a universal “basket of goods” that can be purchased with one unit of a country’s currency.

17. Purchasing Power Parity: The Theory • Purchasing power parity predicts that the ex-change rate will change if relative prices change. • A change in the comparative rates of inflation in two countries necessarily causes a change in their relative exchange rates in order to keep prices fairly similar. • An example: If the domestic inflation rate is lower than the rate in the foreign country, the domestic currency should be stronger than the currency of the foreign country. • The alternative example: If the domestic inflation rate is higher than the rate in the foreign country, the domestic currency should be weaker than the currency of the foreign country. Inflation represents a monetary phenomenon in which a nation’s money supply increases faster than its stock of goods and services, thus causing prices to rise. [continued]

18. Purchasing power parity seeks to define the relationships between currencies. • While PPP may be a reasonably good long- term indicator of exchange rate movements, it is less accurate in the short run because: • the theory falsely assumes that no barriers to trade exist and that transportation costs are zero • it is difficult to determine an appropriate basket of commodities for comparative purposes • profit margins vary according to the strength of competition • different tax rates have different effects upon prices

19. The Big Mac Index: Under/Over Valuation Against the U.S. Dollar Price in Implied Exchange Under[-]/ Local Price in PPP of Rate: Over[+] Currency Dollars the US$ 20/05/04 Valuation United States 2.90 2.90 - - - Brazil 5.39 1.70 1.86 3.1350 - 41 Britain 4.47 3.37 1.54 1.7825 +16 Canada 3.19 2.33 1.10 1.3770 - 20 China 10.41 1.26 3.59 8.2869 - 57 Denmark 27.75 4.46 9.57 6.1959 +54 Egypt 10.01 1.62 3.45 6.2294 - 44 Euro Area 3.07 3.28 1.06 1.2010 +13 Japan 261.87 2.33 90.30 113.00 - 20 Russia 42.05 1.45 14.50 28.995 - 50 South Africa 12.41 1.86 4.28 6.7707 - 36 Source: “The Big Mac Index: Food for Thought,” The Economist, 2004, pp. 71-72.

20. The Role of Interest Rates Fisher Effect Theory: [links interest rates and inflation] r: the nominal interest rate, i.e., the actual rate of interest earned on an investment R: the real interest rate, i.e., the nominal interest rate less inflation A country’s nominal interest rate r is determined by the real interest rate R and the inflation rate i as follows: (1 + r) = (1 + R)(1 + i). International Fisher Effect Theory (IFE):[links interest rates and exchange rates] The currency of the country with the lower interest rate will strengthen in the future because the interest rate differential is an unbiased predictor of future changes in the spot exchange rate. [continued]

21. • Like PPP, the International Fisher Effect is not a particularly good predictor of short-run changes in spot exchange rates. • An example of the Fisher Effect: Because the interest rate should be the same in every country, the country with the higher interest rate should have higher inflation. Thus, if R = 5%, the U.S. inflation rate is 2.9%, and the Japanese inflation rate is 1.5%, the nominal interest rates are: rus = (1.05)(1.029) – 1 = .08045 or 8.045% rj = (1.05)(1.015) – 1 = .06575 or 6.575% On the other hand, if inflation rates were the same, investors would place their money in countries with higher interest rates in order to get higher real returns.

22. Forecasting Exchange Rates: Fundamental vs. Technical Approaches Fundamental forecasting: trend analyses and econometric models that use economic variables to predict future exchange rates Technical forecasting: analyses that use past trends in exchange rate movements to predict future exchange rates • Forecasters need to provide ranges or point estimates within subjective probabilities based on available date and subjective interpretations.

23. Forecasting Exchange Rates:Factors to Monitor • The institutional setting—the extent and nature of government intervention • Fundamental factors—PPP rates, balance-of-payments levels, macroeconomic data, levels of foreign exchange reserves, fiscal and monetary policies, etc. • Confidence factors • Critical events, e.g., 9/11 • Technical factors—expectations and market trends

24. Operational Implications of Exchange Rate Fluctuations Exchange rate changes can affect: • marketing decisions, i.e., demand for a firm’s products, both at home and abroad • production decisions, i.e., production site locations, insourcing vs. outsourcing • financial decisions, i.e., sourcing of funds (debt and equity), the timing and level of the remit-tance of funds, and the reporting of financial results