Chapter 10

The Determination of Exchange Rates

Objectives
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Describe the International Monetary Fund and its role in the determination of
exchange rates.
Discuss the major exchange-rate arrangements countries use.
Identify the major determinants of exchange rates in the spot and forward markets.
Show how managers try to forecast exchange-rate movements using factors such
as balance-of-payments statistics.
Explain how exchange-rate movements influence business decisions.

Chapter Overview
From a managerial point of view, it is critical to understand how exchange-rate movements
influence business decisions and operations. Chapter 10 first describes the International
Monetary Fund and the role it plays in exchange-rate determination. Next the chapter
examines the various types of exchange-rate regimes countries may choose, as well as the
role central banks play in the currency valuation process. It then presents the theories of
purchasing power parity, the Fisher Effect and the International Fisher Effect and discusses
their contributions to the explanation of exchange-rate movements. The chapter concludes
with a brief examination of the potential effects of exchange-rate fluctuations on business
operations.

Chapter Outline
OPENING CASE: The Chinese Renminbi
This case describes Chinas efforts to manage the renminbi (RMB), also known as the
yuan, as the country moves toward a more market-based economy. Prior to 1994, China
operated under a dual-track system that provided for two government-approved exchange
rates: the official rate and the swap-market rate (primarily used by multinationals). As part
of the move to the new exchange rate system, the Chinese government closed the swap
centers in 1994. Although it announced it would allow the RMB to float according to
market forces, the government then pegged the RMB to the U.S. dollar (roughly 8.2
RMBs per dollar) and also retained its controls on both current and capital account
transactions. In 1996, the RMB was made fully convertible on a current account (trade),
but not a capital account (investment), basis. Thus, Chinese citizens have a difficult time
moving their money elsewhere, and foreigners are unable to invest in Chinas stock market
(except for special stocks priced in foreign currency). While there are several
steps China could take before letting its currency float freely, the government does not
appear to be planning any moves in the near future.

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Teaching Tip: Carefully review the PowerPoint slides for Chapter 10 and select
those you find most useful for enhancing your lecture and class discussion. For
additional visual summaries of key chapter points, also review the figures, tables
and maps in the text.
I.

INTRODUCTION
An exchange rate represents the number of units of one currency needed to
acquire one unit of another currency. Managers must understand how governments
set exchange rates and what causes them to change so they can make decisions
that anticipate and take those changes into account.

II.

THE INTERNATIONAL MONETARY FUND (IMF)

In 1944, the major allied governments met in Bretton Woods, NH, to discuss postwar economic needs. One of the results was the establishment of the International
Monetary Fund (IMF). Its objectives are to promote exchange-rate stability, to
facilitate the international flow of currencies and hence the balanced growth of
international trade, to establish a multilateral system of payments and to serve as
the lender of last resort to governments. Initially, the Bretton Woods Agreement
established a system of fixed exchange rates under which each IMF member
country set a par value (benchmark) for its currency based on gold and the U.S.
dollar. Par values were later done away with when the IMF moved toward greater
exchange-rate flexibility. When a country joins the IMF, it contributes a certain
sum of money, i.e., a quota, relating to its national income, monetary reserves,
trade balance and other economic indicators. The quota then becomes part of a
pool of money the IMF can draw on to lend to member countries. It also forms the
basis for the voting power of each country, as well as the allocation of its special
drawing rights.
IMF Assistance
When a member country experiences economic difficulties, the IMF will
negotiate loan criteria designed to help stabilize its economy. However,
such stabilization measures are often unpopular with a countrys citizens
and firms and, ultimately, its government officials.
B.
Special Drawing Rights (SDRs)
The help increase international reserves, the IMF created special drawing
rights (SDRs), an international reserve asset designed to supplement
members existing reserves of gold and foreign exchange. The SDR is used
as the IMFs unit of account and for IMF transactions and operations. The
value of the SDR is based on the weighted average of four currencies. At
the end of 2002 those weights were: the U.S. dollar 45%, the EURO 29%,
the Japanese yen 15% and the British pound 11%. Although the SDR was
intended to serve as a substitute for gold, it has not assumed the role of
either gold or the U.S. dollar as a primary reserve asset.

A.

C.

Evolution to Floating Exchange Rates

The IMFs original system was one of fixed exchange rates; the U.S. dollar
remained constant with respect to the value of gold and other currencies
operated within narrow bands of value relative to the dollar. Following
President Nixons suspension of the dollars convertibility to gold in 1971,
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the international monetary system was restructured via the Smithsonian

Agreement, which permitted a devaluation of the U.S. dollar, a revaluation
of other currencies and a widening of the exchange-rate flexibility bands.
These measures proved insufficient, however, and in 1976 the Jamaica
Agreement eliminated the use of par values by abandoning gold as a
reserve asset and declaring floating rates to be acceptable.
III.

A.

B.

C.

EXCHANGE-RATE ARRANGEMENTS [See Table 10.1 and Map 10.1]

The IMF surveillance and consultation programs are designed to monitor the
economic policies of member nations to be sure they act openly and responsibly
with respect to their exchange-rate policies. Member countries are permitted to
select and maintain their exchange-rate regimes, but they must communicate those
choices to the IMF.
From Pegged to Floating Currencies
The IMF now recognizes several categories of exchange-rate regimes that
begin with pegging (fixing) the rate for one currency to that of another (or
to a basket of currencies) under a very narrow range of fluctuations in
value (e.g., no separate legal tender, currency boards, conventional pegs).
The next category, pegged exchange rates within horizontal bands, is
characterized by a broader band of fluctuations than the first three. The last
four categories exhibit at least some degree of floating exchange-rate
arrangements from crawling pegs to crawling bands to managed floats to
independent floats.
Black Markets
The less flexible a countrys exchange-rate system, the more likely there
will be a black market, i.e., a foreign exchange market that lies outside the
official market. Black markets are underground markets where prices are
based on supply and demand; the adoption of floating rates eliminates the
need for their existence.
The Role of Central Banks
Each country has a central bank responsible for the policies affecting the
value of its currency. Central banks are primarily concerned with liquidity,
in order to ensure they have the cash and flexibility needed to protect their
countries currencies. Their reserve assets are kept in three forms: gold,
foreign-exchange reserves and IMF-related assets. The EURO is
administered by the European Central Bank which, although independent
of all EU institutions and governments, works with the governors of
Europes various central banks to establish monetary policy and manage the
exchange-rate system. The central bank in the U.S. is the Federal Reserve
System, i.e., the Fed, a system of 12 regional banks. The New York Fed,
representing both the Fed and the U.S. Treasury, is responsible for
intervening in foreign-exchange markets to achieve dollar exchange-rate
policy objectives. Selling U.S. dollars for foreign currency puts downward
pressure on the dollars value; buying U.S. dollars for foreign currency puts
upward pressure on the dollars value. The New York Fed also acts as the
primary contact with other foreign central banks. Depending on market
conditions, a central bank may:

coordinate its actions with other central banks or go it alone

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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 very discrete

operate openly or indirectly through brokers.

The Bank for International Settlements (BIS) in Basel, Switzerland, acts
as the central bankers central bank and serves as a gathering place where
central bankers meet to discuss monetary cooperation. Although just 50
central banks are shareholders in the BIS, it regularly deals with some 130
central banks worldwide.
IV.

THE DETERMINATION OF EXCHANGE RATES

Exchange-rate regimes are either fixed or floating, with fixed rates varying in
terms of just how fixed they are and floating rates varying with respect to just how
much they are allowed to float.
A.
Floating Rate Regimes [See Figure 10.2]
Floating rates regimes are those whose currencies respond to the
conditions of supply and demand. Technically, an independent floating
currency is one that floats freely, unhampered by any form of government
intervention. Equilibrium exchange rates are achieved when supply equals
demand.
A.
Managed Fixed-Rate Regimes
In a managed fixed exchange-rate system, a nations central bank
intervenes in the foreign exchange market in order to influence the
currencys relative price. To buy foreign currencies, it must have sufficient
reserves on hand. When economic policies and market intervention dont
work, a country may be forced to either revalue or devalue its currency. A
currency that is pegged to another (or to a basket of currencies) is usually
changed on a formal basis. In 1999, the G7 group of industrial countries
was expanded to the G20 for the purpose of including some developing
countries in the discussion of effective exchange-rate policies.

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B.

D.

E.

Purchasing-Power Parity
The theory of purchasing-power parity states that the prices of tradable
goods, when expressed in a common currency, will tend to equalize across
countries as a result of exchange-rate changes. Put another way, the theory
claims 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 interesting illustration of this theory is the Big
Mac Index (see Table 10.2).) While purchasing-power parity may be a
reasonably good long-term indicator of exchange-rate movements, it is less
accurate in the short run because it is difficult to determine an appropriate
basket of commodities for comparison purposes, profit margins vary
according to the strength of competition, different tax rates will influence
prices differently and the theory falsely assumes no barriers to trade exist
and transportation costs are zero.
Interest rates
Although inflation is the most important long-run influence on exchange
rates, interest rates are also important. While the Fisher Effect theory links
inflation and interest rates, the International Fisher Effect (IFE) theory
links interest rates and exchange rates. The Fisher Effect theory states a
countrys nominal interest rate r (the actual monetary interest rate earned
on an investment) is determined by the real interest rate R (the nominal rate
less inflation) and the inflation rate i as follows:
(1 + r) = (1 + R)(1 + i).
Because the real interest rate should be the same in every country, the
country with the higher interest rate should have higher inflation. Thus,
when inflation rates are the same, investors will likely place their money in
countries with higher interest rates in order to get a higher real return. The
International Fisher Effect implies the currency of the country with the
lower interest rate will strengthen in the future, i.e., the interest-rate
differential is an unbiased predictor of future changes in the spot exchange
rate. The country with the higher interest rate (and higher inflation) should
have the weaker currency. In the short run, however, and during periods of
price instability, a country that raises its interest rate is likely to attract
capital and see its currency rise in value due to increased demand.
Other Factors in Exchange-Rate Determination
A key factor affecting exchange-rate movements is confidence in a
countrys economy and administration. Technical factors such as the
seasonal demand patterns for a given currency, the release of national
economic statistics and events such as 9/11, corporate scandals and budget
deficits also exert their influence.

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A.

B.

VI.

V.
FORECASTING EXCHANGE-RATE MOVEMENTS
Managers must be able to formulate at least a general idea of the timing,
magnitude and direction of exchange-rate movements.
Fundamental and Technical Forecasting
While fundamental forecasting uses trends regarding fundamental
economic variables to predict future exchange rates, technical forecasting
uses past trends in exchange-rate movements to spot future trends. Smart
managers develop their own exchange-rate forecasts and then use the
fundamental and technical forecasts of outside experts to corroborate their
analyses.
Factors to Monitor
When forecasting exchange-rate movements, key variables to monitor
include:
the institutional setting (the extent and nature of government
intervention)
fundamental factors (PPP rates, balance-of-payments levels, the
level of foreign-exchange reserves, macroeconomic data, fiscal and
monetary policies, etc.)
confidence factors
critical events
technical factors (market trends and expectations).
BUSINESS IMPLICATIONS OF EXCHANGE-RATE CHANGES
Exchange-rate fluctuations can affect all areas of a companys operations.
A.
Marketing Decisions
Exchange-rate changes can affect demand for a firms products both at
home and abroad. For instance, the strengthening of a countrys currency
could create price competitiveness problems for exporters; on the other
hand, importers would favor that situation.
B.
Production Decisions
Firms may choose to locate production operations in a country whose
currency is weak because initial investment there is relatively inexpensive; it
could also be a good base for exporting the firms output. Exchange-rate
differentials contribute to this situation across industrialized nations, as well
from industrialized to developing nations.
C.
Financial Decisions
Exchange-rate fluctuations can affect financial decisions in the areas of
sourcing funds (both debt and equity), the timing and the level of the
remittance of funds and the reporting of financial results. (Translation,
transaction and economic exposure will all be considered in Chapter 20.)

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ETHICAL DILEMMA:
Black Market Issues Arent Black and White
On a local black market, one can obtain more local currency in exchange for hard
currency, but relatively less hard currency for local currency. While its always tempting to
trade on the black market, governments have differing ethical and legal attitudes toward
such transactions. If trading on the black market is illegal, the governments objections
will be emphatic, although the law is often unevenly applied. It is easier to eliminate a
black market by letting a countrys currency float freely and thus removing the temptation
to circumvent the law than by police enforcement.
LOOKING TO THE FUTURE:
Changing Times Will Bring Greater Exchange-Rate Flexibility
The trend toward greater flexibility in exchange-rate regimes will surely extend well into
the future. The EURO will continue to strengthen and claim market share from the U.S.
dollar as a prime reserve asset, just as Europes transition economies will progress in their
moves toward floating exchange-rate regimes. Regional trading relationships will also
encourage South American governments to move still closer toward dollarization, or at
least some form of regional monetary union. Likewise, the U.S. dollar should continue to
be the benchmark currency in Asia, because so many countries there (including China) rely
on the U.S. market as an export destination. Although one of the most widely traded
currencies in the world, the Japanese yen remains specific to the Japanese economy.
WEB CONNECTION
Teaching Tip: Visit www.prenhall.com/daniels for additional information and
links relating to the topics presented in Chapter 10. Be sure to refer your students
to the on-line study guide, as well as the Internet exercises for Chapter 10.
_________________________
CLOSING CASE: Pizza Hut and the Brazilian Real [See Figure 10.3]
1.

Do you think it makes sense for Pizza Hut to get out of Brazil, or should it try to
weather the storm and stay in? Justify your position.
Given the strategic role that Brazilian operations are likely to play in Pizza Huts
worldwide strategy, withdrawing from Brazil could have serious long-term
consequences. Nonetheless, while the worst problems associated with Brazils
rampant inflation and currency revaluation appear to be under control, Pizza Hut
must carefully consider the nature of the pizza business in Brazil. Largely made up
of small entrepreneurs, pizzarias typically charge one set price for all the pizza a
customer can eat; toppings are different, and dessert pizzas are popular. Pizza Hut
must determine the extent to which it is willing to modify its image and operations
in order to fit local tastes in Brazil (and elsewhere). Problems related to corporate
expansion and management strategy must also be resolved. Though the Brazilian
economy is still shaky, its ability to weather the Mexican currency crisis in 1994
and the speed with which it recovered from its own currency crisis in 1999 are
reassuring. The size of the potential market, Brazils proven taste for pizza and its
affinity for American products all bode well for Pizza Huts eventual success there
as its gains expertise in effectively managing in the Brazilian context.
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2.

Where does the Brazilian real fit in the exchange-rate regimes in Table 10.1?
What does that imply in terms of how you would predict future values of the real?
Having suffered the inflationary effects of very weak currencies for many years,
maintaining the relative stability of Brazils currency value is critical to controlling
inflation and thus protecting the Brazilian economy. In the early years of the Real
Plan, the real was allowed to move within a 7% band again the U.S. dollar (a
pegged exchange rate with horizontal bands). Each year, the real moved 7%
against the dollar, and a new 7% band was established (an exchange rate with a
crawling band). In January, 1999, keeping the real within its band was costing the
Brazilian government billions of U.S. dollars per day; therefore, the government
decided to let it float. Since that time, the government has intervened to stabilize
the real at its new, lower rate. The Brazilian government has clearly demonstrated
its willingness to intervene in the foreign exchange market when necessary to
support the real.

3.

Discuss whether or not you think the Brazilian government should dollarize its
economy and get rid of the real.
Dollarization could be a powerful tool in Brazils fight against rampant inflationary
pressures; it could also help curtail the speculative pressures on the Brazilian real.
Nonetheless, there is a strong argument against doing so. If Brazil were to
dollarize its economy, or even simply fix the exchange rate between the U.S. dollar
and the real, the Brazilian government would no longer be able set its own
monetary policy to manage its economy. Brazils money supply would have to be
set at the level necessary to maintain the fixed rate between the real and the dollar.
Further, full dollarization would not sit well with Brazilian patriotic and
nationalistic sentiments. Unlike Argentina, whose currency is fixed at parity with
the U.S. dollar, Brazil has resisted pressures to follow suit. Nonetheless, Brazil has
expressed some willingness to consider the idea of a single currency for
MERCOSUR member countries because of the importance of its trade with
Argentina, and its strong links to the economies of Uruguay and Paraguay as well.

4.

What are some of the ways instability in the real might be affecting Pizza Huts
operations in Brazil?
Because of the relatively high price of its product, Pizza Huts success in Brazil
depends upon a growing, increasingly affluent middle class. However, a prolonged
period of economic instability tends to increase the gap between the rich and the
poor and reduce the size of the middle class. Further, consumers are less likely to
spend money on luxury items during times of economic stress, even when they
can afford to do so. An overvalued real makes imported products cheaper and thus
encourages Pizza Hut to export inputs and supplies to its Brazilian operations. On
the other hand, an undervalued real makes local products cheaper and encourages
Pizza Hut to source locally. Thus, currency instability makes it very difficult for
businesses to plan effectively.

Additional Exercises: Exchange-Rate Determination

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Exercise 10.1. A dozen or so years ago, the Canadian and U.S. dollars were close
to par. At the end of June 2003, the Canadian dollar was worth about US $0.7374.
Ask students to discuss the reasons they believe the Canadian dollar has lost so
much ground against its American counterpart. Be sure they raise factors such as
the implementation of the North American Free Trade Agreement and the
separatist movement in Quebec. Then, note the importance of U.S. trade to the
Canadian economy and ask students if they think Canada should consider
Americanizing (pegging) its dollar to its neighbors. Why or why not?
Exercise 10.2. Use the IMF International Financial Statistics to identify countries
that use the SDR as a basis for the value of their currencies and those that use the
EURO. Then engage the students in a discussion as to why certain countries have
chosen to use the SDR while others have chosen the EURO. In what ways are the
SDR and the EURO similar? In what ways are they different?
Exercise 10.3. Historically, the International Monetary Fund has prescribed strict
monetary policies and reduced government spending for developing countries that
sought aid in dealing with currency crises. Ask students to debate the wisdom of
the IMFs approach. Do they believe it was effective? Then ask the students to
suggest ways in which the IMF might change its approach in the future. Be sure
they consider the implications of their suggestions for international businesses.

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