WORKING WITH EXCHANGE RATES: COMMON

DEFINITIONS AND PREDICTIONS

There are some basic definitions in international finance which you

should remember. Additionally, knowing the long-run relationships
between macroeconomic fundamentals and exchange rates help you
predict the direction of the change in exchange rates. Check out these
tips to step up your exchange rate know-how:

Exchange rate as a relative price. The dollar-euro exchange

rate indicates the amount of dollars necessary to purchase one
euro. If the exchange rate is $1.31, it means that you need $1.31
per euro.
Real vs. nominal exchange rates. Nominal exchange rates
imply the relative price of two currencies. As in the case of $1.31
per euro, the only information you get out of nominal exchange
rates is how many of one currency you need to buy one unit of
the other currency. Real exchange rates compare the price of a
consumption basket in one country to that of another country in
the same currency.
Terminology for the changes in exchange rates. If both
currencies in an exchange rate are freely traded in foreign
exchange markets, you refer to changes in this exchange rate as
depreciation or appreciation. If $1.31 changes to $1.35 per euro,
this indicates depreciation of the dollar (appreciation of the euro).
If the Chinese Yuan (CNY)-dollar exchange rate changes from
CNY6.21 to CNY6.15, this shows revaluation of the Chinese
 Yuan, because the value of the yuan with respect to other
currencies is determined by the Chinese government.
Nominal macroeconomic variables and exchange
rates. When it comes to the long-run effects of nominal
macroeconomic variables on exchange rates, remember this:
Higher money supply growth rates, inflation rates, and nominal
interest rates depreciate a currency. While, lower money supply
growth rates, inflation rates, and nominal interest rates
appreciate a currency.
Real macroeconomic variables and exchange rates. In terms
of the long-run effects of real macroeconomic variables on
exchange rates, remember the following: Lower real interest
rates and growth rates depreciate a currency and higher real
interest rates and growth rates appreciate a currency.
BASIC INTERNATIONAL FINANCE EQUATIONS
TO REMEMBER

International finance is a subject based on numbers. And, with that

comes calculations. Calculating the fundamentals of international
finance puts the subject in perspective and gives it a visual component
to help understand how things work. Here are some of the widely-
used equations in international finance:

Inverting exchange rates. If you have the Chine Yuan (CNY)-

dollar exchange rate, but need the dollar-Chinese Yuan
exchange rate, just invert the former. Suppose you have the
 exchange rate as CNY6.22 per dollar. The dollar-Chinese Yuan
exchange rate is:

Calculating cross rates. Suppose the dollar-British pound

(GBP) and the dollar-Canadian Dollar (CAD) exchange rate is
$1.51 and $0.97, respectively. Even if the Canadian dollar-British
pound exchange rate is not listed, you can easily calculate the
Canadian dollar-British pound exchange rate as CAD1.57:

Therefore,

Of course, if you need the British pound-Canadian dollar rate,

take the inverse of CAD1.57:

Calculating real exchange rate (RER). The nominal exchange

rate indicates the relative price of two currencies. The real
exchange rate expresses the relative price of two countries
consumption baskets in the same currency. If the price of the
consumption basket in the U.S. and the Euro-zone is PUS and PE,
respectively, and you have the dollar-euro exchange rate, the
RER becomes:
 By multiplying the exchange rate with the price of the European
consumption basket, you convert the latter into dollar. Therefore,
the dollar price of the European basket divided by the price of
the U.S. basket (expressed in dollars) gives you the real
exchange rate.
If the dollar-Euro exchange, the euro price of the European
basket, and the dollar price of the U.S. basket are $1.31, 135,
and $121, the RER is:

Calculating the percent change in exchange rates. The

percent change formula is a handy tool to calculate the change
in exchange rates (or other variables). If a year ago the dollar-
euro exchange rate was $1.32 and is now $1.31, then the
change in the exchange dollar-euro exchange rate (ER) is 0.76
percent appreciation in the dollar:

Applying the interest rate parity (IRP). This concept relates

the nominal interest rates in home (RH) and foreign country (RF)
to the change in the exchange (), which is referred to as
forward premium or discount:

For smaller differences between two countries interest rates,

you can use the following approximation:
 After calculating , you apply it to the spot rate (S t) to calculate
the IRP-suggested forward rate (FIRP):

If, for example, RH, RF, and St are 1 percent, 1.12 percent, and
$1.32 per euro, the forward discount on euro is 0.12 percent:

In this case, the IRP-suggested forward rate is $1.318 per euro:

Using the purchasing power parity (PPP). The PPP relates

home countrys inflation rate (H) to that of foreign country (F) to
predict the change in the exchange rate (e):

For smaller differences between two countries inflation rates,

you can use the following approximation:

After calculating e, you apply it to the spot rate (St) to calculate

the PPP-suggested expected exchange rate :

If, for example, H, F, and St are 3 percent, 2 percent, and $1.31

per euro, the dollar is expected to depreciate by 0.98 percent
against the euro:
 Given the spot rate of $1.31 per euro, the PPP-suggested
expected exchange rate is $1.323 per euro:

KEY ISSUES ABOUT THE INTERNATIONAL

MONETARY SYSTEM

The international monetary system is a way for people to conduct

business with each other from different parts of the world. The system
covers types of money from different countries and the resulting
exchange rates as well as the characteristics of various exchange rate
regimes. The following points are good to keep in mind to understand
how the international monetary system works:

Exchange rate regimes when money is based on a metallic

standard. If money has an intrinsic value, in other words, if its
value is based on a precious metal, it leads to a fixed exchange
rate system. For most of history, money was based on some
variation of a metallic standard. The last period with such a
standard (called reserve currency standard) ended in 1971. One
of the challenges of a metallic standard is that it doesnt allow
countries to conduct independent monetary policies.
Exchange rate regimes when money is fiat (no metallic
standard). Fiat currency has no intrinsic value and doesnt lead
to a specific exchange rate regime. In this case, countries decide
about their exchange rate regime. When the last metallic
 standard period (or a variation of it) ended in 1971, money in all
countries was fiat money. However, most developed countries
decided for flexible exchange rate regimes where the value of
currencies is decided in foreign exchange markets with minimum
interventions based on the demand for and supply of currencies.
Pegged regimes and their purpose in a fiat currency
system. After 1971, most developing countries adopted a variety
of pegged exchange rate regimes. One of the important factors
that affect the type of the pegged regime is the extent to which
the pegged regime can exercise control over monetary policy.
Hard pegs such as currency board and dollarization dont allow
monetary policy to be used as much as soft pegs do. While hard
pegs are used to signal stability, soft pegs can serve to make
exports or imports cheaper or to attract foreign investors.
Optimum currency area and the Euro. The concept of the
optimum currency area shows that under certain circumstances
it would be more efficient to have a common currency in a
region, consisting of countries with their own currencies. The
term optimumimplies the requirements for an efficiency-
enhancing common currency. Countries in the common-currency
region should experience similar economic shocks and have
labor mobility among them. Despite benefits, a common currency
requires a strong monetary policy coordination as well as fiscal
policy coordination.
Tradeoffs associated with various exchange rate
regimes. All exchange rate regimes have their costs and
benefits, which implies tradeoffs. The table provides a summary
of the costs and benefits associated with various exchange rate
regimes.
Exchange Rate Pro Con
Regimes

Fixed No sudden changes in ER Importing other countries domestic

(commodity No need to forecast future exchange rates economic problems, such as inflation
money) and unemployment
Monetary policy cannot be used as
stabilization policy

Flexible Insulation of countries from other Excessive volatility in exchange rates

(fiat money) countries economic problems, such as
inflation and unemployment
Ability to conduct monetary policy

Pegged Stability provided by a nominal anchor Efficiency cost of keeping prices of

(fiat money) Aiding economic development through exports or imports low
adjusting the price of exports or imports Prone to speculative attack; hot money
as well as attracting portfolio flows leaving the country fast if investors
doubt the credibility of the peg