Exchange Rate Systems

The basis for international finance is the exchange of well over 100 national currencies. An exchange rate is the price of a countrys currency in terms of another currency.

Country UNITED States AUSTRALIA

Currency Dollar Dollar

ISO USD AUD GBP PHP BRL CAD CNY EUR JPY KRW

09/22/11

09/23/11

1.000000 1.000000 1.012328 1.025768 0.649978 0.647910 43.80771 43.62039 1.850565 1.881093 1.023295 1.030815 6.389029 6.387310

UNITED KINGDOM Pound PHILIPPINES

Peso Real Dollar Yuan

BRAZIL CANADA CHINA

EUROPEAN UNION Euro

0.742974 0.743676 76.45458 1175.44 76.32419 1169.73

JAPAN KOREA (SOUTH)

Yen Won

Exchange Rates 25 September 2011

Country US Japan UK Hong Kong Singapore Bahrain Saudi Arabia South Korea China Taiwan Unit Dollar Yen Pound Dollar Dollar Dinar Riyal Won Yuan Nt Dollar Peso Equivalent 43.725 0.573 67.149 5.605 33.468 115.979 11.658 0.0371 6.844 1.438

Exchange Rates
Flexible Exchange Rates A. Freely floating exchange rates are determined by the forces of demand and supply. 1. The demand curve for any currency is downsloping because as the currency becomes less expensive, people will be able to buy more of that nations goods and, therefore, want larger quantities of the currency. 2. The supply curve for any currency is upsloping because as its price rises, holders of that currency can obtain other currencies more cheaply and will want to buy more imported goods and, therefore, will give up more of their currency to obtain other currencies.

As with other commodities, the intersection of the supply and demand curves for a currency will determine the price or exchange rate. In the example it is Php 43 to $1. B. Depreciation means the value of a currency has fallen; it takes more units of that countrys currency to buy another countrys currency. Php 50 for $1 would be a depreciation of the peso, compared to the original example of 43Php per $1. C. Appreciation means the value of a currency or its purchasing power has risen; it takes less of that currency to buy another countrys currency. Php40 = $1 would be an appreciation of the peso relative to the dollar.

THE MARKET FOR CURRENCY

P Dollar price of one pound EXCHANGE RATE: $2 = 1
3

Dollar depreciates Dollar appreciates

D
Quantity of pounds

Determinants of exchange rates are the forces that cause the demand or supply curves to shift. Three Generalizations: If the demand for a nations currency increases, that currency will appreciate; if the demand declines, that currency will depreciate. If the supply of the nations currency increases that currency will depreciate; if the supply decreases, that currency will appreciate. If a nations currency appreciates, some foreign currency depreciates relative to it.

Determinants of Exchange Rates

1. Changes in tastes or preferences for a countrys products would shift the demand for the currency. Ex. Japanese electronic equipment declines in popularity in the U.S. (Japanese yen depreciates and U.S. dollar appreciates) European tourists reduce visits to the U.S. (U.S. dollar depreciates; Euro appreciates)

2. Relative income changes will cause changes in the demand and supply of currencies. Rising incomes increase the demand for imports, which increases the supply of that countrys currency and the demand for other countrys currencies. Ex. England encounters a recession, reducing its imports, while U.S. real output and real income surge, increasing U.S. imports (British pound appreciates; U.S. dollar depreciates).

3. Relative price changes will cause changes in the demand and supply of currencies. If Philippine prices rise relative to U.S. prices, this will increase the demand for U.S. goods and dollars; conversely, it will reduce the supply of dollars as U.S. purchase fewer Phillipine goods. The theory of purchasing power parity asserts that exchange rates will change to maintain a uniform price in one currency, e.g., dollars, for each product across countries. Ex. Taiwan experiences a 3% inflation rate compared to Philippines 10% rate. Taiwan dollar appreciates; Phil. Peso depreciates.

Purchasing-power-parity theory a theory in international exchange that holds that exchange rates are set so that the price of similar goods in different countries is the same.
A high inflation rate in one country relative to another puts pressure on the exchange rate between two countries, and there is a general tendency for the currencies of relative highinflation countries to depreciate. The high inflation countries would depreciate their currencies so as to discourage people from importing. This would somehow offset the relatively expensive domestic products.

Big Mac Index

Instead of using a market basket of goods and services, The Economist magazine used a lighthearted test of the purchasing-power-parity theory through its Big Mac index. It uses the exchange rates of 100 countries to convert the domestic currency price of a Big Mac into U.S. dollar prices Ex. If Britain exceeds the dollar price in the U.S. the pound is over valued relative to the dollar. If the adjusted dollar price of Big Mac in Britain is less than the dollar price in the U.S. then the pound is undervalued relative to the dollar.

4. Changes in relative real interest rates will affect the demand and supply of currencies. Higher U.S. interest rates attract foreign savings; hence, they raise the demand for dollars and reduce the supply of dollars as U.S. investment dollars may remain in this country. Ex. The Federal Reserve drives up interest rates in the U.S. while Bank of England takes no such action. ( U.S. dollar appreciates; British pound depreciates)

5. Speculation is another determinant. If one believes the value of a currency is about to fall, it will increase the supply of that currency and reduce its demand. Likewise, if one believes the value of a currency is about to rise, it will increase its demand and reduce its supply as people want to hold that currency. Ex. Currency traders believe South Korea will have much greater inflation than Taiwan (South Korean won depreciates; Taiwan dollar appreciates).

Monthly Average Exchange Rate

Month Average December November October September August July June May April March February January 48.161 48.146 47.905 47.524 48.217 48.458 47.585 47.207 48.094 49.186 48.025 46.692 44.877 44.956 44.281 42.902 41.820 41.252 40.671 40.938 2009 2008 2007 46.148 41.743 43.218 44.380 46.131 46.074 45.625 46.160 46.814 47.822 48.517 48.381 48.914 2006 51.314 49.467 49.843 50.004 50.401 51.362 52.398 53.157 52.127 51.360 51.219 51.817 52.617 2005 55.085 53.612 54.561 55.708 56.156 55.952 56.006 55.179 54.341 54.492 54.440 54.813 55.766

Flexible Rates and the Balance of Payments

Theoretically, flexible rates have the virtue of automatically correcting any imbalance in the balance of payments. If there is a deficit in the balance of payments, this means that there will be a surplus of that currency and its value will depreciate. As depreciation occurs, prices for goods and services from that country become more attractive and the demand for them will rise. At the same time, imports become more costly as it takes more currency to buy foreign goods and services. With rising exports and falling imports, the deficit is eventually corrected.

There are some disadvantages to flexible exchange rates. 1. Uncertainty and diminished trade may result if traders cannot count on future prices of exchange rates, which affect the value of their planned transactions. 2. Terms of trade may be worsened by a decline in the value of a nations currency. 3. Unstable exchange rates can destabilize a nations economy. This is especially true for nations whose exports and imports are a substantial part of their GDPs.

Fixed Exchange Rates

Fixed exchange rates are those that are pegged to some set value, such as gold or the U.S. dollar. A. Official reserves are used to correct an imbalance in the balance of payments, since exchange rates cannot fluctuate to bring about automatic balance. This is called currency intervention. B. Trade policies directly controlling the amount of trade and finance might be used to avoid imbalance in trade and payments.

C. Exchange controls and the rationing of currency have been used in the past but are objectionable for several reasons. 1. Controls distort efficient patterns of trade. (this policy would restrict the value of Phil. Import to the amount of foreign exchange earned by Phil. Export) 2. Rationing involves favoritism among importers.

3.

Rationing reduces freedom of consumer choice.

4. Enforcement problems are likely as black market rates develop.

Domestic macroeconomic adjustments may be more difficult under fixed rates. For example, a persistent deficit of trade may call for tight monetary and fiscal policies to reduce prices, which raises exports and reduces imports. Such contractionary policies can also cause recessions and unemployment, however.