Exchange Rates

Dr. Antony MuellerDr. Antony Mueller

The Continental Economics InstituteThe Continental Economics Institutewww.continentaleconomics.comwww.continentaleconomics.com

Types of exchange rates

Exchange rate is the price of one currency Exchange rate is the price of one currency in terms of another currencyin terms of another currency

$/Peso or Peso/$$/Peso or Peso/$ Exchange rate (e) usually as Peso/$, so a Exchange rate (e) usually as Peso/$, so a

higher quotations means depreciationhigher quotations means depreciation Exchange rates also exist between goods Exchange rates also exist between goods

and their pricesand their prices

Exchange rate as a price relation

X beer/1 pack of cigarettesX beer/1 pack of cigarettes Price relations are the inverse of the exchange Price relations are the inverse of the exchange

relationrelation 3 beer/1pack of cigarettes means that cigarettes 3 beer/1pack of cigarettes means that cigarettes

cost three times more than one beercost three times more than one beer One can also say: 3 beer exchange for 1 pack of One can also say: 3 beer exchange for 1 pack of

cigarettes in a bartercigarettes in a barter Thus exchange rates are prices and are linked to Thus exchange rates are prices and are linked to

the exchange ratios of goodsthe exchange ratios of goods

Fixed and floating exchange rates

Fixed exchange rate needs a “fixer”, usually Fixed exchange rate needs a “fixer”, usually the country’s central bank or ministry of the country’s central bank or ministry of financefinance

When you fix price, you cannot control When you fix price, you cannot control quantityquantity

Therefore, authorities must intervene in the Therefore, authorities must intervene in the free market by buying and sellingfree market by buying and selling

Price Fixing

When currency tends to depreciate, country When currency tends to depreciate, country must buy own currency with foreign must buy own currency with foreign exchangeexchange

The intervention is limited by the foreign The intervention is limited by the foreign exchange reserves stockexchange reserves stock

If the currency tends to appreciate, If the currency tends to appreciate, authorities must buy foreign currency which authorities must buy foreign currency which they can do without limitthey can do without limit

Limits to Price Fixing

When authorities buy foreign exchange, When authorities buy foreign exchange, they increase domestic money supply, they increase domestic money supply, “imported inflation”“imported inflation”

The other limit is the stock of reserves The other limit is the stock of reserves when currency tends to depreciatewhen currency tends to depreciate

Most currencies nowadays are “flexible” or Most currencies nowadays are “flexible” or rather they are under “managed floating”rather they are under “managed floating”

Currency Arrangements

Fixing one monetary unit to another or a basket of Fixing one monetary unit to another or a basket of other monies under some ruleother monies under some rule

Gold standard: unit of domestic currency defined Gold standard: unit of domestic currency defined in goldin gold

Dollar standard: unit of domestic currency defined Dollar standard: unit of domestic currency defined in dollarin dollar

Basket: unit of local currency defined in a basket Basket: unit of local currency defined in a basket of other currency, e.g. x dollars + x euros of other currency, e.g. x dollars + x euros

Two basic types of currency arrangements Symmetric and asymmetricSymmetric and asymmetric Symmetrical arrangements: authorities of Symmetrical arrangements: authorities of

both countries have to interveneboth countries have to intervene Asymmetrical: one country fixes and must Asymmetrical: one country fixes and must

solely intervenesolely intervene Bretton Woods system: asymmetricalBretton Woods system: asymmetrical EMS: symmetricalEMS: symmetrical

Determinants of exchange rates

Supply and demandSupply and demand Supply and demand depend on current Supply and demand depend on current

needs, yields, and profit expectationsneeds, yields, and profit expectations Current needs: import and export of goods Current needs: import and export of goods

and services, interest paymentsand services, interest payments Yield: currency investmentYield: currency investment Profit expectations: speculationProfit expectations: speculation

Purchasing Power Parity (PPP)

One basket of goods in one country must One basket of goods in one country must cost the same in the other country, the cost the same in the other country, the exchange rate equalizes the pricesexchange rate equalizes the prices

Problems: tradable and non-tradable, Problems: tradable and non-tradable, international capital movements, interest international capital movements, interest payments, expectations, political risk, payments, expectations, political risk, intervention, restrictionsintervention, restrictions

Big Mac Indicator (The Economist)Big Mac Indicator (The Economist)

Efficiency and inefficiencies of international currency markets Any buyer needs a sellerAny buyer needs a seller Perfect or imperfect informationPerfect or imperfect information Prices are always past pricesPrices are always past prices Random walk (similar to stock market prices)Random walk (similar to stock market prices) Money, trade, politics, intervention, expectations Money, trade, politics, intervention, expectations

etc. make it impossible to prognosticate exactly – etc. make it impossible to prognosticate exactly – like with any other market: trend-following, like with any other market: trend-following, herding, speculative excessesherding, speculative excesses