Download The Determination of Exchange Rate

International
Business
Environments & Operations
15e
Daniels
●
Radebaugh
●
Copyright © 2015 Pearson Education, Inc.
Sullivan
9-1
Chapter 9
The Determination of
Exchange Rates
Copyright © 2015 Pearson Education, Inc.
9-2
Learning Objectives






Describe the International Monetary Fund and its
role in the determination of exchange rates
Discuss the major exchange-rate arrangements
that countries use
Explain the European Monetary System and how
the euro became the currency of the euro zone
Identify the major determinants of exchange
rates
Show how managers try to forecast exchangerate movements
Explain how exchange-rate movements influence
business decisions
Copyright © 2015 Pearson Education, Inc.
9-3
The International Monetary Fund-1



IMF is a multinational institution established in
1945 as part of the Bretton Woods Agreement to
maintain order in the international monetary
system. 187 members as of 2012.
Bank of International Settlements (BIS) does the
exchange rate settlements
The Bretton Woods Agreement


established a par value, or benchmark value, for each
currency initially quoted in terms of gold and the U.S.
dollar
The dollar became the world benchmark for trading
currencies and continues in that role today
Copyright © 2015 Pearson Education, Inc.
9-4
Goals of IMF

The goals of the International Monetary
Fund (IMF) are to




ensure stability in the international monetary
system
promote international monetary cooperation
and exchange-rate stability
facilitate the balanced growth of international
trade
provide resources to help members in balanceof-payments difficulties or to assist with
poverty reduction
Copyright © 2015 Pearson Education, Inc.
9-5
The IMF Today




IMF Quota: the sum of the total assessments levied on member countries
to form the pool of money (about $1 trillion) from which the IMF draws to
make loans to member nations. National quotas are based upon countries’
GDP, 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. Now, 24 executive
board members run IMF.
Special Drawing Rights (SDR), an artificial international reserve asset
created in 1969 to supplement IMF members’ existing reserves of gold and
foreign exchange. The value of the SDR is based upon the weighted
average of a basket of four currencies (2010): U.S. dollar-42%, Euro37%, Japanese yen-9%, British pound-11%.
IMF constantly monitors global economy through internal surveillance,
policy suggestions are mandated accordingly. IMF lends money to ease
balance-of-payments difficulties.
Copyright © 2015 Pearson Education, Inc.
9-6
Global Financial Crisis and the IMF
Asian Financial Crisis-late 1990s
 The global crisis in 2008-2009 raised
concerns over global liquidity



prompted the G20 to inject huge amounts of
cash into the IMF
Greece’s 2010-2011 financial crisis
required assistance from the IMF and the
EU

the IMF required Greece to adopt very
unpopular austerity measures
Copyright © 2015 Pearson Education, Inc.
9-7
Exchange Rate Arrangements-1


The Smithsonian Agreement
 8% devaluation of the dollar
 revaluation of other currencies
 widening of exchange rate flexibility
The Jamaica Agreement
 provided greater exchange rate flexibility
 eliminated the use of par values
 Under the Jamaica Agreement countries
selected and maintained their own exchange
rate arrangements
Copyright © 2015 Pearson Education, Inc.
9-8
Exchange Rate Arrangements-2

Refers to the monetary system/discipline that
determines the value of a currency is in
international markets. Usually, weaker currencies
are tied to stronger currencies. Each country
declares in advance as to what it will during the
year. Current system includes:


Independently floating (about 40 countries)
Pegged arrangement: hard, soft and free-float




Various forms of pegs possible, single currency, composite
Par value, band issue
Bipolar/Tripolar monetary system?-USD,
Eurozone and Yen
Renminbi continues to be pegged with US Dollar
9
Exchange Rate Arrangements-3
Exchange Rate Arrangements and Anchors
Copyright © 2015 Pearson Education, Inc.
9-10
IMF Financial Discipline


The IMF manages global exchange rate discipline
through currency pegging.
Hard peg




Soft peg



value is locked into something and does not change
dollarization
currency boards
more flexible than hard peg
Chinese Yuan is an example
Floating


floating or free floating
change according to market forces
Copyright © 2015 Pearson Education, Inc.
9-11
Factors Determining the
Value of a Currency


Currency is like a commodity and the laws of
demand and supply will hold
A complex set of factors/variables simultaneously
(thus a dynamic view) influence the value of the
currency. They are:
1. BOP statistics (trade and reserve)
2. Interest rate differentials
3. Inflation differentials
4. Fiscal and monetary policy
5. Business cycles
6. Political events
7. Psychological (confidence) factors
12
Determining Exchange Rates
The Equilibrium Exchange Rate and How it Moves
Copyright © 2015 Pearson Education, Inc.
9-13
Balance of Payments Account
(BOP)
All Subheads of the of the Balance of
Payments (BOP) must be considered to
understand the influence
A. Current Account
Gold, Silver, and Precious Metals
Foreign Currency
Special Drawing Rights (SDR)
Merchandise Trade
Services
Unilateral Transfer
B. Capital Account
Portfolio Investment
Direct Investment
Short term loans
C. International Reserve
D. Net Statistical
Discrepancy
Equation: A+B = C+D
BOP Account must balance
Copyright © 2015 Pearson Education, Inc.
9-14
Interest Rate Differential

Government affects Money Supply through



Interest rate
Open market operations-buying and selling of
government bonds
Reserve ratio (for deposits in banks)
The DIFFERENTIAL of the interest rates
between two countries (or more) will
determine the exchange rate
 Also, consider money as an asset. People
tend to keep assets in stronger currencies.

15
Inflation Differential
Inflation is given by the price index. It
reduces the value of a currency
 Generally, forward rate of a currency is
determined by discounting a currency with
the prevailing inflation rate
 Again, DIFFERENTIAL between two (or
more) countries is important

16
Fiscal and Monetary Policy

Fiscal Policy-policy of the government
regarding REVENUE and EXPENDITURE

Surplus/Deficit = Revenue - Expenditure
Monetary Policy-policy of the government
regarding Money Supply (see earlier
slides)
 Budget Deficit, Trade Deficit, and
Government Debt matters-FX market
respects responsible governments

17
Business Cycle, Political Events and
Psychological Factors





U.S. business cycle: 5-7 years of high and 3-5
years of low
A currency is more demanded when an economy
is on a rising curve (and vice versa)
Business Cycle and Politics-what is the
relationship?
Political instability negatively affects a currency
Confidence and faith in the currency is importantdespite a huge budget deficit, trade deficit and
debt the mighty U.S. Dollar prevails-do you know
why?
18
Foreign Exchange
Convertibility and Controls

Hard currencies


Soft currencies


U.S. dollar, euro, British pound, Japanese yen
developing countries
Countries can control convertibility
through




licenses
multiple exchange rate systems
advance import deposits
quantity controls
Copyright © 2015 Pearson Education, Inc.
9-19
Exchange Rates and
Purchasing Power Parity

Purchasing power parity (PPP)

a change in relative inflation between two
countries must cause a change in exchange
rates to keep the prices of goods in the
countries fairly similar
The Big Mac Index
 A black market closely approximates a
price based on supply and demand for a
currency instead of a government
controlled price

Copyright © 2015 Pearson Education, Inc.
9-20
Business Implications of
Exchange Rate Changes

Marketing Decisions


Production Decisions


when the value of a country’s currency rises, exporting
becomes more difficult as the product becomes more
expensive in foreign markets
might locate production in a weak currency country
because the initial investment is cheap and it will make
a good base for exports
Financial Decisions

currency rates influence sourcing, cross-border
remittance of funds, and the reporting of financial
results
Copyright © 2015 Pearson Education, Inc.
9-21
The Future: The Dollar, The
Euro, The Yen, The Yuan

Europe


Asia


the euro should take market share away from
the dollar as the prime reserve asset assuming
the problems in Greece and other countries are
controlled
China is moving forward to establish the yuan
as a major world currency
Latin America

emerging market currencies should strengthen
as commodity prices recover
Copyright © 2015 Pearson Education, Inc.
9-22
Chapter 9: Discussion Questions
1.
2.
3.
4.
5.
Discuss the role of IMF in a global economy.
What is IMF? What are their goals? How does it
manage global monetary stability?
What is a peg rate system? Explain the current
global pegging exchange rate arrangement.
What is convertibility of a currency? How
governments intervene FX, and why? Explain.
How do we determine the value of a currency?
Explain the factors that determine the value of a
currency. I may ask you to explain one or more
specific factors.
23
All rights reserved. No part of this publication may be reproduced, stored in
a retrieval system, or transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording, or otherwise, without the prior written
permission of the publisher. Printed in the United States of America.
Copyright © 2015 Pearson Education, Inc.
9-24