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Chapter 10
Exchange
Rates and
Exchange
Rate Systems
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
Chapter Objectives
• Define exchange rate
• Understand the relationship between domestic
and foreign exchange rates
• Examine the many possible exchange rate
systems a country can adopt
• Understand the interaction of an exchange rate
system, government policy, and the world
economy
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Introduction
• Economists tend to disagree on issues related to exchange rates
and exchange rate systems more than on the issues examined
thus far
• Countries have numerous choices among exchange rate systems
on a continuum from fixed to completely flexible systems
• Each type of exchange rate system requires a different set of
policies and responds differently to the pressures of the world
economy
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Exchange Rates and Currency
Trading
• Exchange rate: the price of a currency stated in
terms of another currency
– U.S. dollars per Mexican peso = 0.10 dollars
– Mexican pesos per U.S. dollar = 10 pesos
– Exchange rates are reported on a daily basis in the
financial pages of major newspapers and in
numerous Web sites
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Exchange Rates and Currency
Trading (cont.)
• Appreciation of a currency: the currency’s
becoming more valuable (or able to buy more
units of another currency)
• Depreciation of a currency: the currency’s
becoming less valuable in relation to another
currency
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TABLE 10.1 Exchange Rates for
Selected Countries, September 1, 2006
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3 Reasons for Holding Foreign
Currency
1. Trade and investment purposes
2. Interest rate arbitrage: taking advantage of interest
rate differentials between countries; arbitrageurs buy
money where interest rates are low and sell it where
interest rates are high
3. Speculation: buying and selling of currency in
anticipation of changes in the currency’s exchange
rate; speculators sell overvalued currencies and buy
undervalued currencies
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Institutions
• Four main actors involved in foreign currency markets
– Retail customers: firms and individuals that hold foreign
currency in order to trade, engage in arbitrage, or speculate
– Commercial banks: hold inventories of foreign currencies as
part the services to customer
– Foreign exchange brokers: middlemen between buyers
(banks) and sellers of foreign currency
– Central banks: a country’s bank of banks
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Exchange Rate Risk
• Exchange rate risk stems from the fact that
currencies are constantly changing in value
– Expected future payments in a foreign currency will
likely be a different domestic currency amount from
when the contract was signed
– Firms that do business in more than one country are
thus subject to exchange rate risk
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Two Ways to Deal
with Exchange Rate Risk
• Forward exchange rate: the price of currency that will
be delivered in the future; allows an exporter or
importer to sign a currency contract that guarantees a
set price for the foreign currency in either 30, 90, or
180 days into the future
• Forward market: market in which the buying and
selling of currencies for future delivery takes place;
important mechanism for exporters, importers, financial
investors, and speculators
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Dealing with Exchange Rate Risk
• Hedging: an interest rate arbitrageur’s insuring against
exchange rate risk through buying a forward contract to
sell foreign currency at the same time that the bonds or
other financial assets owned by the arbitrageur mature
– Covered interest arbitrage: use of forward market by an
interest rate arbitrageur against exchange rate risk
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Foreign Exchange:
Supply and Demand
• A currency’s value is determined by its supply and
demand, regardless of which exchange rate system is
adopted
– Under a flexible exchange rate system, an increase in the
demand for the dollar will cause it to appreciate, while an
increase in the supply of the dollar will cause it to depreciate
– Under a fixed exchange rate system, the central bank
counteracts the demand and supply forces of the dollar,
holding its value constant
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FIGURE 10.1 The Demand Curve
for Foreign Exchange
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FIGURE 10.2 The Supply of
Foreign Exchange
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FIGURE 10.3 Supply and Demand in
the Foreign Exchange Market
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FIGURE 10.4 An Increase
in Demand for British Pounds
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FIGURE 10.5 An Increase
in the Supply of British Pounds
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TABLE 10.2 A Hypothetical Example
of the Exchange Rate in the Long Run
• Purchasing power parity: the equilibrium value of an
exchange rate is at the level that allows a given amount
of money to buy the same quantity of goods abroad as
it will buy at home
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Exchange Rates: Medium Run
• Medium run forces affecting exchange rate
– The country’s economic growth: produces an
increase in imports and an outward shift in the
demand for foreign currency
– Growth abroad: results in an increase of exports
from the home country and an increase in the supply
of foreign currency
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Exchange Rates: Short Run
• Short run (a year or less) effects on the exchange
rate stem from financial capital flows
• These flows are determined by (1) interest rates
and (2) expectations of future exchange rates
• Let’s analyze these forces more closely…
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Short-Run Forces 1: Interest Rates
• Interest parity: the difference between any two
countries’ interest rates is equal to the expected
change in the exchange rate
– If i = i*, investors are indifferent
– If i > i*, investors prefer home to foreign
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Short-Run Forces 2:
Expectations of Future Rates
• The difference between forward exchange rate and spot
rate reflects the expected appreciation or depreciation
of the home currency
– F > R: home currency expected to depreciate, and home
interest rates must exceed foreign rates by an equivalent
percentage
– However, say, i < i* and F = R: no changes are expected in
the exchange rate, and investors should invest in foreign
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FIGURE 10.6 The Effects of an
Increase in Home’s Interest Rate
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TABLE 10.5 Major Determinants
of an Appreciation or Depreciation
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Real Exchange Rate
• Foreign prices ultimately determine the purchasing
power of the domestic currency in terms of the foreign
currency
– Real exchange rate: the market exchange rate (nominal
exchange rate) adjusted for price differences between
countries
– Real exchange rate = [(nominal exchange rate)
 (foreign prices)] / (domestic prices) = Rr = Rn(P*/ P)
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Alternatives to Flexible
Exchange Rates
• Fixed system: the value of a nation’s money is defined in terms
of a fixed amount of a commodity (e.g., gold) or of another
currency (e.g., U.S. dollar)
• Flexible (floating) system: the value of the currency is allowed
to float up and down with market forces
• Bretton Woods exchange rate system: a type of gold standard
in 1947–1971: U.S. dollar and British Pound were fixed to each
other and to gold
• Purely fixed or floating systems are today rare
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FIGURE 10.7 Fixed Exchange
Rates and Changes in Demand
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FIGURE 10.8 Selling Reserves of
Pounds to Counter a Weakening Dollar
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Pegged System
• Pegged exchange rate system: one currency is
anchored to another currency instead of gold
• Crawling peg: fixed (pegged) exchange rates
that are periodically adjusted
– Allows for dealing with real depreciations or
appreciations better than a pegged system
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Single Currency Areas
• In 1999, 11 of 15 European Union (EU) members
adopted a common currency, the euro, which began
circulating in 2002
• 4 reasons for countries to adopt common currency
–
–
–
–
Reduces currency conversions and transaction costs
Eliminates of price fluctuations
Increases in inter-state political trust
Provides exchange rate greater credibility
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Single Currency Areas (cont.)
• Optimal currency area: Robert Mundell’s criteria to
determine whether two or more countries would be
better off by sharing a currency
• For common currency to be viable, countries must
share
–
–
–
–
synchronized business cycles
high degree of labor and capital mobility
regional policies to deal with economic imbalances
an integration effort that goes beyond mere free trade
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TABLE 10.3 Composition of
World Currency Trades, April 2004
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TABLE 10.4 Currency Trading
Centers
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TABLE 10.6 Inflation in Argentina,
1985-1994
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