7. Dealing with Foreign Exchange
§1. What Determines Foreign Exchange Rates?
A foreign exchange rate is the price of one currency, such as the dollar, in terms
of another, such as the euro. An appreciation is an increase I the value of the
currency, and a depreciation is a loss in the value of the currency.
Some countries are famously expensive, and others are known to have cheap
prices. How do these price differences affect exchange rates? The answer lies in
the theory of purchasing power parity (PPP), which is essentially the “law of one
price”. It suggests that in the absence of trade barriers, the price for identical
products sold in different countries must be the same. In the long run, exchange
rates should move toward levels that would equalize the prices of an identical
basket of goods in any two countries.
In the short run, variations in interest rates have a powerful effect. If one
country’s interest rate is high relative to other countries, then the country will
attract foreign funds. Because inflows of foreign funds usually must be converted
to the home currency, a high interest rate will increase the demand for the home
currency, thus enhancing its exchange value. The exchange rate is very sensitive
to changes in monetary policy. It responds swiftly to changes in money supply.
The rise of a country’s productivity, relative to that of other countries, will
improve its competitive position. Leading to more attraction of foreign direct
investment (FDIs) in the country, fueling demand for its home currency.
Balance of payments (BOP) – officially known as a country’s international
transaction statement, which includes merchandise trade, service trade, and
capital movement. Technically, the current account balance consists of exports –
imports of merchandise and services + income on a country’s assets abroad –
payments on foreign assets in the focal country + government transfers and
private remittances. A current account deficit has to be financed by financial
account – consisting of purchases and sales of assets. This is because a country
needs to balance its accounts in much the same way a family deals with its
finances.
Long story short, a country experiencing a current account surplus will see its
currency appreciate. Conversely, a country experiencing a current account deficit
will see its currency depreciate.
There are two major exchange rate policies:
- Floating (or flexible)exchange rate policy a government policy to let
supply-and-demand conditions determine exchange rates via the foreign
market.
o Clean (or free) float a pure market solution to determine
exchange rates. (few countries adopt this)
o Dirty (or managed) float using selective government intervention
to determine exchange rates. (most countries adopt this)
- Target exchange rates known as crawling bands – intervention will only
occur when the snake craws out of a tube’s upper or lower bounds.
- Fixed exchange rate policy a government policy to set the exchange
rate of a currency relative to other currencies.
Many developing countries peg their currencies to a key currency.
o Peg stabilizes the import and export prices for developing countries.
o Many countries with high inflation have pegged their currencies to
the dollar in order to restrain domestic inflation.
§1. What Determines Foreign Exchange Rates?
A foreign exchange rate is the price of one currency, such as the dollar, in terms
of another, such as the euro. An appreciation is an increase I the value of the
currency, and a depreciation is a loss in the value of the currency.
Some countries are famously expensive, and others are known to have cheap
prices. How do these price differences affect exchange rates? The answer lies in
the theory of purchasing power parity (PPP), which is essentially the “law of one
price”. It suggests that in the absence of trade barriers, the price for identical
products sold in different countries must be the same. In the long run, exchange
rates should move toward levels that would equalize the prices of an identical
basket of goods in any two countries.
In the short run, variations in interest rates have a powerful effect. If one
country’s interest rate is high relative to other countries, then the country will
attract foreign funds. Because inflows of foreign funds usually must be converted
to the home currency, a high interest rate will increase the demand for the home
currency, thus enhancing its exchange value. The exchange rate is very sensitive
to changes in monetary policy. It responds swiftly to changes in money supply.
The rise of a country’s productivity, relative to that of other countries, will
improve its competitive position. Leading to more attraction of foreign direct
investment (FDIs) in the country, fueling demand for its home currency.
Balance of payments (BOP) – officially known as a country’s international
transaction statement, which includes merchandise trade, service trade, and
capital movement. Technically, the current account balance consists of exports –
imports of merchandise and services + income on a country’s assets abroad –
payments on foreign assets in the focal country + government transfers and
private remittances. A current account deficit has to be financed by financial
account – consisting of purchases and sales of assets. This is because a country
needs to balance its accounts in much the same way a family deals with its
finances.
Long story short, a country experiencing a current account surplus will see its
currency appreciate. Conversely, a country experiencing a current account deficit
will see its currency depreciate.
There are two major exchange rate policies:
- Floating (or flexible)exchange rate policy a government policy to let
supply-and-demand conditions determine exchange rates via the foreign
market.
o Clean (or free) float a pure market solution to determine
exchange rates. (few countries adopt this)
o Dirty (or managed) float using selective government intervention
to determine exchange rates. (most countries adopt this)
- Target exchange rates known as crawling bands – intervention will only
occur when the snake craws out of a tube’s upper or lower bounds.
- Fixed exchange rate policy a government policy to set the exchange
rate of a currency relative to other currencies.
Many developing countries peg their currencies to a key currency.
o Peg stabilizes the import and export prices for developing countries.
o Many countries with high inflation have pegged their currencies to
the dollar in order to restrain domestic inflation.
