I BUS 300 Chapter Foreign Exchange Rate

Gold Standard

The practice of pegging currencies to gold and guaranteeing convertibility

Gold Par Value

The amount of currency needed to purchase one ounce of gold

Balance of Trade Equilibrium

Reached when the income a nation’s resident can earn from exports = money paid for imports

Key Strength of Gold Standard

Simultaneously allowing all countries to achieve balance-of-trade equilibrium

Bretton Wood

• US dollar was the world currency and all other currency was pegged to the dollar, the dollar was pegged to gold

• adopted during the creation of the IMF and World bank, ended around 1970s due to high inflation in America and their macroeconomic policy

Floating Exchange Rate System

• a system under which the exchange rate for converting one currency into another is continuously adjusted depending on the laws of supply and demand

• Currency’s value is determined by market forces without intervention

Determinants of Exchange Rates

• Inflation

• Supply of the currency

• Confidence

Hard Currencies

• Currencies that are freely tradable, or convertible

• Typically belong to countries with strong economies, low inflation, and trusted financial institutions

• Tend to maintain value

Soft Currencies

• Currencies that are not freely tradable (gov. restrictions)

• often belong to countries with economic instability, inflation issues, or limited global demand for their currency

• often lose value

Fixed Exchange Rate

• Currency is pegged to another currency or a basket of currencies

• central bank intervenes to maintain fixed rate

Managed Float (Dirty float)

a mix of fixed and floating where currency is mostly market driven, central bank intervenes occasionally to stabilize fluctuations

Pegged exchange rate

exchange rate is adjusted periodically at a predetermined rate or responds to market conditions in a controlled manner

Currency Board

Monetary policy is directly tied to maintain the peg

Dollarization

A country uses another nation’s currency instead of issuing its own

Why must Inflation be Controlled

Increase money supply too much, can lead to inflation

• devalues currency

• reduce purchasing power

• imports more expensive

Interest rates

• central banks adjust money supply through monetary policy

• lower money supply = high interest rates

  • attracts foreign investors due to high return

  • strengthens currency

• larger money supply = low interest rates

  • excess currency in circulation

  • deflates value

Rule of Thumb regarding money supply

• aggregate value of the money supply should reflect the value of national economy

Trade Surplus leads to:

• more money coming into country than leaving it, which pushes money supply up

Trade Deficit leads to

• More money leaving country than entering: which pushes money supply down

Strong Dollar helps:

• importers + consumers

• US firms with offshore outsourcing

Weak Dollar helps:

• Domestic manufactures competing against importers

• MNE returning income from abroad (another currency is stronger = more of the dollar during exchange)

• US companies exporting abroad (cheaper prices compared to everyone else)

Forward Contracts

Lock in exchange rate for a future date, reducing uncertainty

How can firms protect themselves against exchange rate uncertainty

• diversification of markets, currency supply, suppliers of raw materials, and production

• outsourcing manufacturing

• Using a strong currency in contracts

Carry Trade

a kind of speculation that involves borrowing in one currency where interest rates are low and then using proceeds to invest in another currency where interest rates are high

Spot exchange

the foreign exchange rate at which a foreign exchange dealer will convert one currency into another that particular day