Exchange Rate Notes

EXCHANGE RATE

  • Definition: The amount of domestic currency needed to purchase foreign currency.
    • Example: At an exchange rate of 87:1 between the US and Jamaica in 2010, 87 Jamaican Dollars are needed to buy 1 US Dollar.
    • January & February 2015 average rates: 115.32 and 115.7 respectively.

MAJOR TYPES OF CURRENCIES

  • United States: $US
  • Pound Sterling: £
  • Euro Dollar: €
  • Canadian Dollar: $

TYPES OF EXCHANGE RATE SYSTEM

  1. Floating Exchange Rate:
    • Determined by market forces (demand & supply).
  2. Managed Exchange Rate System:
    • Also known as "dirty float”, where government intervenes to influence the direction of the float by buying/selling currencies.
  3. Fixed Exchange Rate System:
    • Currency value is maintained constant against one another (e.g., a nation’s currency value can be pegged to gold or another currency).

NOMINAL EXCHANGE RATE

  • The official exchange rate quoted by banks.
    • Example: If the bank states the exchange rate as 2 dollars for 1 pound, this is the nominal exchange rate.
    • Does not reflect the purchasing power differences between currencies.

REAL EXCHANGE RATE

  • Defined as the nominal exchange rate adjusted for price levels.
    • Formula: q = rac{E imes P*}{P} where:
    • E = nominal exchange rate (home currency/foreign currency)
    • P = domestic price level
    • P* = foreign price level
  • If Purchasing Power Parity (PPP) holds, q is equal to 1.

TRADE-WEIGHTED EXCHANGE RATE

  • Measure of a country’s currency strength based on its trade volume with trading partners.
    • Indicates that major trading partners' currency fluctuations carry more weight in the overall exchange rate calculation.

FOREIGN EXCHANGE FLUCTUATIONS (1990 – 2010)

  • Sample average annual $J/US$ exchange rates:
    • 1990: 7.18
    • 2000: 43.32
    • 2010: (context from previous entries) up to 88.49

TYPES OF CURRENCY MARKETS

  1. Spot Market:
    • For immediate currency transactions, usually settled within 2 business days.
  2. Forward Market:
    • Transactions occur at a specified future date.

PARTICIPANTS IN THE EXCHANGE MARKET

Spot Market Participants:

  • Commercial banks
  • Brokers
  • Customers of banks

Forward Market Participants:

  • Arbitrageurs
  • Traders
  • Hedgers
  • Speculators

THE MARKET FOR FOREIGN EXCHANGE

  • Demand for US Dollars comes from holders of Jamaican Dollars aiming to purchase US Dollars.
  • Supply of US Dollars is from holders wishing to exchange for Jamaican Dollars.

EQUILIBRIUM EXCHANGE RATE

  • It is achieved when the quantity demanded of a currency equals the quantity supplied.

FACTORS AFFECTING EXCHANGE RATES

  1. Differentials in Inflation
  2. Differentials in Interest Rates
  3. Current-Account Deficits
  4. Public/National Debt
  5. Terms of Trade
  6. Political Stability and Economic Performance

1. Differentials in Inflation

  • A country with lower inflation tends to see its currency appreciate, while higher inflation usually results in depreciation.

2. Differentials in Interest Rates

  • Higher interest rates attract foreign capital, increasing currency exchange rates unless countered by high inflation or other factors.

3. Current-Account Deficits

  • A current account deficit indicates a country is spending more on foreign trade than it earns, leading to borrowing from abroad.

EFFECTS OF EXCHANGE RATES ON THE ECONOMY

  • Currency depreciation increases import prices and decreases export prices (in foreign currencies).
  • Results:
    • U.S. goods become more competitive abroad.
    • Foreign goods become expensive to U.S. buyers.
    • Potential economic stimulus via increased spending on domestic goods.

THE J CURVE AND BALANCE OF TRADE

  • Balance of trade = ext{export revenue} - ext{import costs}
  • Initial negative impacts of currency depreciation can lead to improved balance of trade over time.

EXCHANGE RATES AND PRICES

  • Currency depreciation tends to increase price levels, leading to shifts in demand and changes in aggregate supply.

TRADE AND EXCHANGE RATES IN A TWO-COUNTRY/GOOD WORLD

  • The exchange rate affects trade flow decisions:
    • Trade possibilities showcased by various exchange rates determine which goods are imported or exported based on comparative advantage.