L14-15: Exchange rate basics

EXCHANGE RATE BASICS

• The exchange rate (S) is defined as the domestic currency price of one unit of foreign currency.

  • In layman's terms, it's how much of your money you need to buy one unit of another country's money. Think of it like the price tag on foreign currency.

  • Example: 1 GBP = 1.25 USD OR 1 USD = 0.80 GBP.

    • Using USD/GBP exchange rate = 0.80 means that the price of one US dollar is 0.80 pounds.

  • In this module, the convention is USD/GBP exchange rate = 0.80 (price of US dollar in terms of pounds).

• An increase in S implies a depreciation of the home currency and an appreciation of the foreign currency.

  • If S goes up, it means your currency is getting weaker (you need more of it to buy the same amount of foreign currency), and the other currency is getting stronger.

• A fall in S implies an appreciation of the home currency and depreciation of foreign currency.

  • If S goes down, it means your currency is getting stronger, and the other currency is getting weaker.

• Other things equal:

  • Depreciation reduces the foreign currency price of exports and increases the domestic currency price of imports.

    • If your currency weakens, your goods become cheaper for foreigners to buy (exports increase), and foreign goods become more expensive for you (imports decrease).

  • Appreciation has the opposite effect.

    • If your currency strengthens, your goods become more expensive for foreigners, and foreign goods become cheaper for you.

BILATERAL VS. MULTILATERAL EXCHANGE RATES

• The bilateral exchange rate between the US and the UK is the price of dollars in terms of pounds.

  • This is a one-on-one comparison of two currencies.

• Distinction between bilateral vs multilateral or trade-weighted exchange rates is important.

• The effective or trade-weighted exchange rate of currency A is a weighted average of its exchange rate against currencies B, C, D, and E.

  • Imagine a country trades with many others; the multilateral rate looks at all these trades together to give a broader view of currency value.

  • Weights are the proportion of country A’s trade that involves B, C, D, and E, respectively.

  • The effective exchange rate is multilateral rather than bilateral.

SPOT VS. FORWARD EXCHANGE RATES

• Spot rates involve buying and selling currency at the current time.

  • It's like buying something off the shelf right now.

• Forward exchange rates (or futures exchange rate) are contracts that commit two parties to exchange one currency for another at some future date at a pre-specified price.

  • This is an agreement to buy or sell currency later at a set price. It's used to protect against future exchange rate changes.

BUYING VS. SELLING RATES

• The bid rate for currency A in terms of currency B is the rate at which dealers buy currency A (sell currency B).

  • The price the dealer is willing to pay you for your currency.

• The offer or ask rate is the rate at which dealers sell currency A (buy currency B).

  • The price at which the dealer will sell you the currency.

• The bid-ask spread is the gap between the offer and bid rates.

  • The dealer makes money on this difference.

• The exchange rates that are usually quoted gives the average of the bid and ask exchange rates.

DEMAND/SUPPLY MODEL OF EXCHANGE RATE DETERMINATION

• Demand curve for foreign exchange:

  • Importers, outgoing foreign investment, and speculators are major sources of demand.

    • People wanting to buy goods from other countries, invest abroad, or bet on currency movements create demand for foreign currency.

• Supply curve for foreign exchange:

  • Exporters, incoming foreign investment, and speculators are major sources of supply.

    • People selling goods to other countries, foreign investment coming in, or currency bets being cashed out create a supply of foreign currency.

• The demand curve is downward sloped, and the supply curve is upward sloped.

• The intersection of demand and supply curves of foreign exchange determines the equilibrium value of foreign exchange or exchange rate.

• A completely flexible (or freely) floating exchange rate is determined exclusively by the underlying balance of supply and demand for the currencies involved, with no outside intervention.

DEMAND SUPPLY MODEL - SHIFT IN DEMAND

• Assume the demand curve for foreign currency (USD) shifts to the right.

  • More foreign currency is being demanded for any level of the exchange rate.

  • Due to a rise in domestic income which increases imports.

    • When people earn more, they buy more stuff from other countries, needing more foreign currency.

• At the existing GBP/USD exchange rate (0.82), there is an excess demand for dollars (excess supply of pounds).

• A new equilibrium is established where the price of dollar is higher at 1.

  • The USD appreciates, or the pound depreciates.

FLEXIBLE VS. FIXED EXCHANGE RATES

• Assume that the government does not want the value of the exchange rate to move from 0.82 to 1.

  • The government/central bank wants to hold the value of the US dollar (in terms of pounds) constant at 0.82 even after the demand curve for USD has shifted to the right.

• The central bank can sell foreign currency (USD) and buy pounds in the foreign exchange market.

  • The foreign exchange market intervention increases the supply of US dollars in the market and can hold its value constant.

  • Reduces the supply of pounds, thereby helping prevent a fall in its value.

HOW FIXED EXCHANGE RATES WORK

• First case, when the exchange rate is not convertible:

  • The government may announce the fixed exchange rate and impose it by placing legal restrictions on dealings.

    • The authorities might mandate that sale and purchase of foreign exchange occurs ONLY via the central bank.

    • Private holdings of foreign currency can be banned altogether or permitted only with official consent.

    • Many developing countries in earlier decades maintained a fixed exchange rate using such methods.

  • The exchange rate is not convertible.

    • You can't freely exchange the currency.

• Second case, exchange rate is convertible (on the current account):

  • The central bank intervenes in the foreign exchange market (by buying or selling foreign/domestic currency as required) to maintain a fixed value of the exchange rate.

• A fixed exchange rate is incompatible with an independent monetary policy.

  • The central banks foreign exchange market interventions (often necessary to maintain a fixed exchange rate) causes changes in the level of money supply.

  • One policy tool (money supply) may not be very effective when targeted at two macroeconomic goals: inflation and maintaining a fixed value of the exchange rate.

EXCHANGE RATE ARRANGEMENTS

• Most countries today have ”managed float” or ”dirty float”.

• Most countries use a system called "managed float" or "dirty float." This means that the value of their money can mostly change freely, but the central bank will sometimes step in to influence it. Think of it like this: the currency is like a boat on the ocean, usually floating on its own, but sometimes someone will nudge it in a certain direction to keep it from drifting too far. Also, under a pure float, the reserves are constant; Under a managed float, the reserves vary depending on the extent of the central bank’s foreign exchange market interventions; Under a purely fixed exchange rate system, the reserves must carry the full burden of adjustment to disequilibrium in the currency markets and can be far more volatile.

  • The exchange rate is mostly free to move, but the central bank steps in sometimes.

• The movement of foreign reserves is an indicator of actual exchange rate status.

  • Under a pure float, the reserves are constant; there is no need for the monetary authorities to hold any reserves at all.

    • If the exchange rate is truly free, the central bank doesn't need to keep a stash of foreign currency.

  • Under a managed float, the reserves vary depending on the extent of the central bank’s foreign exchange market interventions.

    • When the central bank interferes, its foreign currency stash changes.

  • Under a purely fixed exchange rate system, the reserves must carry the full burden of adjustment to disequilibrium in the currency markets and can be far more volatile.

    • In a fixed system, the foreign currency stash absorbs all the shocks and can change a lot.

CHINA’S EXCHANGE RATE POLICY

• China’s rising foreign exchange reserves during 2001-2013.

  • https://data.worldbank.org/indicator/FI.RES.TOTL.CD?locations=CN (context to be explained in the lecture).

STERILIZATION OF CENTRAL BANK FOREIGN EXCHANGE MARKET INTERVENTIONS

• Sterilization is the process of neutralizing the impact of the central bank’s foreign exchange market interventions on money supply by creating or retiring enough domestic credit to offset the change in foreign exchange reserves.

  • It's like the central bank is cleaning up after itself, so its actions don't mess with the money supply.

• The government can offset the impact of foreign exchange market intervention on money supply by conducting open market sale or purchase of government securities.