1

Money and Banking

Foreign Exchange & the International Monetary SystemChapters 17, 18

Week 11

2

Foreign Exchange Market

• Abbreviation: FOREX

• Over a trillion dollars worth are traded daily.

• Most trading is to finance the purchase of assets

• (e.g., bank deposits), not goods and services.

• OTC (several hundred dealers, mostly banks)

• Wholesale vs. retail

3

Quotes

Euro-dollar quote of $1.2120

The euro is the BASE currency.

The dollar is the TERMS currency.

4

www.newyorkfed.org/markets

5

Purchasing Power Parity Theory

A method of calculating exchange rates that attempts to value currencies at rates such that each currency will buy an equal basket of goods.

Creates a balance in trade. When a country has an inflation, its currency depreciates.

6

Other factors affecting exchange rates

• Tariffs and quotas

• Import demand

• Export demand

• Productivity

7

Volatility in forex market not explained by PPPT

Purchasing power changes gradually. Exchange rates change rapidly.

8

Asset Demand Theory

Exchange rates adjust so that expected returns across assets of equal risk are equalized.

So if the expected return on European assets is higher than ones in the U.S. assets, the value of the Euro will appreciate.

In equilibrium all expected returns are equal.

9

Exchange Rate Overshooting

• A change in money supply causes a short-run change in the real interest rate.

• Eventually the real interest rate adjusts back to its original level and the exchange rate goes back as well.

Purchasing power changes slowly.

Most forex trading is not to finance import/export traded.

10

19th Century Gold Standard

1 oz of gold = $20 = £4

£1 = $5

Suppose £1 = $5.25.

What’s the arbitrage opportunity?

Liberty Gold Dollar (1849-1854)

11

Two types of exchange rate regime

Flexible• Exchange rate determined by

supply and demand.• Characterized by volatility.• Creates uncertainty in

conducting international business.

• Changes in value called appreciation and depreciation.

Fixed• Central bank buys and sells

domestic currency at a fixed price.

• The gold standard was a fixed exchange rate regime.

• Bretton Woods was another.• Provides more certainty in the

short run but the system is susceptible to speculative attacks.

• Changes in value called revaluation and devaluation.

12

Bretton Woods Agreement 1944

Established a system of fixed exchange rates.

Major architect of agreement J.M. Keynes called gold a “barbarous relic.”

13

Nixon Closes the Gold Window (1971)

1960’s inflation in USAccumulation of $’s

in ROWGerman CB requests

gold for $’s.Nixon refuses to

honor agreement signaling the beginning of the end of fixed exchange rates.

14

Exchange Rate Interventions

UnsterilizedCB enters into forex

market to influence value of currency.

E.g. Fed buys $ to keep value high.

SterilizedCB enters into forex

market and then conducts OMO to keep money supply constant.

E.g. Fed buys $ in forex market and then conducts expansionary OMO.

15

Effect of Interventions

Evidence shows sterilized interventions have little effect.

Consider, Germany during final years of BW.

Buying dollars, selling DM and then buying DM to prevent inflation.

No matter how many dollars they bought they couldn’t get the exchange rate at BW levels.

16

George Soros vs. Bank of England

Minus $1.1 billionPlus $1.1 billion

17

Common Currency

Advantages

Eliminates costs of exchanging currencies.

Facilitates price comparisons.

Creates a larger market.

Disadvantage

Loss of control over monetary policy

18

Euroland12 Member States of the European

Union are participating in the single currency:

• Belgium• Germany• Greece• Spain• France• Ireland• Italy• Luxembourg• The Netherlands• Austria• Portugal• Finland

19

Dollarization

• A country abandons their domestic currency and uses the dollar.