1. Introduce exchange rates

2. Explain and evaluate the various kinds of exchange rate systems that trading nations use.

3. Examine the impact of Balance of Payments outcome for the domestic economy.

4. Purchasing Power Parity

5. Asian Currency Crisis

We have considered the Balance of Payments and the associated trade & financial flows.

These exchanges between nations are facilitated by exchange rates that allow one currency to be expressed in terms of another.

At a superficial level, we can view the exchange rate as responding to changes in these flows – i.e. the flows generate demand for & supply of these currencies onto the foreign exchange market, thus altering the exchange rate.

There are fundamental economic influences that impact on the value of these exchange rates.

For example, an increase in exports will increase the demand for $A and (with all other things constant) result in the value of the exchange rate being bid up.

But what economic factors will provoke the increase in exports?

Short Run (Speculative) Real interest rates Expectations

Medium Run (Cyclical) Cyclical changes in economic Activity

Long Run (Structural) Real income: increase imports Employment Productivity: lower costs increase exports Inflation rates and relative price levels between countries Consumer Preferences Government Policy: trade and domestic

These factors affect the demand for and supply of an economy’s currency and therefore the value of its exchange rate.

But an Exchange Rate is extremely volatile, especially in the short run.

Can we specifically identify the factors that determine the Exchange Rate?

Such information would be extremely useful to businesses and macroeconomic policy makers for forecasting Exchange Rate movement.

Can we posit a theory that helps our thinking about Exchange Rate determination?

Currency is demanded and supplied not for its own sake but to facilitate international trade.

The Exchange Rate is determined by the flow of funds associated with this international trade.

These flows constitute Demand for and Supply of $A on FOREX market.

Demand for $A comes from credit items on Balance of Payments (such as Merchandise Exports).

Supply of $A comes from debit items on Balance of Payments (such as Merchandise Imports).

Direct Quote(e.g. $A per $US, $A per £)The exchange rate is expressed as the number of units of a country’s currency required to buy a single unit of some foreign currency.

Appreciation is a reduction in the number of units of local currency required to buy a single unit of the foreign currency. For example, $A1.60/$US appreciates to $A1.50/$US.

Depreciation is an increase in the number of units of local currency to buy one unit of foreign currency. For example, $A1.50/$US depreciates to $A1.60/$US

Indirect Quote(e.g. $US per $A)The exchange rate is expressed as the foreign currency price per unit of the local currency.Reciprocal of a direct quote

For example, one $A is worth $US0.66 and then the $A depreciates to $US0.625. Therefore, you get less foreign currency for each $A (in other words, one $A buys less foreign currency)

Indirect quote is also used in financial media reports as it is conceptually easier to understand.

There are three main types:1. Flexible exchange rate : value of currency

is determined by market forces

2. Fixed exchange rate: value of currency is determined by Central Bank

3. Managed exchange rate: the central bank intervenes in the FX market to smooth out fluctuations but doesn’t seek to maintain currency at predetermined level.

The type of exchange rate system an economy adopts depends on a number of factors:Size and openness of the economyPolitical SystemDegree of financial sector developmentCapital Mobility

COUNTRY CURRENCY CURRENCY CODE

EXCHANGE RATE SYSTEM

AustraliaChinaHong KongIndiaIndonesiaJapanMalaysiaNew ZealandPhilippinesSingaporeSouth KoreaTaiwanThailandVietnam

DollarYuan RenminbiDollarRupeeRupiahYenRinggitDollarPesoDollarWonDollarBahtDong

AUDCNYHKDINRIDRJPY

MYRNZDPHPSGDKRWTWDTHBVND

FloatingFixedFixedManagedFloatingFloatingManagedFloatingFloatingManagedFloatingManagedManagedFixed

Changes in $US Exchange Rates for selected APEC Countries

Source: Congressional Research Committee, East Asia’s Foreign Exchange Rate Policies, April 10, 2008.

Market forces determine the value of a country’s exchange rate.

Depreciation and Appreciation

Depreciation in the exchange rate is an increase in the number of units of a country’s currency required to buy a single unit of some foreign currency.Direct Quote: $A1.50=$US1 depreciates to $A1.60=$US1; or Indirect Quote: A$1=$US0.66 depreciates to $US0.625.

Appreciation is a reduction in the number of units of a country’s currency required to buy a single unit of some foreign currency.Direct Quote: $A1.50=$US1 appreciates to $A1.40=$US1; or Indirect Quote: A$1=$US0.66 appreciates to $US0.68.

P¥/$

Q$

S0

D0

A Current Account deficit causes excess supply of $A at the original equilibrium exchange rate. A depreciation of the exchange rate from

¥99 to ¥90 occurs under a freely floating exchange rate system.

Depreciation¥90

¥99

S1

Excess Supply of $A

Monetary policy autonomyIf the Central Bank is not obliged to intervene in the currency market to fix exchange rates, each country’s Monetary Policy is more autonomous relative to international circumstances. The money supply can be dedicated solely to addressing domestic economic problems, particularly inflation. For example, a country does not have to import an inflation rate established abroad. (e.g. in the late 1960s many countries felt that they were importing US inflation)

SymmetryUnder a system of floating exchange rates, one country no longer is able to set world monetary conditions by itself. At the same time, any country has the same opportunity as others to influence its exchange rate against foreign currencies. Exchange rates would be determined symmetrically by the foreign exchange market, not government decisions.

Exchange Rates as Automatic StabilisersEven in the absence of active monetary policy, the swift adjustment of market-determined exchange rates help countries maintain internal and external balance in the face of aggregate demand.

For example, as output falls, domestic demand falls which reduces transaction demand for money. The home interest rate declines to keep the money market in equilibrium.

This fall in home interest rates causes the domestic currency to depreciate in the foreign exchange market. This can increase the demand for exports and GDP.

Discipline: Central Banks are freed from the obligation to fix exchange rates so might embark on overexpansionary fiscal or monetary policy (particularly near election time).

Destabilising speculation and money market disturbances: speculation on changes in exchange rates could lead to instability in foreign exchange markets. This instability, in turn, might have negative effects on countries’ internal and external balances.

Further, disturbances to the home money market could be more disruptive under a floating than a fixed rate. For example, a rise in money demand works like a fall in money supply - currency appreciates and output falls. Under a fixed rate, the central bank would simply purchase foreign exchange and expand the money supply.

However, destabilising speculators who persisted in selling currency after it had depreciated below its long run value (or buying after it had appreciated above its long run value) would lose money over the long term.

Injury to international trade and investment: floating rates make relative international prices more unpredictable. This can harm international trade and investment. For example, importers are more uncertain of what they will pay; exporters are uncertain of what they will receive. Supporters of floats argue traders can use the forward exchange market, sceptics reply that forward markets are expensive to use and cannot cover all exchange-rate risks.

Illusion of greater autonomy: floating exchange rates can contribute to inflation.

A currency depreciation that raised import prices might induce workers to demand higher wages. Higher wages fuel price level rises and further inflation.

In addition, currency depreciation would raise price of imported goods used in production of domestic output.

Disadvantages of floating exchange rates:Uncertainty and diminished tradeuncertainty on prices due to movements in the exchange rateTerms of trade (declining terms of trade if you are a commodity exporter).Instability in the macroeconomic environment: shifts in net exports brought about by changes in the exchange rate. Appreciation of the dollar lowers exports and increases imports.

Nations have often fixed or pegged the exchange rate at a certain value to overcome the disadvantages from floating exchange rates.

The value decided upon is the par value associated with another currency or commodity.

Provide stability but government must intervene in the foreign exchange market by using its stock of currency (domestic and international) to manipulate the market process.

Fixed exchange rates require adequate reserves held by the central bank to accommodate periodic balance of payments deficits

Stabilisation fundssupplies of both foreign and domestic monies and gold held with the central bank or treasury for the purpose of intervention in the foreign exchange market to maintain the par value of the exchange rate

IMF credit

To maintain a fixed exchange rate a country may enact protectionist trade policies to increase net exports.

Imports: outflow of domestic currency, depreciationExports: inflow of foreign currency, appreciation

Exchange controls: rationingrestricting imports to the amount of foreign exchange earned by exportsthe deficit would cause changes in domestic prices and incomes, shifting the demand and the supply of currency into equilibrium.

P¥/$

Q$

S0

D0

Under a Gold or fixed exchange rate system, the government would need to buy the excess quantity of $A (increase demand for $A and, conversely, supply more Japanese Yen) in the foreign exchange market to maintain the exchange rate value at ¥99.

¥90

¥99

S1

Excess Supply of $A

D1Depreciation

Devaluation and revaluation of an economy’s currency value refers to the deliberate alteration of the par value of a currency against a particular standard.

This is decided by the central government in an attempt to address problems stemming from an over-valued or under-valued currency and its consequences for domestic economic activity (such as economic growth, aggregate demand, employment and inflation).

Need adequate foreign reservesIf constantly run Current Account deficits and are not receiving foreign currency then this will be a problem.

If market decides a devaluation is coming, foreign reserves drop sharply due to private capital flows abroad (capital flight). Self fulfilling currency crisis can occur when an economy is vulnerable to speculation.

Domestic macroeconomic adjustmentsuse fiscal and monetary policies to adjust GDP to a level consistent with the fixed exchange rate. But to maintain exchange rates might mean domestic economic activity is not able to be effectively controlled.

In other circumstance, the exchange rate collapse may be the result of inconsistent government policies. For example, the central bank may be buying bonds from the domestic government to allow the government to continue running fiscal deficits. Central bank purchases may eventually run down reserves to the point where exchange rate cannot be supported.

Also, the Central Bank may loan to uncreditworthy domestic banks to prevent domestic financial collapse. In the process, reserves are run down so the Central Bank loses ability to support the exchange rate.

An exchange rate system where central banks buy and sell foreign exchange to smooth out short-run or day-to-day fluctuations in rates.

Exchange rates are allowed to float or fluctuate in response to more fundamental changes in a nation’s exports and imports.

Encourages international trade and finance, while allowing for trend or long-term exchange rate flexibility to correct fundamental payments disequilibria.

Liquidity and Special Drawing RightsSpecial Drawing Rights are bookkeeping entries at the IMF, available to IMF members in proportion to their IMF quotas, that may be used to settle payments deficits or satisfy reserve needs in place of foreign exchange or gold.

Arguments for Managed FloatTrade growthManaging turbulence (Australia’s ‘managed float’ had the ability to depreciate, thus weathered the Asian currency crisis)

Arguments against a Managed FloatVolatility and adjustmentReinforcement of inflation

A Current Account deficit results from domestic consumers buying more imports than foreign consumers buying exports.

This causes an oversupply of domestic currency in the foreign exchange market.

Under a freely-floating exchange rate system, this oversupply results in a decrease in the price of the domestic currency’s value against other currencies.

This is a depreciation.

Currency depreciation generally improves a nation’s competitiveness.

A depreciation makes exports cheaper and imports dearer in foreign currency terms.

This can have the effect of automatically correcting a Current Account deficit (by increasing demand for exports and decreasing demand for imports).

The ability of a currency depreciation to correct a Current Account deficit depends on a number of factors.

J-curve effectRepresents a time lag between a depreciation and an improvement in an economy’s trade balance.

Exchange Rate Pass-throughHow much of a depreciation is passed through to a change in prices of goods and services.

A depreciation can:Improve trade balance if economy has excess capacity.

Reduce domestic performance if economy operating at full capacity because resources are taken away from domestic production and used for export production.

So, currency depreciation not good for an economy operating at maximum capacity.

Under a fixed exchange rate system, the central government must meet the excess supply of currency brought about by a Current Account deficit by buying it on the foreign exchange market to maintain the pre-determined exchange rate value. It deals in the foreign exchange market by selling foreign currency.

A nation finances a Current Account deficit out of its international reserves or by attracting investment or borrowing from other nations.

The capacity of a deficit nation to cover excess out-payments over in-payments is limited by its stocks of international reserves and willingness of other nations to invest in, or lend to the deficit nation.

Flexible exchange rates automatically adjust so as to eliminate balance of payments deficits or surpluses.

This involves automatic adjustment depending on demand and supply for domestic currency on the foreign exchange market.

Law of One PriceIdentical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency.

So, prices of goods and services in an economy can influence the value of an economy’s exchange rate.

This law applies only in competitive markets free of transport costs and official barriers to trade.

It implies that the dollar price of good i is the same wherever it is sold:Pi

A = (E$A/¥) x (PiJ)

where:Pi

A is the dollar price of good i when sold in Australia

PiJ is the corresponding Yen price in Japan

E$A/¥ is the Dollar/Yen exchange rate (i.e. direct quote from the perspective of the Australian currency)

ExampleIf the Dollar/Pound exchange rate is $A1.50 per Pound, a sweater that sells for ¥30 in Tokyo must sell for $A1.50 x ¥30 = $A45 in Sydney.

The theory of Purchasing Power Parity (PPP) explains movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels. It differs to the Law of One Price by examining general price levels in 2 different economies.

Theory of Purchasing Power Parity (PPP) The exchange rate between two counties’

currencies equals the ratio of the counties’ price levels.

It compares average prices across countries. It predicts a $A/¥ exchange rate of:

E$A/¥ = PA/PJ

where:PA is the Dollar price of a reference commodity

basket sold in Australia.PY is the Yen price of the same basket in Japan

The Relationship Between PPP and the Law of One Price The law of one price applies to individual

commodities, while PPP applies to the general price level.

If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries.

Proponents of the PPP theory argue that its validity does not require the law of one price to hold exactly.

Absolute PPP and Relative PPP Absolute PPP

States that exchange rates equal relative price levels. Relative PPP

States that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels.

Relative PPP between Australia and Japan would be: (E$A/¥,t - E$A/¥, t –1)/E$A/¥, t –1 = A, t - J, t

where: t = inflation rate

Holding constant other determinants, low interest rates lead to reduced demand for an economy’s currency and to exchange rate depreciation for that economy;

High interest rates result in appreciation.

The relative interest rate is the nominal rate adjusted for inflation.

If domestic inflation exceeds foreign inflation, then the purchasing power of the domestic currency falls relative to the foreign currency.

There is proportional depreciation.

For example, if inflation in Australia exceeds Japan’s inflation by 2% per year, the purchasing power of the $A falls 2% relative to the yen. The foreign exchange value of the $A should therefore depreciate 2% per year.

Market fundamentals influence flows of exports and imports: bilateral trade relationships; consumer tastes; investment profitability; product availability; productivity changes; trade policy.

In the short-run however, market expectations influence exchange rate movements. Future expectations of rapid domestic growth, falling domestic interest rates and high domestic inflation rates tend to cause the domestic currency to depreciate.

When exchange rates respond immediately to market forces, they are subject to expectations; that is, rather than reflecting existing market fundamentals, rates can move in anticipation of future changes.

Factor Change Impact

Expected domestic price level (relative to foreign nations)

IncreaseDecrease

DepreciationAppreciation

Expected domestic interest rate (relative to foreign nations)

IncreaseDecrease

AppreciationDepreciation

Expected domestic trade barriers (relative to foreign nations)

IncreaseDecrease

AppreciationDepreciation

Expected domestic import demandIncreaseDecrease

DepreciationAppreciation

Expected domestic export demandIncreaseDecrease

AppreciationDepreciation

Expected domestic productivity (relative to foreign nations)

IncreaseDecrease

AppreciationDepreciation

Demonstrate how future expectations of the $A depreciating can be self-fulfilling.

Importers stock up on foreign currency, yet holders of foreign currency (including importers of Australian products domestic goods) will restrict supply of foreign currency as its price relative to the $A is expected to rise.

Therefore price of foreign currency rises

Forecasts used by exporters, importers, investors, bankers and foreign-exchange dealers. Useful in practice e.g. Multi-National Corporations need to know what currency to make bank deposits in.

3 types:1. Judgmental forecasts: examine data of individual nations and

includes economic, social and political factors. Involves subjectivity.

2. Technical forecasts: uses historic exchange-rate data to estimate future values. Only works if market follows a consistent pattern and more reliable in the short-term.

3. Fundamental analysis: uses computer based econometric models. Consider economic variables likely to affect a currency’s value.

Most forecasters use a combination of the three.

Problems Too much foreign debt financing

unproductive activity Debt default Reduced foreign investment Depreciating exchange rate values High inflation in affected countries Reduced asset values and declining wealth Fall in Aggregate Expenditure and GDP Growth in unemployment

Government response to protect exchange rate values : Buy domestic currency; and Raise interest rates Increased liquidity provided by IMF Expansionary Fiscal Policy

Contributing Factors Insufficient financial sector management Inadequate financial regulation Overvalued exchange rates Currency speculation Poor political management

Countries most affected: Indonesia, South Korea and Thailand

ResponseFloating of many Asian currencies

Build up of foreign currency reserves

Regional Free Trade Agreements (instead of uncontrolled globalisation)

Improved corporate governance

Financial market reform

Greater financial regulation

General economic structural reform