Lecture-VIII: Exchange Rate (ECN220) PDF

ECN220 Evolution of the Global Economy @ 2024. All rights reserved Dr. Hakan Toksoy Foreign Exchange Rates Currencies Canadian $ U. S. Dollar Euro Japanese Yen Canadian $ ………………….....

ECN220 Evolution of the Global Economy @ 2024. All rights reserved Dr. Hakan Toksoy Foreign Exchange Rates Currencies Canadian $ U. S. Dollar Euro Japanese Yen Canadian $ ………………….. 1.3755 1.4986 0.0091 U. S. Dollar $ 0.7270 ………………….. 1.0894 0.0066 Euro € 0.6672 0.9178 ………………….. 0.0061 Japanese Yen ¥ 108.932 149.836 163.246 ………………….. Source: Monthly average foreign exchange rates in Canadian dollars, Bank of Canada October 2024 Different countries operate with their own currencies, and the exchange rate acts as a "converter," translating the value of one currency into another. Foreign exchange involves trading currencies between nations, similar to how money is used within a country Foreign Exchange Rates Exchange rate price one currency exchanges for another currency If C$1.00 = US$0.72 it takes 72 cents U.S. to buy 1 Canadian dollar There are two main types of exchange rates based on the timing of currency exchanges: Spot Exchange Rate: This is the rate for "immediate" currency exchange. For most large trades, "immediate" typically means delivery or exchange happens two business days after the agreement. But, for certain currency pairs, like the U.S. dollar and Canadian dollar, delivery occurs within one business day. Forward Exchange Rate: This is the rate agreed upon today for a currency exchange that will occur at a specified future date, such as 30, 90, or 180 days from the agreement. Forward rates are used to lock in the exchange price for future transactions. Foreign Exchange Market The foreign exchange market is a decentralized system rather than a single physical location where traders meet to execute transactions. Banks act as key dealers in this market, with their traders facilitating most of the activity. While a small portion of trades involves individuals making minor exchanges, the majority of transactions come from nonfinancial corporations, financial institutions, and other organizations conducting large-scale trades. Over half of all foreign exchange transactions are conducted by banks located in London and New York. Most transactions involve U.S. dollars paired with another currency. Even when trading directly between two non-dollar currencies, the U.S. dollar often acts as an intermediary in a two-step process. This widespread use of the dollar as a medium of exchange makes it a "vehicle currency" in the foreign exchange market. Foreign Exchange Market The spot foreign exchange market facilitates the smooth flow of payments between individuals, businesses, and organizations that use different currencies. It plays a crucial role in enabling transactions for a wide range of activities captured in the balance of payments, such as trade in goods and services and the buying or selling of foreign financial assets The interbank market plays a key role in providing banks with real-time information on foreign exchange conditions through interactions with other traders and by observing quoted exchange rates. It enables banks to quickly and cost-effectively adjust their positions after executing large trades with customers. For instance, if a Canadian Bank buys a large amount of yen from a Japanese firm, it may choose to sell the yen to another bank to avoid holding the currency. Additionally, interbank trading allows banks to quickly take short-term speculative positions on foreign currencies, often closing these positions by the end of the trading day.  Appreciation and Depreciation Source: Statistics Canada Example: In the U.S., the product is priced at $1,000 USD. With an exchange rate of 1.375, the cost of the product in Canada would be $1,375 CAD. If the US dollar appreciates to 1.60 CAD, the price of the product in Canada rises to $1,600 CAD, while it remains $1,000 USD in the U.S. Demand and Supply for Foreign Exchange Supply of one currency is demand for another currency Price of CAD$ (US$ per CAD $) Supply 0.90 Demand 0 60 Quantity of CAD$ (billions) The simplest system is a floating exchange-rate system, where governments or central banks do not intervene. The spot price of foreign currency is determined by market forces, driven by the interaction of private demand and supply.  Demand in Foreign Exchange Law of demand for Canadian dollars as exchange rate rises, quantity demanded of CAD$ decreases. Non-Canadians’ demand for CAD$ is demand for Canadian exports and assets, and for speculating on future value of CASD$ Price of CAD$ (US$ per CAD $) Price of 1 Canadian Price of Canadian Price of Canadian Dollar (US$ per CAD$ Products supplied in Products supplied in Canada (in CAD$) U.S. (in US$) US$ 0.60 CAD$ 100 US$ 60 1 US$ 1.00 CAD $100 US $100 0.60 Demand 0 60 100 Quantity of CAD$ (billions)  Supply in Foreign Exchange Law of supply for Canadian dollars as exchange rate rises, quantity supplied of CAD$ increases Price of CAD$ (US$ per CAD $) Supply 1 Reasons for supplying Canadian dollars include: (i) To pay for imports and acquire assets. (ii) To speculate on the future value of the Canadian dollar. 0.60 0 60 100 Quantity of CAD$ (billions) Demand and Supply for Foreign Exchange Price of CAD$ (US$ per CAD $) Supply SURPLUS of CAD$ 1.10 0.90 0.80 SHORTAGE of CAD$ Demand 0 40 60 80 Quantity of CAD$ (billions) Supply of one currency is demand for another currency Reciprocal Exchange Rate Currencies Canadian $ U. S. Dollar Euro Japanese Yen Canadian $ ………………….. 1.3755 1.4986 0.0091 U. S. Dollar $ 0.7270 ………………….. 1.0894 0.0066 Euro € 0.6672 0.9178 ………………….. 0.0061 Japanese Yen ¥ 108.932 149.836 163.246 ………………….. Source: Monthly average foreign exchange rates in Canadian dollars, Bank of Canada October 2024 Americans demanding CAD$ supply US$ in exchange Canadians demanding US$ supply CAD$ in exchange For reciprocal exchange rate, divide 1 by the other exchange rate When CAD$ appreciates against any currency, that currency depreciates against CAD$ In the Foreign Exchange Market, 1) The demand for one currency is the supply of another currency 2) The appreciation of one currency is the depreciation of another currency  FLOATING EXCHANGE RATES Exchange rate fluctuations are driven by changes in: Interest rate differentials Inflation rate differentials Canadian real GDP Global demand for Canadian exports and world prices Speculator expectations. Each of the five economic forces affects both demand and supply in the foreign exchange market, causing shifts in both the demand and supply curves.  Increase in Canadian Interest Rate Differential (i) Interest rate differential difference in interest rates between countries Price of CAD$ (US$ per CAD $) Supply Supply 1.0 0.90 Demand Demand 0 Quantity of CAD$ (billions) 𝐑𝐞𝐚𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 = 𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 − 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞 𝐫𝐂𝐀𝐃 − 𝐫𝐔𝐒 > 𝟎 → 𝐫𝐂𝐀𝐃 > 𝐫𝐔𝐒  Decrease in Canadian Interest Rate Differential (i) Interest rate differential difference in interest rates between countries Price of CAD$ (US$ per CAD $) Supply Supply 0.90 0.80 Demand Demand 0 Quantity of CAD$ (billions) 𝐑𝐞𝐚𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 = 𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 − 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞 𝐫𝐂𝐀𝐃 − 𝐫𝐔𝐒 < 𝟎 → 𝐫𝐂𝐀𝐃 < 𝐫𝐔𝐒  An increased inflation rate differential (ii) Inflation rate differential difference in inflation rates between countries Price of CAD$ (US$ per CAD $) Supply Supply 0.90 0.80 Demand Demand 0 Quantity of CAD$ (billions) 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧𝐂𝐀𝐃 > 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧𝐔𝐒  A decreased inflation rate differential (ii) Inflation rate differential difference in inflation rates between countries Price of CAD$ (US$ per CAD $) Supply Supply 1.0 0.90 Demand Demand 0 Quantity of CAD$ (billions) 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧𝐂𝐀𝐃 < 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧𝐔𝐒  FLOATING EXCHANGE RATES (iii) Effects of increasing and decreasing Canadian real GDP on CAD$ When Real GDP Increases: 1-Import Effect (Total Income Increases) Consumers’ demand for US$ increases which increases the supply of CAD$ on the foreign exchange market 2-Growth Effect Canadian assets become more attractive, this increases the demand for Canadian dollar, and decreases the demand for US$. (iv) Increasing R.O.W. demand for Canadian exports causes slight appreciation of CAD$ (increases demand for C$) Rising world prices for Canadian resource exports causes C$ to appreciate relative to currencies of non–resource producing countries (increases demand for C$) (v) Currency speculators are the most important force for fluctuations of foreign exchange rates Globalization Transmission Mechanisms Exchange rates influence real GDP and inflation through the globalization transmission mechanism, which impacts net exports, aggregate demand, and the price level. For example, a weaker currency can reduce net exports, lowering aggregate demand, decreasing real GDP, and increasing unemployment. It can also reduce inflation, pushing the economy into a contraction. A depreciating Canadian dollar acts as a positive aggregate demand shock. It boosts net exports, leading to an increase in aggregate demand, real GDP, and a decrease in unemployment. This also results in higher inflation and drives the economy into an expansion phase. Changes in the exchange rate for the Canadian dollar affect the price of imports in Canadian dollars and, consequently, the inflation rate. An appreciating CAD$ leads to deflation, as it lowers the cost of imports. A depreciating CAD$ causes inflation, as import prices rise The law of one price (Purchasing Power Parity-PPP) The law of one price, purchasing power parity, and rate of return parity are the most reliable standards for predicting where exchange rates are likely to settle, although they have certain limitations. Purchasing power parity (PPP) exchange rates adjust so that money has equal real purchasing power in any country. Example (if PPP exists): Suppose the price of a book is US$8 in the U.S. and CAD$10 in Canada, with an exchange rate of 0.80 CAD$ per US$. This means that US$8 is equivalent to CAD$10. If you exchange CAD$10, you would receive (CAD$10 × 0.80) = US$8. Thus, the Canadian dollar has the same purchasing power in both Canada and the U.S.  Example (when PPP does not exists): Now, suppose the exchange rate is CAD$1 = US$1, meaning the Canadian dollar is overvalued Price of CAD$ (US$ per CAD $) Supply Supply 1.00 0.80 Demand Demand 0 Quantity of CAD$ (billions) If you buy a book for US$8 in the U.S. and have US$2 remaining to spend elsewhere, your purchasing power is higher in the U.S. Canadians will increase the supply of CAD$ and demand more US dollars, while Americans will reduce their demand for CAD$. The pressure on the Canadian dollar to depreciate continues until the exchange rate returns to its previous level of 0.80 CAD$ per US$.  The law of one price (Purchasing Power Parity-PPP) Big Mac Purchasing Power Parity Index The Economist’s calculations in July 2014, a Big Mac costs US$4.80 in the United States. The CAD$5.64 required to buy a Big Mac in Canada is equivalent to US$4.80 (calculated as CAD$5.64 × 0.85), which allows you to purchase the same Big Mac in the U.S. 𝟎. 𝟗𝟑 − 𝟎. 𝟖𝟓 CAD$ is Overvalued by 9% 𝟏𝟎𝟎 = 𝟗% 𝟎. 𝟖𝟓 Fixed Exchange Rates A fixed exchange rate system is where a country's currency value is pegged to another major currency, such as the US dollar, or a basket of currencies, by government or central bank intervention. The exchange rate is maintained at a fixed value, even if it differs from the market equilibrium (Pegged Rate). The exchange rate may fluctuate within a narrow "band" or range. If the rate hits the upper or lower limit of the band, central authorities intervene to maintain the peg. Aims to provide exchange rate stability, particularly for trade and investment. Advantages: Promotes stability in international trade. Reduces exchange rate risk for businesses and investors. Can encourage foreign investment. Disadvantages: Requires large reserves of foreign currency to maintain the peg. Limits the country’s ability to conduct independent monetary policy. Vulnerable to speculative attacks if the peg is unsustainable. International Currency Experience Gold Standard, 1870 to 1914 (A Fixed Exchange Rate System) Each country’s currency was fixed to a specific quantity of gold, enabling stable exchange rates. Origins in Britain: Britain tied the pound to gold due to favorable gold-silver value ratios. Its dominance in trade and industrialization enhanced gold’s prestige. Britain’s financial stability, unaffected by invasions, bolstered confidence in the system. Gold Supply Stability: Gold discoveries (California, Australia, South Africa) were gradual, preventing overabundance. Silver, however, became devalued due to excessive mining in the 1870s–1880s. Mechanics of the System: Currencies were convertible to gold, and gold flows ensured exchange rates remained within narrow bands. Gold movements influenced money supply, price levels, inflation, and macroeconomic stability. Widely regarded as a successful and stable system, shaping post-World War I calls for fixed exchange rates. International Currency Experience Interwar Instability (Beggar-thy-neighbor policies in the 1930s) Post-World War I Challenges (1919–1923): European currencies became inconvertible and heavily devalued compared to the U.S. dollar, the new financial leader. Britain’s Gold Parity Decision (1925): Britain returned the pound to its prewar gold value, causing high unemployment and loss of price competitiveness. Other countries (e.g., France and Italy) took more inflationary routes due to political instability. Hyperinflation in Germany (1922–1923): The German mark lost all value, requiring reissuance of a new currency after extreme devaluation. Currency Crisis During the Great Depression (1931–1934): Austria's Creditanstalt collapse triggered a run on German banks and the pound sterling. Britain abandoned the gold standard in 1931, followed by the U.S. in 1933–1934. Economic Retaliation: Countries used devaluations, tariffs, and trade restrictions to protect domestic jobs. Beggar-Thy-Neighbor Policies: These measures worsened the global depression, shrinking international trade.  International Currency Experience Bretton Woods System, 1944 to 1971 The U.S. dominated the conference, reflecting its economic power and gold reserves. Reform: Global consensus on the need for a more stable monetary system. The U.S. favored fixed exchange rates, with temporary reserves to manage deficits. Keynes’s Plan: Creation of a new central bank, automatic adjustments for surpluses/deficits, and policies promoting balanced international payments. White’s Plan: A central institution offering reserves to deficit countries to stabilize the system. The Bretton Woods System: 1.Adjustable Peg: Fixed exchange rates with room for adjustments if a country’s balance of payments faced “fundamental disequilibrium.” 2.IMF Creation: The International Monetary Fund (IMF) was established to stabilize the global monetary system, lending reserves for temporary deficits. International Currency Experience The Dollar Crisis and the Collapse of Bretton Woods The U.S. Dollar as Reserve Currency: Under the Bretton Woods system, countries pegged their currencies to the U.S. dollar, which was convertible to gold at $35 per ounce. The U.S. dollar became the primary reserve currency in the postwar global economy Reasons Leading to the Crisis: Postwar Economic Growth and U.S. Deficits: As Europe and Japan recovered, they gained competitive advantages over U.S. firms, leading to large U.S. payment deficits. The U.S. dollar accumulated in foreign reserves as countries ran surpluses to increase their own reserves. Dwindling U.S. Gold Reserves: From 1958 to 1968, U.S. gold reserves fell significantly, raising doubts about the dollar's gold backing. France led calls for converting dollar claims into gold, creating international concern over the stability of the dollar. International Currency Experience The Dollar Crisis and the Collapse of Bretton Woods Potential Solutions and the U.S. Response: Options for the U.S.: Shrink the U.S. economy to reduce deficits. Tighten exchange controls or devalue the dollar in terms of gold. Instead of these measures, the U.S. opted to change the rules of the international system. International Currency Experience Key Events in the Dollar Crisis and the Collapse of Bretton Woods 1968: Two-Tier Gold Price System: A seven-country meeting led by the U.S. introduced a system where the private price of gold could fluctuate, but the official price remained fixed at $35 per ounce for transactions among the governments. Despite this, the U.S. continued facing large payment deficits. 1971: Nixon’s Suspension of Gold Convertibility: President Nixon suspended the convertibility of dollars into gold, effectively ending the gold-dollar link. Nixon also imposed a temporary 10% tariff on imports to push other countries to revalue their currencies. The Smithsonian Agreement (December 1971): Attempted to patch the system by devaluing the U.S. dollar (~10%) and revaluing major currencies like the DM and yen. The official gold price was raised to $38 per ounce, but the system could not be restored. End of the Bretton Woods System (1973): By March 1973, most major currencies floated against the dollar, signaling the end of the Bretton Woods system.  International Currency Experience Current System The post-1973 international monetary system is often described as a managed floating regime. Most major economies now have floating or flexible exchange rates, but government intervention is common to manage fluctuations. Floating Exchange Rates: Many countries, especially developed economies, have currencies that float relative to one another. Market forces primarily determine the exchange rates, but governments sometimes intervene to stabilize their currency or influence its value. Government Intervention: Countries often attempt to manage or influence the floating exchange rate, especially during periods of excessive volatility or to maintain competitive advantage. Example: Japan has actively tried to keep the yen's value low to protect the international price competitiveness of its products by purchasing large amounts of dollars. Despite this, the yen still appreciated over time against the dollar.