Introduction to the World of Exchange Rates

Introduction to the World of Exchange Rates Everyday millions of companies and individuals around the world do business with companies and individuals located in different countries. Often these transactions involve two or more currencies. Juanita, a resident of the United States, wants to send her grandmother in Mexico money to buy a new microwave. Juanita earns income in US dollars but her grandmother needs Mexican pesos in order to buy the microwave in Mexico. Juanita knows that the microwave costs 20,000 Mexican pesos. How many US dollars would she need to send to her grandmother? This example is just one of many situations in which there is a need for a foreign exchange transaction. Individuals and companies enter into millions of foreign exchange transactions everyday. The standard for how many units of one currency (e.g. US dollars) must be surrendered to obtain one unit of another currency (e.g. Mexican pesos) is commonly known as the exchange rate between two currencies. That is, the exchange rate is the price of one currency in terms of the another currency. The value of the currency has huge implications for a nation’s economy. If the value of the domestic currency appreciates, that is, more units of the foreign currency are needed in order to buy one unit of the domestic currency, then this country will be able to buy foreign products more cheaply. On the other hand, the products of this country are going to be more expensive in foreign markets and, as a result, the stronger currency may hurt local exporters as foreign demand decreases. It can be argued that not only the value of a currency, but also its predictability can affect international businesses. If one company is going to have operations in a country whose currency has an uncertain future value then there may be uncertainty about this company’s future revenues, operational costs, and therefore profits. As it is well known, risk averse companies prefer to decrease the risk and uncertainty of future revenues and costs. In addition to its importance for trade and investment across countries the exchange rate is important as the essential component of the foreign exchange market or "FX" market. The FX market, the global market for currencies, is the largest and most liquid financial market in the world. According to a survey conducted by the Bank of International Settlements, the average daily trade in the FX market surpasses $ 1.2 trillion US dollars. All of these reasons and many more, make study of exchange rates an essential component of the curriculum for any student of economics or aspiring economist. In this paper you will learn about the functioning of the foreign exchange rate system. We start by giving a historical account of the different exchange rate systems around the world. In the past, particularly in the period from the Second World War to the end of the Breton Woods era, it was common for many countries around the world to have fixed exchange rates. That is, the value of the currency was pegged to the value of some other currency. This arrangement was adopted by different countries with the hope that it would avoid uncertainty about the value of their currency and the economic consequences of such uncertainty. Nowadays most major currencies are flexible and their values are determined by demand and supply in the foreign exchange market. Next, we discuss the determinants of a currency’s value according to the main theories of exchange rate determination. The determinants of the value of a currency are far from settled in the academic literature. However, several theories of exchange rate determination provide useful insights about the functioning of the foreign exchange rate market. For example, by looking at theories of exchange rate determination we can relate the exchange rate to other important macroeconomic variables such as interest rates and prices. Once we have a good understanding of the history and determinants of the exchange rate, we discuss the difference between the nominal and real exchange rate. Finally, the chapter ends with summary and conclusions and with a list of additional readings on the topic. Exchange Rate Regimes: An Historical Perspective Let’s start the discussion by defining three main types of exchange rate regimes differentiated by their degree of flexibility. First, there is the floating exchange rate regime in which currencies are free to float and their values are determined by demand and supply in the foreign exchange rate market. Proponents of the flexible exchange rate system argue that floating exchange rates provide monetary policy autonomy as the central bank is not required to intervene in the foreign exchange market in order to maintain a given value for the currency and insulation from external shocks. In his 1969 article praising the benefits of floating exchange rates, economics professor Harry G. Johnson even argued that floating exchange rates are an essential component of the national autonomy and independence of each country. This national autonomy he argues is essential for the efficient organization and development of the global economy. On the down side, flexible exchange rates have been often associated with destabilizing speculation. However, proponents of flexible exchange rates argue that, to the contrary, speculation by rational agents should reduce exchange rate volatility and provide a less disruptive adjustment mechanism in the face of nominal rigidities. Economist and Nobel laureate Milton Friedman argues that if there is a domestic currency appreciation that is expected to be temporary there is an incentive for holders of domestic currency to sell some of their holdings, acquiring foreign currency, and then buying the domestic currency back at a lower price. By behaving this way speculators meet part of the excess demand for domestic currency and accelerate the process of returning to the long term equilibrium value of the currency. Friedman stated that those that argue that speculation can be destabilizing in the foreign exchange market do not realize that this is equivalent to saying that speculators constantly lose money, since speculation can be destabilizing only if speculators sell when the currency is cheap and buy when it is expensive. He suggests that speculators who behave this way will be driven out of the market relatively quickly. The second type of regime that must be defined is the fixed exchange rate regime, in which the value of the currency is tied to the value of some other currency. The exchange rate uncertainty that may result from floating exchange rates has a negative impact on some types of investments, possibly affecting trade. It is believed that by fixing the value of the domestic currency relative to that of a major economy, a country can lower exchange rate volatility and promote trade and investment. Fixed exchange rates have been seen by some economists as helpful in obtaining several other economic goals. For instance, it has been argued that fixed exchange rates are useful in obtaining price stability. An exchange rate target is straightforward and easily understood by the general public. If this exchange rate target is credible, that is, if the public has confidence that the monetary authorities will pursue such a target, then it may lower inflation expectations to the level prevailing in the anchor country. Some fixed exchange rates arrangements imply the surrender of the monetary authorities' control over domestic monetary policy. For some countries (specially developing countries), with a lack of discipline and too many incentives to create revenue from money creation, a surrender of the monetary policy may be a desirable outcome. Even Milton Friedman, who as we mentioned above championed floating exchange rates, admitted that fixed exchange rates can be sometimes preferable for developing countries. However, because fixed exchange rate arrangements limit the monetary policy options of the country, these arrangements can expose the country to international shocks. Some examples of fixed exchange rates regimes include dollarization and currency boards. In dollarized economies the currency of another country circulates as the sole legal tender. The term dollarization refers to any country that uses a foreign currency as the domestic currency, not only to those countries that adopt the US dollar. Dollarization differs from a monetary union in which members belong to a currency union in which the same legal tender is shared by members of the union. The adoption of a dollarized regime implies the complete surrender of the monetary authorities' control over domestic monetary policy. In the case of currency boards there is an explicit legal commitment to exchange domestic currency for a specified foreign currency at a certain value, combined with restrictions on the monetary authorities' power to ensure the execution of that legal obligation. Finally, our third type of regime is the intermediate regime. This regime is essentially some type of pegged float in which the exchange rate is free to fluctuate but it is kept by the country’s monetary authorities from deviating from a certain range. There are numerous intermediate arrangements and the possibilities are only limited by the imagination. Some of the intermediate exchange rate regimes recognized by the International Monetary Fund include pegged exchange rates within horizontal bands, crawling pegs, exchange rates within crawling bands, and managed floating with no predetermined path for the exchange rate. Next we discuss the International Monetary Fund definition of each of these regimes. The pegged exchange rate within horizontal bands is a regime in which the value of the currency is maintained within a range of 1 percent around a fixed value or the difference between the minimum and maximum value of the exchange rate exceeds 2 percent. In a crawling peg regime the exchange rate is adjusted periodically at a fixed rate or in response to changes in several indicators (e.g. relative inflation measures). These two regimes leave the country with a limited degree of monetary policy discretion. The exchange rate within crawling bands is a regime that combines certain aspects of the previous two regimes. Finally, in a regime of managed floating with no predetermined path, the monetary authority influences the exchange rate without having a specific exchange rate path or target. Across time, countries have moved from one currency regime to another in order to facilitate business and improve national economies. Next we provide a short historical recount of the main trends in exchange rate regimes. The Gold Standard Although there were some reappearances of a gold standard, after 1914 and the outbreak of World War I, its is agreed that 1914 marks the end of the classical gold standard era, during which the majority of countries adhered to some type of gold standard system. Under the gold standard currencies were linked to gold, that is, the value of a country’s currency was set at a given rate to gold ounces. Gold has been traditionally used for commercial purposes as a medium of exchange and store of value because it is rare and durable. Paper currency itself has no intrinsic value (it’s just plain paper), but was accepted as payments for goods and services because it could be redeemed any time for its equivalent value in gold. The gold standard also worked as an international pegged exchange rate system. Countries maintained a fixed price for gold and therefore, if we take into account transaction costs, the rates of exchange between currencies were limited by a very tight band. The automatic adjustment process under the gold standard implied that sometimes policy tools were not available to be used for fighting cyclical economic downturns or inflation. The gold standard regulated the quantity and growth rate of a country's money supply. This, according to economics professor and gold standard expert Michael D. Bordo, implied that the price level should not vary much in the long run. That is, under the gold standard there would be a tendency towards price stability. In 1914, with the advent of World War I and the financing of war related expenses by printing money, the classical gold standard era came to an end. The Bretton Woods Period After 1914, there were some efforts to establish a new gold standard that for several reasons, including the great depression, were unsuccessful. Many countries decided to abandon the gold standard and adopt free floating exchange rates. At the closing of World War II, delegates from Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire in the United States. Delegates deliberated extensively in a effort to establish the basic rules of the international monetary system. The goals of the attendees included global economic stability and increased volumes of global trade. The agreements included the creation of the International Bank for Reconstruction and Development (IBRD) (now part of the World Bank Group) and the International Monetary Fund (IMF). Attendees also agreed that there were disadvantages in the use of floating exchange rates. It was, therefore, also agreed that currencies would once again be fixed. World major currencies were pegged to the US dollar. At this point the US dollar was pegged to gold at $ 35 dollars per ounce of gold. The Bretton Woods system lasted until the early 1970’s, when the US dollar could no longer hold the peg of $ 35 dollars per ounce of gold and the convertibility of US dollars to gold was suspended. The Post-Bretton Woods Period After the Bretton Woods era ended, countries moved in several directions. Several developed countries, like the United States, have since embraced floating exchange rates. These group of countries determined that exchange rates were no longer the optimal method to conduct monetary policy. It has become the convention to argue that exchange rates should be determined directly by market forces and should be free to fluctuate continually. Many developing countries have followed suit and have liberalized their currencies. However, it is argued that many countries which say they allow their exchange rate to float are not really floaters and intervene frequently in the foreign exchange market in order to manipulate the value of their currency. Economists Guillermo A. Calvo and Carmen M. Reinhart argue that since countries that are supposedly classified as having a free float mostly resemble non-credible pegs the demise of fixed exchange rates is a myth. They argue that many of these suppose floaters suffer from an epidemic of “fear of floating.” On the other hand, another series of countries have explicitly decided to adopt fixed or pegged exchange rate systems. Many of these countries have arrangements that fall in one of two categories. The first category includes countries that favor regional arrangements. For instance, during the 1970’s there was a regional movement towards currency integration in Europe, that resulted in the European Monetary System in 1979, a pegged exchange rate regime within horizontal bands. According to Michael D. Bordo the motivation for the European Monetary System (EMS) included the strong dislike by Europeans for flexible exchange rates and the common agricultural policy established in Europe in 1959. Later on it was decided to replace most of the region’s currencies for a single currency. The final result was the euro, (€), the official currency of the European Union (EU). The euro was launched on January 4, 1999 with 11 member states of the EU and is currently used by 15 member states (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia and Spain). Other countries have decided to dollarize their economies. These countries have decided to relent discretionary monetary policy and use a foreign currency instead of the domestic currency. Some examples of recently dollarized economies include Ecuador and El Salvador. In both cases the US dollar is the sole legal tender. Given all these examples someone may ask which is the best currency regime? Should countries adopt flexible exchange rates? Are countries better off with a fixed currency? Are intermediate regimes the best alternative? Michael D. Bordo and Jeffrey Frankel, among other economists, argue that no single currency regime is optimal for all countries. The best regime depends on the specific case of each country and a case can be made for each regime under particular circumstances. The Determinants of the Exchange Rate Economists have not yet reached a consensus on the factors that should be included as determinants of the exchange rate. Exchange rates may respond to many different variables, some which are real variables (e.g. exports and imports) and some which are financial and monetary variables (e.g. interest rates and inflation). Let’s starts the discussion of the determinants of the exchange rate with a simple model of exchange rate determination in which the exchange rate is determined by the interaction of supply and demand for foreign exchange. We assume that domestic and foreign exporters are paid in their respective country’s currency. For example, Japanese exporters are paid in yen, while American exporters are paid in US dollars. Both the supply and demand for foreign exchange are determined by the amount exported and imported in each country. For instance, if Americans want to import Japanese cars, then they must pay the Japanese exporters for their cars using yen. Alternatively, if Japanese tourists want to visit New York they need US dollars for expenditures in food, accommodations, entertainment, and shopping. All these expenditures are considered US exports and are a source of demand for US dollars. The interaction between demand and supply in this market is represented in Figure 1. We label domestic exports as X, domestic imports as M, domestic prices as P, while the foreign prices are labeled P*. The demand for foreign currency is the foreign price multiplied by the amount imported, that is (P*)(M). In our previous example this will be the number of Japanese cars multiplied by the price of those cars. The supply of foreign exchange is the domestic price (adjusted by the exchange rate) multiplied by the amount exported, that is (P/S)X. If a country increases exports then there is an increase in the supply of foreign exchange as foreigners buy domestic currency in order to pay for the exports. On the other hand, imports increase the demand for foreign exchange as more foreign currency is needed to pay for the foreign goods. The equilibrium between demand and supply is point E and the exchange rate that equilibrates demand and supply is SE. [Exchange Rates Figure 1 about here] Suppose that there is an increase in the demand for foreign exchange. As presented at the bottom of Figure 1, as a result of the increase demand for foreign exchange there is a shift of the demand curve from D to D', and a depreciation of the domestic currency. The new equilibrium is point b. At this point more units of the domestic currency are needed in order to buy one unit of the foreign currency. If the monetary authority of the domestic country wants to avoid the domestic currency depreciation, then it must shift the supply curve for foreign exchange from S to S', getting to the new equilibrium point c at which the exchange rate gets back to SE.