The Determination of

Exchange Rates
 Learning Objectives
 Describe the International Monetary Fund and its
role in the determination of exchange rates
 Discuss the major exchange-rate arrangements
that countries use
 Explain the European Monetary System and how
the euro became the currency of the euro zone
 Identify the major determinants of exchange
rates
 Show how managers try to forecast exchange-
rate movements
 Explain how exchange-rate movements influence
business decisions
The International Monetary Fund

 Established in 1945 with 29 members

 Now IMF includes 189 members

 Headquarter is in Washington D.C.

 The International Monetary Fund
 The goals of the International Monetary
Fund (IMF) are to
 ensure stability in the international monetary
system
 promote international monetary cooperation
and exchange-rate stability
 facilitate the balanced growth of international
trade
 provide resources to help members in balance-
of-payments difficulties or to assist with
poverty reduction
The International Monetary Fund
 The Bretton Woods Agreement
 established a par value, or benchmark value,
for each currency initially quoted in terms of
gold and the U.S. dollar
 the dollar was fixed at $35 per ounce of gold

 The dollar became the world benchmark

for trading currencies and continues in
that role today
 The IMF Today
 The Quota System
 every member contributes a quota based on the relative size
of a country. They influence the voting power of each country
 Assistance Programs
 the IMF lends money to ease balance-of-payments difficulties

 Special drawing rights (SDRs)

 the IMF’s unit of account
 Special drawing rights (SDR) are supplementary foreign
exchange reserve assets defined and maintained by the
International Monetary Fund (IMF). Their value is based on a
basket of key international currencies reviewed by IMF every five
years.
 The Global Financial Crisis
and the IMF

 The global crisis in 2008-2009 raised

concerns over global liquidity
 prompted the G20 to inject huge amounts of
cash into the IMF

 Greece’s 2010-2011 financial crisis

required assistance from the IMF and the
EU
 Evolution to
Floating Exchange Rates
 The Smithsonian Agreement
 8.5% devaluation of the dollar
 revaluation of other currencies
 widening of exchange rate flexibility
 The Jamaica Agreement
 provided greater exchange rate flexibility
 eliminated the use of par values
 Exchange Rate Regimes (Hard Peg,
Soft Peg and Floating)
 Each country depending on their economic
expectation and their political view has
applied different types of exchange rate
regimes. Although there are too many
classifications on this issue, we will use the
following classification which is summarized
under three titles:
 ·    Hard peg system
 ·    Soft peg system
 ·    Free floating system
 Currency Peg
 A country or government's exchange-rate
policy of pegging the central bank's rate of
exchange to another country's currency.
 Currency has sometimes also been pegged
to the price of gold.
 Dollarization of currency

 Countries that use the dollar as an

exchange arrangement with no separate
legal tender are practicing dollarization of
the currency.
 Three Choices:
Hard Peg, Soft Peg, or Floating
 The IMF classifies currencies into three categories

 Hard peg
 value is locked into something and does not change
 dollarization

 Soft peg
 more flexible than hard peg
 Chinese Yuan is an example

 Floating
 floating or free floating
 change according to market forces
 Hard Peg
 Hard peg regimes are the exchange rate systems
in which the national currency is either fixed to a
respectable foreign currency or the government
completely gives up its national currency and
start to use a strong one.
 Panama, which has long used the U.S. dollar,
is an example of full dollarization.
 hard exchange rate peg has no independent
monetary
 Soft Peg
 currencies that maintain a stable value against
an anchor currency or a composite of
currencies. The exchange rate can be pegged to
the anchor within a narrow (+1 or –1 percent) or
a wide (up to +30 or –30 percent) range
 Costa Rica, Hungary, and China are examples of
this type of peg.
 they allow for a limited degree of monetary policy
flexibility to deal with shocks
 However, soft pegs can be vulnerable to financial
crises—which can lead to a large devaluation
 Floating exchange rates
 Floating exchange rate is mainly market
determined. In countries that allow their
exchange rates to float, the central banks
intervene, mostly to limit short-term exchange
rate fluctuations.
 However, in a few countries (for example, New
Zealand, Sweden, Iceland, the United States, and
those in the euro area), the central banks almost
never intervene to manage the exchange rates.
 Floating regimes offer countries the advantage of
maintaining an independent monetary policy.
Independently Floating

The exchange rate is market-determined, with

any official foreign exchange market
intervention aimed at moderating the rate of
change and preventing undue fluctuations in
the exchange rate, rather than at establishing
a level for it.
Exchange Rate Anchor
The monetary authority stands ready to
buy/sell foreign exchange at given quoted
rates to maintain the exchange rate at its pre-
announced level or range
Exchange Rate Arrangements
Exchange Rate Arrangements and Anchors
Determining Exchange Rates
Learning Objective:
Identify the major determinants of
exchange rates
Determining Exchange Rates
 Currency in a floating rate world
 demand for a country’s currency is a function
of the demand for that country’s goods and
services and financial assets
Determining Exchange Rates
The Equilibrium Exchange Rate and How it Moves
 Factors Determining the
Value of a Currency
 Currency is like a commodity and the laws of
demand and supply will hold
 A complex set of factors/variables simultaneously
(thus a dynamic view) influence the value of the
currency. They are:
1. BOP statistics (trade and reserve)
2. Interest rate differentials
3. Inflation differentials
4. Fiscal and monetary policy
5. Business cycles
6. Political events
7. Psychological (confidence) factors 21
Determining Exchange Rates
 Currency in a fixed rate or managed
floating rate world
 Role of central banks
 reserve assets

 intervening in the market

 The Bank for International Settlements

(BIS)
 the central banks’ bank

 coordinates central bank intervention

 Foreign Exchange
Convertibility and Controls
 Hard currencies
 U.S. dollar, euro, British pound, Japanese yen
 Soft currencies
 developing countries
 Countries can control convertibility
through
 licenses
 multiple exchange rate systems
 advance import deposits
 quantity controls
 Exchange Rates and
Purchasing Power Parity

 Purchasing power parity (PPP)

 a change in relative inflation between two
countries must cause a change in exchange
rates to keep the prices of goods in the
countries fairly similar
 Exchange Rates
and Interest Rates
 The Fisher Effect
 links inflation and interest rates
 R (real interest rate)=nominal rate less
inflation
 r (nominal interest rate)= (1+R)(1+i)-1
 i=inflation rate

 The International Fisher Effect (IFE)

 links interest rates and exchange rates
 Forecasting
Exchange Rate Movements
Learning Objective:
Show how managers try to forecast
exchange-rate movements
 Fundamental and Technical
Forecasting
 Forecasting exchange rates
 Fundamental forecasting
 uses trends in economic variables to predict

future rates
 Technical forecasting
 uses past trends in exchange rates to spot

future trends
 Biases can skew forecasts
 Timing, direction, and magnitude of exchange
rate movements are important to consider
 Fundamental Factors
to Monitor
 Monitor
 The institutional setting (intervention by
central banks)
 Fundamental analyses (currency
undervalue or overvalue in terms of PPP)
 Confidence factors (market expectations)
 Circumstances (national or international
events or crises )
 Technical analyses (emerging trends)
 Business Implications of
Exchange Rate Changes
Learning Objective:
Explain how exchange-rate movements
influence business decisions
 Business Implications of
Exchange Rate Changes
 Marketing Decisions
 when the value of a country’s currency rises, exporting
becomes more difficult as the product becomes more
expensive in foreign markets
 Production Decisions
 might locate production in a weak currency country
because the initial investment is cheap and it will make
a good base for exports
 Financial Decisions
 currency rates influence sourcing, cross-border payment
of funds, and the reporting of financial results
 The Euro
Learning Objective:
Explain the European Monetary System
and how the euro became the currency of
the euro zone
 The Euro
 The European Monetary System (EMS)
 established to create exchange rate stability
within the European Community
 European Monetary Union (EMU)
 outlined the criteria for euro applicants
 the U.K., Sweden, and Denmark opted not

to adopt the euro

 The European Central Bank (ECB)
 sets monetary policy for the adopters of the
euro
 The Future: The Dollar, The
Euro, The Yen, The Yuan
 Europe
 the euro should take market share away from
the dollar as the prime reserve asset assuming
the problems in Greece and other countries are
controlled
 Asia
 China is moving forward to establish the yuan
as a major world currency
 Latin America
 emerging market currencies should strengthen
as commodity prices recover