Introduction: Terminologies and Definition Lecture 1 Introduction: Terminologies and Definition

TERMINOLOGIES Foreign Exchange rate Foreign exchange rate is the rate at which one currency is exchanged for other. It is the price of one currency in term of other The exchange rate between dollar and pound refers to numbers of dollars required to purchased one pound For example if $2.50=£1 It means that value of £0.40 pound =$1 2

Meaning of Exchange Rate Value of one currency in units of another currency A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

Meaning of Exchange Rate (Cont.) (Bilateral) (spot) exchange rate, S, is (domestic currency) price of unit of foreign currency (FX), so rise (fall) in S is fall (rise) in value of domestic currency Cross exchange rate is bilateral exchange rate between two currencies other than dollar, $ (For Americans) Example: Cross exchange rate = ratio of two bilateral exchange rates against the $, since deviations create profit opportunities for traders Assume (unless stated otherwise) free capital movements i.e. currency fully convertible.

Foreign Exchange: The exchange rate of $2.50=£1 or £0.40=$1 will be eliminated in world market by arbitrage What is arbitrage: it refers to the purchase of foreign currency in one market where its price is low and sell it in another market where it price is high The effect of arbitrage is to remove differences in exchange rate , so that single exchange rate prevail in world market If exchange rate is $2.48 in London exchange market and $2.50 in new York exchange market

Foreign Exchange: Arbitrageurs will buy pounds in London and sell them in new York for earning profit As a result the price of pounds in term of dollars in London market rises and falls in the new York market This process will end the arbitrage practice

Floating versus fixed exchange rate IMF Exchange Rate Regime Classifications: 8 Regimes (MSE,2009 p. 70-71) Pure float: exchange rate at any moment determined by net demand for currency Fixed exchange rate: monetary authority intervenes by (a) buying up excess supply of $ with £ (when £ strong, $ weak) or (b) satisfying excess demand for $ by selling $ for £ (when £ weak, $ strong), so as to prevent excess demand /supply affecting rate (a) adds $ to FX reserves, adds to £ in circulation (b) takes $ out of FX reserves, reduces £ in circulation.

Foreign Exchange and Balance of payments 1. Current account: export receipts as credits, import payments as debits, net = current account balance (goods, services including financial services, interest and dividends, rent, tourism) 2. Capital account: net capital inflows = net purchases of £ by foreigners in order to acquire claims on UK residents less net sales of £ by UK residents in order to acquire claims on foreigners (long-term including securities – equities, bonds etc., real estate etc. + short-term including bank deposits, short-term securities) Total net underlying demand for £ = 1 + 2 (basic balance) is equated to zero by exchange rate movement, unless Government intervenes to fix exchange rate, in which case: 3. Reserve change = – (1 + 2) to prevent basic balance causing exchange rate to move.

Table 1.3 UK balance of payments 2006 Source: National Statistics website: www.statistics.gov.uk. Crown copyright material is reproduced with the permission of the Controller Office of Public Sector Information (OPSI).

Determination of equilibrium exchange rate The exchange rate in a free market is determined by the demand and supply of foreign exchange Equilibrium exchange rate is a rate at which demand for foreign exchange is equal to supply of foreign exchange It is the rate which clears the foreign exchange market Two method for clearing the market A) Demand and supply of dollars with price of dollars in pounds B) Demand and supply of pounds with price of pounds in dollars…………both method yields same result

Determination of equilibrium exchange rate (cont…) 1) Demand for foreign exchange The demand for foreign exchange (pounds) is a derived from demand from pounds It arises from import of British goods and services into U.S and from capital movements from the U.S to Britain Demand for pounds implies supply of dollars When U.S businessmen buy British goods and services and make capital transfers to Britain they create demand for British pounds in exchange for U.S dollars

Determination of equilibrium exchange rate (cont…) Demand curve for pounds DD is sloping downward from left to right It means that lower the exchange rate on pounds( pounds became cheaper) (dollars price of pound) the larger will be demand for pounds in foreign market This means that British exports of goods and services cheaper in term of dollars The opposite happens if exchange rate on pounds (dollars price of pound) is higher It will make British goods and services dearer

Determination of equilibrium exchange rate (cont…) Supply of foreign exchange Supply of foreign exchange in our case is the supply of pounds It arises from U.S exports of goods and services to Britain and capital movement from U.S to Britain British holders of pounds wish to make payment in $, thus supply of pounds in market will increase Supply curve for pounds SS is an upward sloping curve The relation between exchange rate on pounds (dollar price of pounds) and supply of pounds is positive If exchange rate on pounds increases U.S goods and services become cheaper in Britain ,they would purchase more and as a result supply of pounds in a market increase

Determination of equilibrium exchange rate (cont…) Dollar price of pounds S R2 R Exchange rate R1 S D Q pounds

Determination of equilibrium exchange rate (cont…) Given the demand and supply curve for foreign exchange, the equilibrium exchange rate is determined where demand for pounds intersects supply of pounds Equilibrium exchange rate is “R” and OQ shows equilibrium demand and supply of foreign exchange rate If exchange rate is higher than equilibrium exchange rate it means that supply of pounds is greater than demand for pounds The price of pounds will fall and ultimately equilibrium exchange rate will reach and economy will come back to equilibrium point i.e point “E”

Determination of equilibrium exchange rate (cont…) An exchange rate lower than equilibrium rate mean demand for foreign exchange rate is greater than supply of foreign exchange rate This leads to increase the price of pounds in foreign exchange market so exchange rate will tends to increase and equilibrium rate will re-established in market Economy come back to equilibrium point i.e. point “E”

Meaning of Exchange Rate and Measuring Changes in Exchange Rates Value of one currency in units of another currency A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

Appreciation/Depreciation Percentage change in value US $ New Value of Foreign Currency per unit of $ - Old value of foreign currency per $ -------------------------------------------------- X 100 Old value of Foreign Currency per $ Percentage change in value of Foreign Currency New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency Old value of $ per unit of Foreign Currency HW: Calculate the change in the value of your currency against both Euro and Dollar from September 2016 to September 2017.

Exchange Rate Equilibrium Forces of Demand and Supply Demand for foreign currency negatively related to the price of foreign currency Supply of foreign currency positively related to the price of foreign currency Forces of demand and supply together determine the exchange rate

Demand for Foreign Currency Price for Foreign Currency D $2.00 $1.50 D 75 m 50m Units of Foreign Currency (£)

Supply of Foreign Currency Supply for Foreign Currency S $2.00 $1.50 S 50 m 75 m Units of Foreign Currency (£)

Equilibrium Exchange Rate D S $1.6775 S D Units of Foreign Currency(£)

Factors that influence the Exchange Rate Expectations of the Market Political Events Relative Inflation Rates Relative Interest Rates Relative Income Levels Exchange rate is the results of an interaction of these factors

Market Expectations Expectations about future exchange rate changes on the basis of current and future political and economic conditions 1960s Strong $ Between 1960s and 1970s: weak $ Strong $ in 1999 – 2001 Weak Dollar today 2005 1995 European Exchange Rate Mechanism Devaluation of Asian Currencies Global financial crisis -2008

Political Events Fall of Berlin Wall and unification of East and West Germany Persian Gulf War September 11, 2001

Relative Inflation High inflation relative to a foreign country, decline in value of currency—Why? Low inflation relative to a foreign country, increase in value of currency—Why?

Relative Interest Rates High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?

Relative Income Levels Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?

Exchange Rate Determination An interaction of factors Is it possible for a country with high real returns to have a low currency value? Is it possible for a country with low real returns to have a high currency value?

Exchange rates since 1945 Bretton Woods 1944–68 US $ fixed at 1 oz gold = $35, all other currencies fixed to $ with  1% fluctuation bands, devaluations to correct persistent deficits Breakdown 1968–73 as US printed excess $ causing worldwide inflation and flight into gold, other currencies (DM, Yen) Floating Era 1973 onward managed floats for most convertible currencies at first, but later experiments with limited fixed systems e.g. ERM in Europe, currency boards in Hong Kong, Argentina EMU 1998 onward response to failure of fixed exchange rates Increasing importance of Asian exchange rates 2000 onward especially RMB, Won, Rupee (varying degrees of flexibility/convertibility, increasingly linked to $/€/Yen currency basket).

Figure 1.3 Exchange rates against the US dollar, 1975–2007 (1999 = 100)

Figure 1.4 Effective exchange rates (trade-weighted), 1975–2006

Figure 1.5 The pound (trade-weighted and bilateral), 1975–2006

Figure 1.6 The euro since 1999: currencies per € Note: each exchange rate is the daily closing mid-price of €1.00. For US$, the data are unscaled. The other five exchange rates are scaled so that 25/01/00 = 1.0, to match the $US, which actually stood at €1.00 = $1.0008 on that day