Econ 141 Fall 2015 Slide Set 2 Introduction to exchange rates and exchange rate regimes

Defining the Exchange Rate The exchange rate is the price of a unit of one currency in terms of another currency. For example, the U.S. dollar exchange rate for euros is E $/€ =dollars/one euro This is currently E $/€ = 1.12 dollars per euro. The euro exchange rate for U.S. dollars is E €/$ = 0.89 euros per dollar E $/¥ = dollars per 100 yen and E ¥/$ = yen per dollar E $/£ = 1.52 dollars per pound and E £/$ = 0.66 dollars per pound

Notice that We need to be explicit about how we are expressing the relative price of one currency in terms of the other. We will use the convention that we express exchange rates as the number of units of the home currency that exchange for one unit of foreign. Defining the Exchange Rate

Appreciations and Depreciations If one currency buys more of another currency, we say it has experienced an appreciation – its value has risen, appreciated or strengthened. If a currency buys less of another currency, we say it has experienced a depreciation – its value has fallen, depreciated, or weakened.

Appreciations and Depreciations For the U.S. dollar, When the U.S. exchange rate E $/€ rises, more dollars are needed to buy one euro. The price of one euro goes up in dollar terms, and the U.S. dollar experiences a depreciation. When the U.S. exchange rate E $/€ falls, fewer dollars are needed to buy one euro. The price of one euro goes down in dollar terms, and the U.S. dollar experiences an appreciation.

Appreciations and Depreciations Similarly, for the euro, When the Eurozone exchange rate E €/$ rises, the price of one dollar goes up in euro terms and the euro experiences a depreciation. When the Eurozone exchange rate E €/$ falls, the price of one dollar goes down in euro terms and the euro experiences an appreciation.

Some exchange rates of Sept 28, 2015 Per $Per €Per £Per ¥ United States (dollar) Eurozone (euro) United Kingdom (pound) Japan (yen) Hong Kong (dollar) Sweden (krona) Canada (dollar) Mexico (peso)

At the beginning of January 2015 (1/2/15), the dollar value of the euro was E $/€ = On January 30, 2015, it was E $/€ = Over this period, the euro depreciated against the dollar by the amount ∆E $/€ = = The percentage depreciation of the euro was ∆E $/€ / E $/€ x 100 = (0.0723/ ) x 100 = 6.02% The annual rate of euro depreciation over the month of January was approximately 102%. Appreciations and Depreciations

In terms of the dollar, in January 2015, On January 2, 2015, the euro value of the dollar was E € /$,t = At the end of January (1/30/15), it was E € /$,t+1 = The change in the dollar value of the euro was ΔE € /$,t = − = − The percentage change was ΔE €/$,t / E €/$,t = − / = −6.78%. The dollar appreciated against the euro by 6.78% over the month of January. The annual rate of appreciation of the dollar was 56.93%. Appreciations and Depreciations

Exchange rates and relative prices of goods. Suppose you wanted to buy a Belgian chocolate bar selling for 1 euro: The cost of the bar in dollars will be 1 euro x E $/€ dollars/euro. On Jan 2, 2015, it would cost $ But on Jan 30, 2015, you would pay $ Suppose VW sold a car in L.A. for $25,000 in Once it exchanged its receipts to euros, VW would receive $25,000 x €/$ = € 22,145 at the end of January, but at the end of July 2015, receive $25,000 x €/$ = €22,670

Changes in the exchange rate cause changes in prices of foreign goods expressed in the home currency. Changes in the exchange rate cause changes in the relative prices of goods produced in the home and foreign countries. When the home country’s exchange rate depreciates, home exports become less expensive as imports to foreigners, and foreign exports become more expensive as imports to home residents. When the home country’s exchange rate appreciates, home export goods become more expensive as imports to foreigners, and foreign export goods become less expensive as imports to home residents.

Multilateral Exchange Rates To aggregate different trends in bilateral exchange rates into one measure, we can calculate multilateral exchange rate changes for baskets of currencies using trade weights to construct an average of all the bilateral changes for each currency in the basket. For example, suppose 40% of U.S. trade is with China and 60% is with Canada. The U.S. dollar appreciates 10% against the yuan, but depreciates 30% against the CA$. The change in U.S.’s effective exchange rate is found by calculating the weighted average exchange rate change using the trade shares: (−10% 40%) + (30% 60%) = (− ) + ( ) = − = 0.14 = +14%. The effective exchange rate of the U.S. dollar has depreciated by 14%.

Multilateral Exchange Rates Suppose the U.S. trades with N countries using N currencies. The total trade for the U.S. is the sum, Trade = Trade 1 + Trade Trade N. The weighted average change in the exchange rates is called the change in the effective exchange rate (E effective ).

Fixed (or pegged) exchange rate regimes are those in which a country’s exchange rate fluctuates in a narrow range (or not at all) against some base currency over a sustained period, usually a year or longer. A country’s exchange rate can remain rigidly fixed for long periods only if the government intervenes in the foreign exchange market in one or both countries. Floating (or flexible) exchange rate regimes are those in which a country’s exchange rate fluctuates in a wider range, and the government makes no attempt to fix it against any base currency. Appreciations and depreciations may occur from year to year, each month, by the day, or every minute. Exchange Rate Regimes: Fixed Versus Floating

Floating exchange rates The major currencies of the world, float against one another. For example, the U.S. dollar is allowed to float against the euro, the pound, the yen, as well as many smaller country currencies (for example, the Danish krone, Canadian dollar (loonie) or New Zealand dollar (kiwi)).

Developing Country Exchange Rates Exchange rates in developing countries can be much more volatile than those in developed countries. India is an example of a middle ground, somewhere between a fixed rate and a free float, called a managed float (also known as dirty float, or a policy of limited flexibility. Dramatic depreciations, such as those of Thailand and South Korea in 1997, are called exchange rate crises and they are more common in developing countries than in developed countries.

Green line shows a measure volatility of the exchange rate.

East Asian Crisis of

Currency Unions and Dollarization Under a currency union (or monetary union), there is some form of transnational structure such as a single central bank or monetary authority that is accountable to the member nations. The most prominent example of a currency union is the Eurozone. Under dollarization one country unilaterally adopts the currency of another country. The reasons for this choice can vary. A small size, poor record of managing monetary affairs, or if people simply stop using the national currency and switch en masse to an alternative.

Exchange Rate Regimes Independently Floating: 25 Countries Including the U.S., Canada, Australia, Mexico, United Kingdom, Sweden, South Korea and even Albania. Managed Floating: 44 countries Including India, Singapore, Thailand and Kenya (many Latin American, East Asian and African countries) Crawling bands or pegs: 10 countries Including China

Currency boards: 7 countries Including Hong Kong Other pegs: 60 countries Including Argentina and many Central Asian and African countries No independent currency: 46 countries The Eurozone The Central African and Western African CFA Franc Zones Eastern Caribbean Currency Union Use another currency: Ecuador, Panama, El Salvador and 7 others (7 use USD) Exchange Rate Regimes

FIGURE 2-4 A Spectrum of Exchange Rate Regimes

FIGURE 2-4) An additional 43 counties have bands, crawling pegs or bands, while 46 countries have exchange rates that either float freely, are managed floats are allowed to float within wide bands. A Spectrum of Exchange Rate Regimes (continued)