Chapter 10

The Foreign Exchange Market

 Foreign Exchange
 The foreign exchange market
– Is the market where one buys or sells
the currency of country A with
the currency of country B

 A currency exchange rate

– Is simply the ratio of
a unit of currency of country A to
a unit of the currency of country B
at the time of the buy or sell transaction
An exchange rate is the rate at which one currency can be
exchanged for another.

In other words, it is the value of another country's currency

compared to that of your own.

If you are traveling to another country, you need to "buy" the local
currency. Just like the price of any asset, the exchange rate is the
price at which you can buy that currency. If you are traveling to
Egypt, for example, and the exchange rate for U.S. dollars is 1:5.5
Egyptian pounds, this means that for every U.S. dollar, you can buy
five and a half Egyptian pounds.

Theoretically, identical assets should sell at the same price in

different countries, because the exchange rate must maintain the
inherent value of one currency against the other.
 The Foreign Exchange Market

 Currency conversion in the foreign exchange

market
– Is necessary to complete private and commercial
transactions across borders
– A tourist needs to pay expenses on the road in local
currency
– A firm
• Buys/sells goods and services in the other country’s local
currency
• Uses the foreign exchange market to invest excess funds
 Is used to speculate on currency movements
 The Foreign Exchange Market
 Minimizes foreign exchange risk (unpredictable rate
swings)
 To do so there are different ways to trade currencies
– Spot exchange rates: the day’s rate offered by a
dealer/bank
– Forward exchange rates:
• Agreed in advance rates to buy/sell a currency on a
future date
• Usually quoted 30, 90, 120 days in advance
 The market is “open” 24 hours…
 Arbitrage is the process of buying low and selling high …
given slightly different exchange rate quotes in one
location vs another (e.g., London vs Tokyo)
 Prices and Exchange Rates
 The law of one price:
– Identical products sold in different countries must sell for one
price if their price is expressed in one currency
– Assumptions:
• Competitive markets
• No transportation costs; no trade barriers
 Purchasing Power Parity (PPP):
– If the law of one price holds for all goods / services, the PPP
exchange rate is found by comparing prices of identical
products in different countries
The law of one price says that identical goods should sell for the
same price in two separate markets when there are no transportation
costs and no differential taxes applied in the two markets.

Consider the following information about movie video tapes sold in

the US and Mexican markets.

Price of videos in US market : $20

Price of videos in Mexican market: p150
Spot exchange rate (Ep/$): 10 p/$

The dollar price of videos sold in Mexico can be calculated by

dividing the video price in pesos by the spot exchange rate as
shown,
To see why the peso price is divided by the exchange rate
(rather than multiplied) notice the conversion of units shown in
the brackets. If the law of one price held, then the dollar price
in Mexico should match the price in the US. Since the dollar
price of the video is less than the dollar price in the US, the
law of one price does not hold in this circumstance.
 The Law of One Price
We can mathematically state the law of one price as
follows, for the case of any good g sold in two locations:
g g
qUS  ( E$ / € PEUR )/ PUSg
  / EUR
     
Relative price of good g European price U.S. price
in Europe versus U.S. of good g in $ of good g in $
g
q expresses the rate at which goods can be
US / EUR
exchanged: it tells us how many units of the U.S. good are
needed to purchase one unit of the same good in Europe.
E$ / € expresses the rate at which currencies can be
exchanged ($/€).
 The Law of One Price
We can rearrange the equation for price equality
g
E$ / € PEUR  PUSg
to show that the exchange rate must equal the ratio of the
goods’ prices expressed in the two currencies:
g g
E$ / €  P / P
    
US EUR
Exchange Ratio of
rate goods’ prices
 Purchasing Power Parity

The principle of purchasing power parity (PPP) is the

macroeconomic counterpart to the microeconomic law of
one price (LOOP). To express PPP algebraically, we can
compute the relative price of the two baskets of goods in
each location:
qUS / EUR  ( E$ / € PEUR ) / PUS
       
Relative price European price U.S. price
of basket of basket of basket
in Europe expressed expressed
versus U.S. in $ in $

There is no arbitrage when the basket is the same price in

both locations qUS/EUR = 1. PPP holds when price levels in
two countries are equal when expressed in a common
currency. This statement about equality of price levels is
also called absolute PPP.
The Relationship Between PPP and the
Law of One Price
– The law of one price applies to individual
commodities, while PPP applies to the general
price level.
– If the law of one price holds true for every
commodity, PPP must hold automatically for the
same reference baskets across countries if each
commodity is traded.

Copyright © 2003 Pearson

Slide 15-13
Education, Inc.
 The Real Exchange Rate
The relative price of the baskets is one of the most
important variables in international macroeconomics, and it
has a special name: it is known as the real exchange rate.
The U.S. real exchange rate qUS/EUR = E$/€ PEUR/PUS tells us
how many U.S. baskets are needed to purchase one
European basket; it is the price of the European basket in
terms of the U.S. basket.
The exchange rate for currencies is a nominal concept.
The real exchange rate is a real concept; it says how many
U.S. baskets can be exchanged for one European basket.
 Money Supply and Currency Value
Inflation occurs when the quantity of money in
circulation rises faster than the stock of goods and
services
Money supply growth related to currency value
Relative inflation rates and trends can predict relative
exchange rate movements
When changes in relative prices in two countries
change their currencies’ exchange rate, then the
currency of the country with the highest inflation
should decline in value
 Interest Rates and Exchange Rates
 Interest rates reflect expectations of inflation rates;
– high interest rates reflect high inflation expectation
– Fisher Effect: i = r + I
• i: “nominal” interest rate in a country
• r: “real” interest rate
• I: inflation over the period the funds are to be lent
– International Fisher Effect: (S1-S2)/S2 X 100 = i$ - i¥
• For any two countries the spot exchange rate should
change in an equal amount but in the opposite direction to
the difference in nominal interest rates between the two
countries
• S1: spot rate at time 1, S2 : spot rate at time 1; i$, i¥:
nominal interest rates in the US and Japan
 Convertibility
 Currency convertibility and government policy
– Freely convertible: residents/non-residents allowed to
purchase unlimited amounts of a foreign currency with the
local currency
– Not freely convertible: residents/non-residents not
allowed to purchase unlimited amounts of a foreign
currency with the local currency
 Fixed Exchange Rate Regime

A fixed exchange rate, sometimes called a pegged exchange rate,

is a type of exchange rate regime where a currency's value is fixed
against either the value of another single currency, to a basket of
other currencies, or to another measure of value, such as gold.

A fixed, or pegged, rate is a rate the government (central bank) sets

and maintains as the official exchange rate. A set price will be
determined against a major world currency (usually the U.S. dollar,
but also other major currencies such as the euro, the yen or a basket
of currencies).

In order to maintain the local exchange rate, the central bank buys
and sells its own currency on the foreign exchange market in return
for the currency to which it is pegged.
There are benefits and risks to using a fixed exchange rate.

A fixed exchange rate is typically used in order to stabilize the

value of a currency by directly fixing its value in a predetermined
ratio to a different, more stable or more internationally prevalent
currency (or currencies), to which the value is pegged.

In doing so, the exchange rate between the currency and its peg
does not change based on market conditions, the way floating
currencies will do.

This makes trade and investments between the two currency areas
easier and more predictable, and is especially useful for small
economies, economies which borrow primarily in foreign
currency, and in which external trade forms a large part of their
GDP.
In a fixed exchange-rate system, a country’s central bank typically
uses an open market mechanism and is committed at all times to
buy and/or sell its currency at a fixed price in order to maintain its
pegged ratio and, hence, the stable value of its currency in relation
to the reference to which it is pegged.

The central bank provides the assets and/or the foreign currency or
currencies which are needed in order to finance any payments
imbalances.

System in which the value of a country's currency, in relation to

the value of other currencies, is maintained at a fixed conversion
rate through government intervention. Also called pegged
exchange rate. Opposite of floating exchange rate.
In the 21st century, the currencies associated with large
economies typically do not fix or peg exchange rates to other
currencies. The last large economy to use a fixed exchange rate
system was the People's Republic of China which, in July 2005,
adopted a slightly more flexible exchange rate system called a
managed exchange rate. The European Exchange Rate
Mechanism is also used on a temporary basis to establish a final
conversion rate against the Euro (€) from the local currencies of
countries joining the Eurozone.
Types of fixed exchange rate systems

- The gold standard

Under the gold standard, a country’s government declares that it

will exchange its currency for a certain weight in gold.

In a pure gold standard, a country’s government declares that it

will freely exchange currency for actual gold at the designated
exchange rate. This "rule of exchange” allows anyone to go the
central bank and exchange coins or currency for pure gold or
vice versa.

The gold standard works on the assumption that there are no

restrictions on capital movements or export of gold by private
citizens across countries.
Because the central bank must always be prepared to give out gold
in exchange for coin and currency upon demand, it must maintain
gold reserves. Thus, this system ensures that the exchange rate
between currencies remains fixed.

For example, under this standard, a £1 gold coin in the United

Kingdom contained 113.0016 grains of pure gold, while a $1 gold
coin in the United States contained 23.22 grains.

The mint parity or the exchange rate was thus:

R = $/£ = 113.0016/23.22 = 4.87.

The main argument in favor of the gold standard is that it ties the
world price level to the world supply of gold, thus preventing
inflation unless there is a gold discovery (a gold rush, for example).
- Price specie flow mechanism

The automatic adjustment mechanism under the gold standard is

the price specie flow mechanism, which operates so as to correct
any balance of payments disequilibrium and adjust to shocks or
changes.

This mechanism was originally introduced by Richard Cantillon

and later discussed by David Hume in 1752 to refute the
mercantilist doctrines and emphasize that nations could not
continuously accumulate gold by exporting more than their
imports.
The assumptions of this mechanism are:

-Prices are flexible

-All transactions take place in gold
-There is a fixed supply of gold in the world
-Gold coins are minted at a fixed parity in each country
-There are no banks and no capital flows
Adjustment under a gold standard involves the flow of gold between
countries resulting in equalization of prices satisfying purchasing
power parity, and/or equalization of rates of return on assets
satisfying interest rate parity at the current fixed exchange rate.

Under the gold standard, each country's money supply consisted of

either gold or paper currency backed by gold. Money supply would
hence fall in the deficit nation and rise in the surplus nation.

Consequently, internal prices would fall in the deficit nation and rise
in the surplus nation, making the exports of the deficit nation more
competitive than those of the surplus nations. The deficit nation's
exports would be encouraged and the imports would be discouraged
till the deficit in the balance of payments was eliminated
In brief:

Deficit nation: Lower money supply → Lower internal prices →

More exports, less imports → Elimination of deficit

Surplus nation: Higher money supply → Higher internal prices →

Less exports, more imports → Elimination of surplus
Reserve currency standard

In a reserve currency system, the currency of another country

performs the functions that gold has in a gold standard.
A country fixes its own currency value to a unit of another
country’s currency, generally a currency that is prominently used
in international transactions or is the currency of a major trading
partner.
For example, suppose India decided to fix its currency to the dollar
at the exchange rate E₹/$ = 45.0. To maintain this fixed exchange
rate, the Reserve Bank of India would need to hold dollars on
reserve and stand ready to exchange rupees for dollars (or dollars
for rupees) on demand at the specified exchange rate. In the gold
standard the central bank held gold to exchange for its own
currency, with a reserve currency standard it must hold a stock of
the reserve currency.
 Gold exchange standard
The fixed exchange rate system set up after World War II was a gold-
exchange standard, as was the system that prevailed between 1920 and
the early 1930s. A gold exchange standard is a mixture of a reserve
currency standard and a gold standard.

Its characteristics are as follows:

-All non-reserve countries agree to fix their exchange rates to the
chosen reserve at some announced rate and hold a stock of reserve
currency assets.
-The reserve currency country fixes its currency value to a fixed
weight in gold and agrees to exchange on demand its own currency for
gold with other central banks within the system, upon demand.
-Unlike the gold standard, the central bank of the reserve country does
not exchange gold for currency with the general public, only with
other central banks.
Floating Exchange Rate Regime

A floating exchange rate or fluctuating exchange rate is a type of

exchange-rate regime in which a currency's value is allowed to
fluctuate in response to foreign-exchange market mechanisms.

A currency that uses a floating exchange rate is known as a floating

currency.

A floating currency is contrasted with a fixed currency whose value

is tied to that of another currency, gold or to a currency basket.
In the modern world, most of the world's currencies are floating;
such currencies include the most widely traded currencies: the
United States dollar, the euro, the Norwegian krone, the Japanese
yen, the British pound, and the Australian dollar.

However, central banks often participate in the markets to attempt to

influence the value of floating exchange rates. The Canadian dollar
most closely resembles a "pure" floating currency, because the
Canadian central bank has not interfered with its price since it
officially stopped doing so in 1998. The US dollar runs a close
second, with very little change in its foreign reserves; in contrast,
Japan and the UK intervene to a greater extent.
System in which a currency's value is determined solely by the
interplay of the market forces of demand and supply, instead of
by government intervention.

However, all central banks do try to defend these rates within a

certain range by buying or selling their country's currency as
the situation warrants.
Unlike the fixed rate, a floating exchange rate is determined by the
private market through supply and demand.

A floating rate is often termed "self-correcting," as any differences

in supply and demand will automatically be corrected in the market.

Look at this simplified model: if demand for a currency is low, its

value will decrease, thus making imported goods more expensive
and stimulating demand for local goods and services. This in turn
will generate more jobs, causing an auto-correction in the market. A
floating exchange rate is constantly changing.

In a floating regime, the central bank may also intervene when it is

necessary to ensure stability and to avoid inflation. However, it is
less often that the central bank of a floating regime will interfere.
What is the difference between a fixed and a floating
exchange rate?

A fixed exchange rate denotes a nominal exchange rate that is set

firmly by the monetary authority with respect to a foreign
currency or a basket of foreign currencies. By contrast, a floating
exchange rate is determined in foreign exchange markets
depending on demand and supply, and it generally fluctuates
constantly.
A fixed exchange rate regime reduces the transaction costs
implied by exchange rate uncertainty, which might discourage
international trade and investment, and provides a credible anchor
for low-inflationary monetary policy.

On the other hand, autonomous monetary policy is lost in this

regime, since the central bank must keep intervening in the foreign
exchange market to maintain the exchange rate at the officially set
level.
Autonomous monetary policy is thus a big advantage of a floating
exchange rate. If the domestic economy slips into recession, it is
autonomous monetary policy that enables the central bank to boost
demand, thus 'smoothing" the business cycle, i.e. reducing the
impact of economic shocks on domestic output and employment.

Both types of exchange rate regime have their pros and cons, and
the choice of the right regime may differ for different countries
depending on their particular conditions. In practice there is a range
of exchange rate regimes lying between these two extreme variants,
thus providing a certain compromise between stability and
flexibility.
Chronology of Exchange Rate Regimes in Turkey: 1880–2000

1880–1914 Specie: Gold Standard

1919–1945 Gold Exchange Standard

1946–1971 Bretton Woods adjustable peg

1973–2000 Free float, managed float, adjustable pegs

Period before 1980: Fixed Exchange Rate Regime

Period between 1980-1996

 Crawling Peg Exchange Rate Regime (1980 – 1989)
•Liberalization of the foreign exchange market in 1984
•Currency substitution started in 1985
•Liberalization of capital movements in 1989 with 32 numbered
decree
 A flexible Exchange Rate Regime (1989 – 1993)
 Adoption of Crawling Band Regime (1994 – 1996)
• Economic Crisis in April 1994
• Stabilization Program (April 5, 1994)
Period between 1996-2000

Rate of increase in foreign exchange basket was targeted in order

to minimize the volatility of the real exchange rate for the years
between 1996-1999 .

 Currency-Peg Regime was determined as the nominal

anchor in the stabilization program in 2000.
• Stand-by Agreement with IMF in 2000
• Liquidity Crisis in November 2000
• New Agreement with IMF on December 18, 2000
• No change on the exchange rate policy.
Period Starting from 2001

 Floating exchange rate regime

• Economic crisis in February 2001.
• New Stand-by Agreement with IMF on May 28, 2001
• New Economic Stabilization Program initiated in 2002
• Implicit Inflation Targeting between 2002 and 2005
• Limited Central Bank intervention in the foreign exchange market
- to prevent excessive volatility
• Formal Inflation Targeting adopted in 2006
• Adoption of new regulations to ensure the efficiency in the foreign
exchange market and to reinforce foreign exchange liquidity in the
banking system in 2008
• Expansionary monetary policy was abandoned with announcement
of the Monetary Policy Exit Strategy on April 14, 2010.
• In the fourth quarter of 2010, inflation targeting was augmented
with an additional financial stability orientation.
 Appreciation and Depreciation

Appreciation is an increase in a property’s value caused by

factors like inflation, increasing demand, and improvements to
the property.

Depreciation is a decrease in the value of a property caused by

lower demand, deflation in the economy, deterioration, or the
influences of other undesirable factors.
Depreciation – fall in value of exchange rate – exchange rate
becomes weaker (devaluation)

Appreciation – increase in value of exchange rate – exchange

rate becomes stronger.

Example of Pound Sterling depreciating against the Dollar.

£1 used to equal $2. Now £1 is only equal to $1.75

Example of Pound Sterling appreciating against the Dollar.

£1 used to equal $2. Now £1 is equal to $2.75
A depreciation in exchange rate makes exports more competitive
and imports more expensive.

An appreciation in the exchange rate will tend to reduce aggregate

demand (assuming demand is relatively elastic). Because exports
will fall and imports increase.

An appreciation is likely to reduce inflation because:

-Import prices are cheaper
-Fall in aggregate Demand
-Firms have more incentives to cut costs.