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EXCHANGE RATES. Chapter 8 Lecture 2. EXCHANGE RATES. Defined as the number of units of one currency that have to be paid to acquire a unit of another currency There are different markets for currency SPOT RATE FORWARD RATE

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Exchange rates l.jpg

EXCHANGE RATES

Chapter 8 Lecture 2


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EXCHANGE RATES

  • Defined as the number of units of one currency that have to be paid to acquire a unit of another currency

  • There are different markets for currency

    • SPOT RATE

    • FORWARD RATE

  • Most currency transactions are conducted by commercial banks, and the rest by foreign-exchange brokers


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THE INTERNATIONAL MONETARY SYSTEM

  • Efforts to provide economic stability to Allies led to Bretton Woods agreement to fix exchange rates based on gold and the U.S. dollar

    • Member currencies were denominated in gold and U.S. dollars (because of the dollar’s strength in the 1940s and 1950s) but the U.S. had 70% of gold reserves by 1947 and governments bought and sold dollars rather than gold assuming the U.S. government would pay gold for dollars.


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  • Signators to International Monetary Fund in 1945 agreed to promote exchange stability, maintain orderly exchange relationships, provide a multilateral system of payments, create standby reserves

  • Fixed exchange rates were altered in 1971 because:

    • The U.S. trade surplus began to shrink

    • U.S.dollar was devalued

    • It was no longer desirable to peg the world economy on the dollar


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Three Exchange-Rate Approaches

  • Pegged Rates

    • Exchange rate is fixed to one or several other currencies (according to a market basket of goods)

  • Limited Flexibility

    • Flexibility is limited to 2.25% around the US dollar

    • Cooperative arrangements in EU

  • More Flexible

    • Can freely float

    • Float on the basis of a set of indicators


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WHAT AFFECTS EXCHANGE RATES?

  • Government stability

  • National or international “mood” or attitude toward the country

  • Technical factors, e.g., economic statistics, seasonal demands

  • Inflation

  • In a freely floating system, the market decides


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LOOK AT THE EFFECT OF INTERNAL INFLATION

  • What is inflation? When overall demand grows faster than overall supply, the cost of a good is pushed up (but the value of the good is unchanged)

  • If inflation cannot be stopped, then an inflationary spiral can occur where:

    • prices of goods rise

    • so you demand an increase in earnings to keep up

    • and the price of goods rises to cover the wages organizations have to pay


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INFLATION AFFECTS EXCHANGE RATES

  • This is the concept of Purchasing Power Parity:

    • A change in inflation has to affect exchange rates to keep prices in the two countries roughly equal.


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PPP EXAMPLE

  • Two countries have an equal exchange of $1 to $1

  • One economy experiences a 10% inflation rate; the other experiences a 5% inflation rate

  • Comparing dollar to dollar, the first dollar is worth 5% less than the second

  • So, you will only buy goods from the first country only if your dollar is 5% stronger

  • Hence, the new exchange rate is $1.05 of their money for $1 of your money


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THE HAMBURGER INDEX

U.S. Equivalent % over/under

Norway 4.21 +92

France 2.81 +28

Japan 2.78 +27

U.S. 2.19 —

U.K.1.78 -19

Hong Kong .97 -56

Hungary .74 -66

Based on 1988 data.


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THE PPP EQUATION

  • e=exchange rate

  • i=rate of inflation

  • h=home country

  • f=foreign country

  • o=the base period

  • t=the end of a period


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TO PRACTICE HOW EXCHANGE RATES OPERATE

  • The Big Mac Index: 1995–8


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