FUNDAMENTALS OF BUSINESS ECONOMICS

B.  Exchange Rates:  Why Do They Change?

1.  Concepts

a.  Bilateral exchange rate - value of one currency relative to a second one

b.  Nominal vs. real exchange rates

• Nominal exchange rate - value before adjusting for inflation

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c.  Percentage change in real exchange rates

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2.  Exchange rate determination

a.  Demand

(1)  Demanders of a currency

• Exporters, importers, tourists

• Investors and speculators

• Governments and central banks

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(2)  Downward sloping

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b.  Supply

(1)  Suppliers

• Exporters, importers, tourists

• Investors and speculators

• Governments and central banks

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(2)  Upward sloping

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c.  Equilibrium

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• Gives bilateral, nominal exchange rate

• Demand for one currency means supply of the other

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d.  Changes in exchange rates

(1)  Changes in relative international price levels

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(2)  Changes in relative international real GDP

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(3)  Changes in relative international interest rates / returns

• Both lenders and borrowers affected

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(4)  Changes in relative international risks, taxes, and expectations

(a)  Risks, taxes, and expectations about relative investment returns

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(b)  Expectations about exchange rates

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(5)  Changes in relative central bank intervention

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3.  Exchange rate systems

a.  Fixed exchange rates

• Exchange rate maintained at a particular level

• Benefits:

  - Reduces power of central bank to engage in inflationary monetary policy

  - Reduces risks and costs to traders and investors

• Requires intervention by central bank or other monetary authority

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• Impossible trilogy

  - Fixed exchange rate

  - Free and open international trade and capital markets

  - Monetary independence

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b.  Fixed band exchange rate system

• Exchange rate varies within a predetermined range

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c.  Crawling peg

• Exchange rate fixed for a period, then adjusted according to a predetermined formula

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d.  Managed float

• Exchange rate is usually flexible, but central bank can intervene to reduce volatility or achieve some macroeconomic goal

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e.  Flexible exchange rates

• Exchange rate determined by market forces

• Benefits:

  - Protects against inflation in another country

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- Country can determine own monetary policy

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