Exchange Rates and Exchange Rates and Exchange Rate RegimesExchange Rate Regimes

Foreign Exchange MarketsForeign Exchange Markets

Bilateral Exchange RatesBilateral Exchange Rates

Foreign exchange is other currencies which must be used to buy Foreign exchange is other currencies which must be used to buy goods, services or assets whose prices are denominated in other goods, services or assets whose prices are denominated in other currencies. Foreign exchange markets are markets where currencies currencies. Foreign exchange markets are markets where currencies are exchanged. are exchanged. We measure the prices of foreign currencies by taking the bilateral We measure the prices of foreign currencies by taking the bilateral exchange rates, eg. the US dollar-Australian dollar exchange rate. A exchange rates, eg. the US dollar-Australian dollar exchange rate. A bilateral rate is the rate at which one currency exchanges for another. bilateral rate is the rate at which one currency exchanges for another. These bilateral rates are what are needed to calculate the cost of These bilateral rates are what are needed to calculate the cost of goods and assets denominated in other currencies, and to measure goods and assets denominated in other currencies, and to measure changes in these rates. changes in these rates. These prices are the most important prices in an economy. They These prices are the most important prices in an economy. They define the purchasing power of domestic currency , and this in turn define the purchasing power of domestic currency , and this in turn defines the international competitiveness of local production of goods defines the international competitiveness of local production of goods and services, and the relative attractiveness of domestic and foreign and services, and the relative attractiveness of domestic and foreign financial assets. financial assets.

Quoting Bilateral Exchange RatesQuoting Bilateral Exchange Rates

A bilateral exchange rate can be quoted in either of two ways:A bilateral exchange rate can be quoted in either of two ways:1.1. English-speaking tradition (UK,US, Australia, etc)English-speaking tradition (UK,US, Australia, etc)This expresses a bilateral exchange rate as the number of units of the This expresses a bilateral exchange rate as the number of units of the foreign currency which exchange for a unit of the domestic currency, foreign currency which exchange for a unit of the domestic currency, eg. US 0.75 for an Aus dollareg. US 0.75 for an Aus dollar

2. European tradition2. European traditionThis expresses a bilateral exchange rate as the number of units of the This expresses a bilateral exchange rate as the number of units of the domestic currency which exchange for a unit of the foreign currency, domestic currency which exchange for a unit of the foreign currency, eg. Aus dollar 1.33 for a US dollar.eg. Aus dollar 1.33 for a US dollar.

Note that one of these methods of quotation is the inverse of the other, Note that one of these methods of quotation is the inverse of the other, eg 1.33 =4/3= (¾)eg 1.33 =4/3= (¾)-1-1 or 0.75= ¾ = (4/3) or 0.75= ¾ = (4/3)-1. -1. They convey precisely the They convey precisely the same information. These alternative methods are available because same information. These alternative methods are available because the exchange rate is the price of one currency in terms of another.the exchange rate is the price of one currency in terms of another.

Example: The Australian Foreign Example: The Australian Foreign Exchange marketExchange market

The Australian national currency is the Aus dollar, the AUD. The Aus The Australian national currency is the Aus dollar, the AUD. The Aus dollar now floats freely against other currencies, with no interference dollar now floats freely against other currencies, with no interference from the Reserve Bank of Australia or the Australian government.from the Reserve Bank of Australia or the Australian government.[See RBA exchange rate statistics][See RBA exchange rate statistics]

In fact, according to the latest BIS statistics, the AUS dollar market is In fact, according to the latest BIS statistics, the AUS dollar market is the seventh largest foreign exchange market in the world. The the seventh largest foreign exchange market in the world. The AUD/USD bilateral rate is the fourth most traded in the world, AUD/USD bilateral rate is the fourth most traded in the world, AUD/USD transactions accounting for around 40 per cent of all AUD/USD transactions accounting for around 40 per cent of all onshore foreign exchange transactions.onshore foreign exchange transactions.

Offshore trading of the AUD is now larger than onshore trading . Offshore trading of the AUD is now larger than onshore trading .

Who Fixes Exchange Rates?Who Fixes Exchange Rates?

The exchange rates of one currency are The exchange rates of one currency are determined by the government of the country determined by the government of the country which manages this currency. Some countries fix which manages this currency. Some countries fix their exchange rates vis-à-vis another country their exchange rates vis-à-vis another country rigidly (eg the Chinese Renminbi is fixed vis-rigidly (eg the Chinese Renminbi is fixed vis-àà-vis -vis the US dollar) and others allow their currency to the US dollar) and others allow their currency to move freely in the foreign exchange market (eg move freely in the foreign exchange market (eg Aus dollar), or adopt some intermediate position of Aus dollar), or adopt some intermediate position of managing the exchange rate while allowing it managing the exchange rate while allowing it some movement in the markets. some movement in the markets.

The International Monetary FundThe International Monetary Fund

There is a multilateral organisation with a role in this area, There is a multilateral organisation with a role in this area, the IMF. The IMF oversees the world exchange rate the IMF. The IMF oversees the world exchange rate system. Under its rules, all member countries have to system. Under its rules, all member countries have to maintain “current account convertibility”, i.e. they are not maintain “current account convertibility”, i.e. they are not allowed to restrict foreign exchange payments on current allowed to restrict foreign exchange payments on current account. In the days when all countries pegged their account. In the days when all countries pegged their exchange rates, it played an important role in making short exchange rates, it played an important role in making short term loans to member countries to allow them to maintain term loans to member countries to allow them to maintain their exchange rates. But in an era when most currencies their exchange rates. But in an era when most currencies float and others have some degree of flexibility, the IMF float and others have some degree of flexibility, the IMF role is confined to making loans and giving advice to role is confined to making loans and giving advice to Developing Countries. Developing Countries.

Movements of Bilateral Exchange Movements of Bilateral Exchange RatesRates

Using the English-speaking tradition, we say that Using the English-speaking tradition, we say that one currency one currency devaluesdevalues (or (or depreciatesdepreciates) against ) against another currency if the number of units of the another currency if the number of units of the foreign currency which exchange for the first foreign currency which exchange for the first currency falls; for example, if the number of US currency falls; for example, if the number of US dollars exchanges for an Australian dollar fall from, dollars exchanges for an Australian dollar fall from, say, US 0.80 to US 0.70.say, US 0.80 to US 0.70.

We say that the currency We say that the currency appreciatesappreciates if the if the number of units of the foreign currency which number of units of the foreign currency which exchange for a unit of the first currency increase; exchange for a unit of the first currency increase; for example, from, say, US 0.70 to US 0.75. for example, from, say, US 0.70 to US 0.75.

Effective (Nominal) Exchange Effective (Nominal) Exchange RatesRates

For many purposes, we want a measure that For many purposes, we want a measure that reflects changes in the bilateral exchange reflects changes in the bilateral exchange rate of one country across several of its rate of one country across several of its trading partners. The “effective” or “trade-trading partners. The “effective” or “trade-weighted” exchange rate of one country vis-weighted” exchange rate of one country vis-àà-vis other currencies is an index that -vis other currencies is an index that measures the average movement of one measures the average movement of one currency against other currencies. currency against other currencies.

Trade-weighted IndexTrade-weighted Index

In Australia, the Reserve Bank of Australia uses the following formula In Australia, the Reserve Bank of Australia uses the following formula for the nominal effective exchange rate index:for the nominal effective exchange rate index:

TWI(t) = TWI(t) = ππ e eii(t)(t)wiwi = e = e11(t)(t)w1w1x ex e22(t)(t)w2w2… x e… x enn(t)(t)wnwn

Here eHere eii is the bilateral exchange rate with respect to one currency i is the bilateral exchange rate with respect to one currency i and wand wi i are the weights used to weight the movements of each are the weights used to weight the movements of each currency. The weights are the shares of each major currency in the currency. The weights are the shares of each major currency in the export and import trade of Australia (see RBA sheet in handout). n is export and import trade of Australia (see RBA sheet in handout). n is the number of countries used in the calculation of the index.the number of countries used in the calculation of the index.

This formula gives us the (geometric) mean of the movements with This formula gives us the (geometric) mean of the movements with respect to each of the currencies used in the calculation at time t. If respect to each of the currencies used in the calculation at time t. If this index rises (falls), it means that the currency of the home country this index rises (falls), it means that the currency of the home country is appreciating (depreciating) on average against other currencies. is appreciating (depreciating) on average against other currencies.

Real Effective Exchange RatesReal Effective Exchange Rates

Foreign exchange transactions depend, however, not only on what Foreign exchange transactions depend, however, not only on what happens to the exchange rate but also on whether prices are rising or happens to the exchange rate but also on whether prices are rising or falling in the home country relative to a foreign country. Consequently, falling in the home country relative to a foreign country. Consequently, we can adjust this formula to allow for the differences in the rate of we can adjust this formula to allow for the differences in the rate of increase of prices among trading partners. This gives us an index of increase of prices among trading partners. This gives us an index of the the realreal effective exchange rate. It is given by the formula effective exchange rate. It is given by the formula

E(t) = [IE(t) = [Ihh(t) /I(t) /Ipp(t)] •TWI(t)(t)] •TWI(t)

Here, IHere, Ih h and Iand Ip p are the rates of inflation in the home country and the are the rates of inflation in the home country and the average rate of inflation among the trading partners. Thus, this index average rate of inflation among the trading partners. Thus, this index at time t rises (fall) if the rate of inflation in the home country is higher at time t rises (fall) if the rate of inflation in the home country is higher than among the trading partners or if the TWI rises (falls). If the index than among the trading partners or if the TWI rises (falls). If the index rises (falls), we say there has been a real effective exchange rate rises (falls), we say there has been a real effective exchange rate appreciation (depreciation). This means that the country is becoming appreciation (depreciation). This means that the country is becoming less (or more) competitive with overseas markets. less (or more) competitive with overseas markets.

[See RBA table of real effective exchange rates][See RBA table of real effective exchange rates]

Index calculationsIndex calculations

Both the effective exchange rate and the real effective exchange for a Both the effective exchange rate and the real effective exchange for a currency are useful measures, each designed to measure one aspect currency are useful measures, each designed to measure one aspect of currency movements. of currency movements.

For Australia, the Reserve Bank of Australia makes estimates of the For Australia, the Reserve Bank of Australia makes estimates of the (nominal) effective exchange rate and the real effective exchange rate, (nominal) effective exchange rate and the real effective exchange rate, and the Commonwealth Treasury makes estimates of the real effective and the Commonwealth Treasury makes estimates of the real effective exchange rate, using different indices of price movements. exchange rate, using different indices of price movements.

In other countries the IMF and other organisations measure effective In other countries the IMF and other organisations measure effective and real effective exchange rates for other currencies in a similar way. and real effective exchange rates for other currencies in a similar way. Today a number of financial institutions also calculate indices of Today a number of financial institutions also calculate indices of effective exchange rateseffective exchange rates[See BIS figures][See BIS figures]

Exchange Rate VolatilityExchange Rate Volatility

Bilateral exchange rates tend to be volatile, Bilateral exchange rates tend to be volatile, especially for emerging market countries. especially for emerging market countries. Volatility is usually measured by the standard Volatility is usually measured by the standard deviation of the movements each day or each deviation of the movements each day or each week of one currency vis-week of one currency vis-àà-vis another, say the US -vis another, say the US dollar, over some period.dollar, over some period.[See handouts for Asian currencies during and [See handouts for Asian currencies during and after the period of the Asian Crisis] after the period of the Asian Crisis] A number of currencies have been subject to A number of currencies have been subject to crises in recent years, eg. Mexico (1994), east crises in recent years, eg. Mexico (1994), east Asia (1997), Russia (1998), Turkey (2001).Asia (1997), Russia (1998), Turkey (2001).

Purchasing Power Parity Exchange Purchasing Power Parity Exchange RatesRates

What determines exchange rates in the longer What determines exchange rates in the longer run?run?One hypothesis is that market exchange rates will One hypothesis is that market exchange rates will tend, in the longer run, to reflect the fundamentals tend, in the longer run, to reflect the fundamentals of the price levels in the countries concerned. If of the price levels in the countries concerned. If one country has a higher inflation rate than its one country has a higher inflation rate than its trading partners, it currency will tend to depreciate. trading partners, it currency will tend to depreciate. This is known as the Purchasing Power Parity This is known as the Purchasing Power Parity Hypothesis. It is an application of the Law of One Hypothesis. It is an application of the Law of One Price – exchange rates are such, under this Price – exchange rates are such, under this hypothesis, that a single price holds in the market hypothesis, that a single price holds in the market for each traded commodity. for each traded commodity.

Example 1: the Big Mac Index of Example 1: the Big Mac Index of PPPPPP

The Economist produces a Big Mac Index of the PPP of The Economist produces a Big Mac Index of the PPP of currencies. The Big Mac is chosen as a representative currencies. The Big Mac is chosen as a representative good because it is a good which is virtually identical in all good because it is a good which is virtually identical in all countries in which it is sold, which is almost all countries in countries in which it is sold, which is almost all countries in the world. the world. Suppose, the price of a Big Mac is Suppose, the price of a Big Mac is in Australia A$ 3.00, and in Australia A$ 3.00, and in the US, US $ 2.00.in the US, US $ 2.00.Then the Big Mac PPP of the AUS $ is 2/3 or 66 US cents Then the Big Mac PPP of the AUS $ is 2/3 or 66 US cents to the A$. to the A$. If this were the exchange rate, A$3.0x(2/3) = US$2.0If this were the exchange rate, A$3.0x(2/3) = US$2.0i.e the Law of One Price would hold for Big Macs. i.e the Law of One Price would hold for Big Macs.

Example 2: The CommSec iPod Example 2: The CommSec iPod IndexIndex

From 2007, CommSec has calculated a similar From 2007, CommSec has calculated a similar one good index, but this time using the price of one good index, but this time using the price of iPods in different countries. iPods in different countries. The current price of an iPod in Australia is, in The current price of an iPod in Australia is, in terms of US dollars, US $172.36. the price in the terms of US dollars, US $172.36. the price in the US is US $149.00. If this reflected purchasing US is US $149.00. If this reflected purchasing power parity, one would expect a a bilateral power parity, one would expect a a bilateral AUD/USD exchange rate of 86.44 US cents to the AUD/USD exchange rate of 86.44 US cents to the Aus dollar. At this rate, the Aus dollar is under-Aus dollar. At this rate, the Aus dollar is under-valued, despite its recent rise. valued, despite its recent rise. [see CommSec handout][see CommSec handout]

The Purchasing Power parity The Purchasing Power parity HypothesisHypothesis

In fact, of course, many goods are traded between any two In fact, of course, many goods are traded between any two countries. We can calculate the PPP exchange rate using countries. We can calculate the PPP exchange rate using a bundle of goods. The IMF does this for most countries a bundle of goods. The IMF does this for most countries that have their own currency.that have their own currency.With these PPP exchange rates we can test whether the With these PPP exchange rates we can test whether the PPP hypothesis holds, i.e. does the nominal effective PPP hypothesis holds, i.e. does the nominal effective exchange move to reflect, in the longer run, price levels in exchange move to reflect, in the longer run, price levels in the trading countries. the trading countries. The empirical evidence suggests that the nominal effective The empirical evidence suggests that the nominal effective exchange rates of countries do tend to adjust towards their exchange rates of countries do tend to adjust towards their PPP’s, but PPP is not a complete explanation of the PPP’s, but PPP is not a complete explanation of the movements of nominal exchange rates. Other factors movements of nominal exchange rates. Other factors influence exchange rates. In an age of high capital influence exchange rates. In an age of high capital mobility, interest rate differentials have become important. mobility, interest rate differentials have become important.

Exchange Rate RegimesExchange Rate Regimes

Different countries manage their exchange rates in different ways. Different countries manage their exchange rates in different ways. We can think of exchange rate regimes being arrayed on a continuum, We can think of exchange rate regimes being arrayed on a continuum, from those which are fixed rigidly to those which are allowed to vary from those which are fixed rigidly to those which are allowed to vary freely according to market conditions. It is useful to think of three freely according to market conditions. It is useful to think of three broad categories:broad categories:Hard fixes, i.e. a fixed rate that is hard to change:Hard fixes, i.e. a fixed rate that is hard to change:

-common currency, monetary union, currency board - all -common currency, monetary union, currency board - all involving the abandonment of national monetary sovereignty involving the abandonment of national monetary sovereignty

IntermediateIntermediateCompletely freely floating, i.e. no government interventionCompletely freely floating, i.e. no government intervention

In fact, there are many different possible exchange rate arrangements.In fact, there are many different possible exchange rate arrangements.

IMF ClassificationIMF Classification

The International Monetary Fund (IMF) uses The International Monetary Fund (IMF) uses a classification of exchange rate a classification of exchange rate arrangements.arrangements.

[see IMF hand-out][see IMF hand-out]

These are arrayed from hard to soft. These are arrayed from hard to soft.

Choice of RegimeChoice of Regime

There is a big debate about which type of exchange rate regime is There is a big debate about which type of exchange rate regime is best.best.

A rigidly fixed exchange rate has the advantage of fixity in the short A rigidly fixed exchange rate has the advantage of fixity in the short term but it has some long term disadvantages:term but it has some long term disadvantages:A rate pegged in terms of one currency leads to effective exchange A rate pegged in terms of one currency leads to effective exchange rate changes if the currency to which it is pegged changes in world rate changes if the currency to which it is pegged changes in world markets eg before the Asian Crisis, the US dollar was depreciating in markets eg before the Asian Crisis, the US dollar was depreciating in world currency markets vis-à-vis the Japanese yen and German DM, world currency markets vis-à-vis the Japanese yen and German DM, which caused the effective rates of those Asian currencies pegged to which caused the effective rates of those Asian currencies pegged to the US dollar to appreciate, at a time when there balance of payments the US dollar to appreciate, at a time when there balance of payments positions were worseningpositions were worseningPegged rates are prone to crises when investors and speculators lose Pegged rates are prone to crises when investors and speculators lose confidence in the future of the currency as market fundamentals confidence in the future of the currency as market fundamentals changechange

Choice of Regime Cont’dChoice of Regime Cont’d

The macro-economy managers of the The macro-economy managers of the country concerned lose one instrument of country concerned lose one instrument of monetary policy (the exchange rate itself). monetary policy (the exchange rate itself). Foreign exchange markets must then be Foreign exchange markets must then be managed in by other instruments, such as managed in by other instruments, such as interest rates, exchange rate quantitative interest rates, exchange rate quantitative controls.controls.

The Macro-economic TrilemmaThe Macro-economic Trilemma

There are three common objectives of macro-economic policy in an There are three common objectives of macro-economic policy in an economyeconomyTo retain an independent monetary policy, i.e. to raise or lower To retain an independent monetary policy, i.e. to raise or lower domestic interest rates to control the economydomestic interest rates to control the economyTo maintain stable exchange ratesTo maintain stable exchange ratesTo maintain freedom to convert one currencies into othersTo maintain freedom to convert one currencies into othersHowever, it is not possible to achieve all three simultaneously. This is However, it is not possible to achieve all three simultaneously. This is know as the Macroeconomic Trilemma.know as the Macroeconomic Trilemma.

For example, a hard fixed exchange rate achieve the second and For example, a hard fixed exchange rate achieve the second and perhaps the third but not the first. A floating currency achieves the perhaps the third but not the first. A floating currency achieves the third and perhaps, in association with monetary policy, the second but third and perhaps, in association with monetary policy, the second but not the first.not the first.

There is now a perception among exchange There is now a perception among exchange market experts that the only sustainable market experts that the only sustainable regimes are those at the very hard and very regimes are those at the very hard and very soft extremes, i.e. hard pegs or freely soft extremes, i.e. hard pegs or freely floating exchange rate regimes. This is floating exchange rate regimes. This is know as the “bipolar view” of exchange rate know as the “bipolar view” of exchange rate regimes. However, there is still no regimes. However, there is still no agreement on this issue. agreement on this issue.

DollarisationDollarisation

One exchange rate regime choice is for a country One exchange rate regime choice is for a country to officially adopt the currency of another country to officially adopt the currency of another country as the legal tender circulating in that country. An as the legal tender circulating in that country. An increasing number of countries, mainly small and increasing number of countries, mainly small and island economies, are doing this. In fact, in 2005, island economies, are doing this. In fact, in 2005, 14 independent countries and 15 territories 14 independent countries and 15 territories officially use a foreign currency as their officially use a foreign currency as their predominant currency (Xenias,2006). 13 of these predominant currency (Xenias,2006). 13 of these use the US dollar. The EU Euro is another choice, use the US dollar. The EU Euro is another choice, but a number of other currencies are also used. but a number of other currencies are also used.

The US International Monetary The US International Monetary Stability ActStability Act

To protect the independence of its monetary policy To protect the independence of its monetary policy at a time when more countries were dollarising, the at a time when more countries were dollarising, the US government passed the International Monetary US government passed the International Monetary Stability Act in 1999.Stability Act in 1999.

This Act states that the US is not obliged to act as This Act states that the US is not obliged to act as a lender of last resort to countries that have a lender of last resort to countries that have officially dollarised or to consider their economic officially dollarised or to consider their economic and financial conditions when setting US and financial conditions when setting US monetary policy, or to supervise their financial monetary policy, or to supervise their financial institutions.institutions.

Questions of the DayQuestions of the Day

1.1. Which country or countries use the A$ as Which country or countries use the A$ as their currency?their currency?

2.2. What is the currency used in Timor-Leste What is the currency used in Timor-Leste (East Timor)? (East Timor)?

Currency UnionsCurrency Unions

Another exchange rate choice is a monetary union.Another exchange rate choice is a monetary union.

A monetary union is an agreement among a group of countries to A monetary union is an agreement among a group of countries to share a common currency and to have a common central bank with share a common currency and to have a common central bank with powers to issue notes and coins and to determine the monetary powers to issue notes and coins and to determine the monetary policies of the countries concerned. policies of the countries concerned.

Three examples of monetary unions: Three examples of monetary unions: the European Monetary Union. This uses the Euro( with 12 the European Monetary Union. This uses the Euro( with 12 countries), countries), the Eastern Caribbean Currency Union. This has 6 countries and the Eastern Caribbean Currency Union. This has 6 countries and uses the East Caribbean dollar (that is pegged to the US dollar), and uses the East Caribbean dollar (that is pegged to the US dollar), and the two CFA (Colonies Franthe two CFA (Colonies Franççaise d’Afrique) Frank Zones in West and aise d’Afrique) Frank Zones in West and Central Africa (with 14 countries) - the West African Economic and Central Africa (with 14 countries) - the West African Economic and Monetary Union and the Central African Economic and Monetary Monetary Union and the Central African Economic and Monetary Union, which use the CFA Frank that is now pegged to the Euro. Union, which use the CFA Frank that is now pegged to the Euro.

Optimal Currency UnionsOptimal Currency Unions

Bob Mundell developed a theory of optimal currency areas. According Bob Mundell developed a theory of optimal currency areas. According to this theory, the extent to which a set of countries can be considered to this theory, the extent to which a set of countries can be considered candidates for a monetary union depends on the symmetry/asymmetry candidates for a monetary union depends on the symmetry/asymmetry of the shocks to their economies and on the extent of factor mobility of the shocks to their economies and on the extent of factor mobility between them. If shocks are symmetrical of if factors are highly between them. If shocks are symmetrical of if factors are highly mobile, there is little need for an independent monetary policies and mobile, there is little need for an independent monetary policies and the costs of a monetary union will be small. the costs of a monetary union will be small.

However, this theory is not appropriate in an era of floating exchange However, this theory is not appropriate in an era of floating exchange rates and inflation-targeting monetary policies. Now the crucial issue is rates and inflation-targeting monetary policies. Now the crucial issue is how would monetary union and the loss of independent monetary how would monetary union and the loss of independent monetary policies affect the macro-economies. policies affect the macro-economies.

The Single World Currency The Single World Currency MovementMovement

The number of countries which do not have their own The number of countries which do not have their own currency is increasing as the number of countries that currency is increasing as the number of countries that have adopted another country’s currency or joined a have adopted another country’s currency or joined a monetary union have both increased in recent years; monetary union have both increased in recent years; according to the IMF, 41 countries did not have their own according to the IMF, 41 countries did not have their own currency as at 31 July 2006. currency as at 31 July 2006. Some macroeconomists and some foreign exchange Some macroeconomists and some foreign exchange market experts believe that the optimal foreign exchange market experts believe that the optimal foreign exchange market regime is a single global currency with a single market regime is a single global currency with a single global central bank. One such group is the Single Global global central bank. One such group is the Single Global Currency Association.Currency Association.