1.B: International Finance and the Foreign Exchange Market

a: Explain how exchange rates are determined in a flexible or floating exchange rate system.

Exchange rates are determined by supply and demand. If there is an excess demand for dollars by Germans, Germans will sell marks and buy dollars -- this will make the dollar appreciate relative to the mark. Intuitively, when would this happen? Germans would create an excess demand for dollars if they desired to increase their imports of U.S. goods. In order to buy U.S. goods, Germans need dollars -- hence the price of the dollar rises relative to the mark.

b: Describe the factors that cause a nation's currency to appreciate or depriciate.

Differential income frowth among nations will cause those nations with the highest income growth to demand more imported goods. The heightened demand for imports will increase demand for foreign currency, appreciating the foreign currency and depreciating the domestic currency.

Differential inflation rates will also cause a movement in exchange rates. If prices in the U.S. are rising twice as fast as in Germany, U.S. citizens will increase their demand for German goods (because German goods are now cheaper). This increased demand will appreciate the DM making German goods more expensive for Americans. Hence, adjustments in the exchange rate will offset the effects of the differential inflation rates.

Differential interest rates will cause a flow of capital into those countries with the highest available real rates of interest. Therefore, there will be an increased demand for those currencies and they will appreciate relative to countries whose available real rate of return is low.

c: Explain the role of each component of the balance-of-payments accounts.

Balance of payments accounting is a method used to keep track of transactions in the international sector. It includes government, consumer, and business transactions. The BOP equation is:

CURRENT ACC + CAPITAL ACC + OFFICIAL RESERVE ACCOUNT=0

The current account measures the exchange of goods, services, investment income, and gifts to other nations.

The capital account measures the flow of debt and equity investment funds into and out of the country.

Official reserve transactions are funds held at the International Monetary Fund (IMF) in the form of gold, other foreign currencies, and SDRs (special drawing rights at the International Monetary Fund). These reserve balances are used by the Fed to "intervene" in the foreign exchange markets in an attempt to loosely control exchange rates.

d: Explain how monetary and fiscal policy affect the exchange rate and balance-of-payments components.

Monetary policy and exchange rates - an unanticipated shift to an expansionary monetary policy will lead to more rapid economic growth, an acceleration in the inflation rate, and lower real interest rates. This stimulates imports, and increases the demand for foreign currencies relative to the dollar, causing the dollar to depreciate.

Fiscal policy and exchange rates - an unanticipated shift to a more restrictive fiscal policy will result in budget surpluses. The reduced aggregate demand causes an economic slowdown and lower inflation. These factors discourage imports and encourage exports, which results in a higher value of the dollar. However, budget surplus suggest that government borrowing declines, which reduces real rates, and as a result, depreciates the value of the dollar. This is conflicting. But, we since financial capital is mobile, the effect of the interest rate change generally dominates in the short-run, leading to short-run devaluation.

Monetary policy and the current account - an unanticipated shift to an expansionary monetary policy will lead to higher income, an accelerated inflation rate, and lower real interest rates. The higher income and prices stimulate imports and discourage exports, causing the current account balance to move toward deficit. The lower real interest rate discourages foreign and domestic investment at home, moving the capital account toward deficit. At the same time, the value of the dollar declines because of the earlier shift to imports. Now, however, the lower dollar encourages exports and discourages imports. This more than offsets the movement toward deficit in the current account. Thus, the impact of an unanticipated shift to an expansionary monetary policy will be a shift toward a deficit in the capital account and a shift toward surplus in the current account.

Fiscal policy and the current account - an unanticipated shift to a larger budget deficit will cause an increase in aggregate demand and an increase in domestic interest rates. The increased aggregate demand encourages imports, which moves the current account towards deficit. Meanwhile, the higher interest rates attract foreign investment and discourage domestic investment from leaving the country. Thus, the capital account will move toward surplus.

e: Explain how current-account deficits affect an economy.

Is a nation’s current account balance a good measure of its economic health? No. There is no law, economic or political, which states that the current account must be positive or zero. Running a deficit in the current account balance simply means a country imports more than it exports, and a country can do this for a long time. Countries that run current account deficits tend to run capital account surpluses so that they offset each other. An inflow of capital is not bad if it is being invested in such a way as to enhance the productive capacity of the country. A current account surplus and capital account deficit are not an indication of economic strength, particularly if this occurs because there are few good investment opportunities in the country to attract investment and more attractive investment opportunities abroad.

f: Describe a fixed exchange rate and a pegged exchange rate system.

Fixed rates, unified currency: Some countries fix their exchange rates to other currencies, such as the U.S. dollar, and sacrifice independent monetary policy. For example, Panama, Hong Kong, Argentina, and the U.S. have a unified currency. The non-U.S. countries accomplish this through the use of a currency board, which has the power to create domestic currency only in exchange for a specific quantity of U.S. dollars they hold in bonds and other liquid assets. The currency board promises to redeem the domestic currency at the fixed exchange rate into dollars. The EU has a similar system with the 11 countries that have joined the system using the Euro as the unified currency. The distinguishing characteristic of a fixed rate, unified currency system is the existence of only one central bank that can increase or decrease the money supply. A country that imports more than it exports under this system will find a net decrease in the money supply, which should lead to downward pressure on prices. Lower prices should reverse the export-import relationship until the country’s exports begin to exceed its imports.

Pegged exchange rates: This system involves a commitment of a country to use fiscal and monetary policy to maintain the country’s exchange rate within a narrow band relative to another (stronger) currency or to a bundle of currencies. This type of system requires a country to use its monetary policy to maintain the desired exchange rate.

2: The Foreign Exchange Market

a: Distinguish between the spot and forward markets for foreign exchange.

When currencies trade for immediate delivery (within 2 days of the trade) the transaction is said to take place in the spot market.

In the forward market contracts are made to buy or sell currencies for future delivery. Forward contracts are generally for 30, 90, 180, and 360 day periods. The major participants in the forward market are arbitrageurs, traders, hedgers, and speculators.

b: Define direct and indirect methods of foreign exchange quotations.

Interbank dealer quotes (here the traded currency is quoted against the U.S. dollar) can be stated in:

American terms, which are dollars per foreign currency unit: $/FC. Generally just used for U.K. and Irish pounds.

European terms, which are foreign currency units per dollar: FC/$. The traditional method of quoting exchange rates.

Local nonbank public customer quotes (here the home country currency is quoted against the traded currency) can be stated as:

Direct quotes, which is domestic currency per foreign currency: DC/FC.Usually quoted per 100 FC units except for the $ and ￡ where it is one unit. This is the usual method of quoting currencies.

Indirect quotes, which is foreign currency per domestic currency: FC/DC.This method is used in the U.K., Canada, and U.S. Here’s some exam confusion for you! .555 DM / $ is a European terms quote in the interbank market. However, in the local market it is a direct quote in Germany and an indirect quote in the U.S.

c: Calculate the spread on a foreign currency quotation.

Transactions costs: Banks generally do not charge commissions on foreign currency (FC) transactions. They make their profit off the bid-ask spread. The bid price is always listed first. It is the price the bank will pay for FC. The ask price is always listed second. It is the price the bank will sell FC for.

Example: bid $1.6625/￡, ask $1.6635/￡ is listed at $1.6625–35 or just 25–35.

Note this quote is for British pounds so it is quoted in American terms. To switch the bid-ask spread to European terms (￡/$) you would just take the reciprocal of each number. 1/1.6625 $/￡ = .6015 ￡/$ and 1/1.6635 $/￡ = .60114 ￡/$.

Note the bid-ask spread just reversed to .60114–.601515. Why? Here, the first bid-ask, $1.6625–35/￡, implies you were buying 1￡ for 1.6625 $s and selling 1￡ for 1.6635 $s. Now you are buying 1$ for .60114￡s and selling 1$ for .6015￡s. You have switched your offering position from buying and selling pounds to buying and selling dollars.

d: Explain how spreads on foreign currency quotations can differ as a result of market conditions, bank/dealer, positions, trading volume, and ( for forward contracts) maturity/length of contract.

The bid-ask spread is a function of the breadth (number of market participants) and depth (how much or volume of purchases) of the market for the currency as well as the currency’s price volatility. The spread is stated as a percent of the asking price and appears below.