Ngân hàng, tín dụng - Chapter 10: Understanding foreign exchange

1Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 10 Understanding Foreign Exchange Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-2 Learning Objectives • Measure and determine foreign exchange rates • Understand the equilibrium connection between balance of payments and exchange rate movements • Analyze fixed and floating rate exchange systems and their impact on trade balances and financial crises Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-3 Introduction • The volume of international exchange has grown tremendously since World War II • Whenever an exchange takes place between residents of different countries, one kind of money has to be exchanged for another • Foreign exchange rate between two currencies is determined by supply and demand established in the foreign exchange market consisting of a network of foreign exchange dealers (Figure 10.1) 2Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-4 FIGURE 10.1 Supply of and demand for foreign exchange and foreign exchange rates. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-5 What Determines Foreign Exchange Rates • Imports of a country give rise to a demand for foreign exchange and a supply of U.S. dollars • Exports result in a supply of foreign exchange and a demand for U.S. dollars • Therefore, trade of the U.S. will be a primary contributor to the demand and supply of dollars and foreign currency Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-6 What Determines Foreign Exchange Rates (Cont.) • Balance of Payments – A summary of payments to foreigners for imports and receipts from foreigners for exports • Current Account—international transactions involving trade • Capital Account—international transactions involving financial assets – Deficit • Paying out more abroad than we are taking in (imports > exports— trade deficit) • Demand for foreign currency is greater than supply • As a result, the price of foreign currency will rise—the foreign currency will appreciate relative to the U.S. dollar and the U.S. dollar will depreciate 3Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-7 What Determines Foreign Exchange Rates (Cont.) • Balance of Payments (Cont.) – Surplus • Receiving more from abroad than we are spending (exports > imports—trade surplus) • This will result in an appreciation of the U.S. dollar and a depreciation of the foreign currency – When exchange rates freely react to supply and demand for foreign currency, a new equilibrium exchange rate will tend to eliminate balance of payments and bring trade into balance (exports = imports) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-8 What Determines Foreign Exchange Rates (Cont.) • Balance of Payments (Cont.) – Deficit • Result in a depreciation of the U.S. dollar • Encourages exports and discourages imports • Eventually the trade balance is in equilibrium at the new exchange rate – Surplus • Appreciation of the U.S. dollar • Discourages exports and encourages imports • The trade will be balanced at the new exchange rate Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-9 What Determines Foreign Exchange Rates (Cont.) • Why Do Exchange Rates Fluctuate – Figure 10.2 shows that the exchange rate between the U.S. dollar and other major currencies varies considerably over time – Figure 10.4 and 10.5 demonstrates that anything that causes the demand or supply in the foreign exchange market to shift will change the equilibrium exchange rate • U.S. residents buying more or less foreign goods will shift the demand curve for foreign currency • Changes in foreigner’s purchase of U.S. goods will shift the supply curve of foreign currency 4Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-10 FIGURE 10.2 Recent exchange rate history between the U.S. dollar and other major currencies. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-11 FIGURE 10.2 Recent exchange rate history between the U.S. dollar and other major currencies. (Cont.) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-12 FIGURE 10.2 Recent exchange rate history between the U.S. dollar and other major currencies. (Cont.) 5Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-13 FIGURE 10.2 Recent exchange rate history between the U.S. dollar and other major currencies. (Cont.) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-14 FIGURE 10.3 A rightward shift in the demand curve for pesos raises the dollar price of pesos, implying an appreciation of the peso and a depreciation of the dollar. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-15 FIGURE 10.4 A rightward shift in the supply curve of pesos lowers the dollar price of pesos, implying a depreciation of the peso and an appreciation of the dollar. 6Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-16 What Determines Foreign Exchange Rates (Cont.) • Factors that influence long-run supply and demand conditions – Relative prices of U.S. versus foreign goods • Relative increase in price of U.S. goods will encourage more imports – increase demand for foreign currency – tends to depreciate the value of the U.S. dollar or an appreciation of the foreign currency • Relative decrease in price of U.S. goods will result in an appreciation of the U.S. dollar Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-17 What Determines Foreign Exchange Rates (Cont.) • Factors that influence long-run supply and demand conditions (Cont.) – Productivity • Increased productivity in U.S. will lower price of American goods • Increased demand for U.S. goods internationally • Increased supply of foreign currency will appreciate the value of the dollar while foreign currency depreciates – Tastes for U.S. versus foreign goods • Increased tastes for U.S. goods • Increased demand for U.S. goods and increased supply of foreign currency • Dollar appreciates relative to foreign currency Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-18 What Determines Foreign Exchange Rates (Cont.) • How Global Investors Cause Exchange Rate Volatility – Changes in the factors described above occur slowly over time, so they cannot explain the often violent short-term movement in exchange rates – Figure 10.5 shows the considerable day-to-day movement of U.S. dollar exchange rates versus major foreign currencies 7Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-19 FIGURE 10.5 Daily fluctuations in foreign exchange rates can be quite volatile (2008). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-20 FIGURE 10.5 Daily fluctuations in foreign exchange rates can be quite volatile (2008). (Cont.) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-21 FIGURE 10.5 Daily fluctuations in foreign exchange rates can be quite volatile (2008). (Cont.) 8Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-22 FIGURE 10.5 Daily fluctuations in foreign exchange rates can be quite volatile (2008). (Cont.) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-23 What Determines Foreign Exchange Rates (Cont.) • How Global Investors Cause Exchange Rate Volatility (Cont.) – International capital mobility • Funds flow freely across international borders and investors can purchase U.S. or foreign securities • U.S. investors compare the expected return on domestic securities versus foreign securities to determine which are the most attractive • Therefore, changes in preferences of U.S. versus foreign securities will result in a change in demand and supply of foreign currency and a change in the exchange rate Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-24 What Determines Foreign Exchange Rates (Cont.) • How Global Investors Cause Exchange Rate Volatility (Cont.) – International capital mobility (Cont.) • In this case, expectations of future exchange rates play a central role in the decision process • When considering investing in foreign securities to take advantage of a higher yield, must consider the expected movement of future exchange rates • In order to invest in foreign securities, must first purchase foreign currency and eventually re-purchase U.S. dollars to bring currency back to U.S. 9Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-25 What Determines Foreign Exchange Rates (Cont.) • How Global Investors Cause Exchange Rate Volatility (Cont.) – International capital mobility (Cont.) • It is possible that a change in the future exchange rate will offset any increased yield by holding foreign securities • In fact, the international mobility of capital will often cause the change in future exchange rates that was anticipated—self-fulfilling prophesy Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-26 What Determines Foreign Exchange Rates (Cont.) • How Global Investors Cause Exchange Rate Volatility (Cont.) – This suggests that the equilibrium foreign exchange rate is sensitive to investor expectations of future movement in exchange rates – Since these expectations might be quite unstable and susceptible to change, this may cause considerable short-term volatility in the actual exchange rates Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-27 Fixed Versus Floating Exchange Rates • Volatility in foreign exchange rates represents a cost of doing business internationally and imposes considerable risk on investments overseas • Historically governments tried to avoid this cost by fixing exchange rates at some predetermined level 10 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-28 Fixed Versus Floating Exchange Rates (Cont.) • Fixed exchange rate system – This was the system maintained globally from 1944 until the early 1970s. – It came under the supervision of the International Monetary Fund (IMF) – After the collapse of the fixed exchange rate system, it was resurrected with a more limited scope in 1979 for the major European countries Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-29 Fixed Versus Floating Exchange Rates (Cont.) • Fixed exchange rate system (Cont.) – The most recent example of a fixed exchange rate is the introduction of the Euro as the common currency of the 12 members of the European Monetary Union • This new monetary union sets the exchange rate between the Euro and the member countries’ national currencies at a fixed rate • Individual member countries are expected to maintain domestic economic conditions that will not cause these agreed upon exchange rates to change Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-30 Fixed Versus Floating Exchange Rates (Cont.) • How Fixed Rates Are Supposed to Work – The correction process under a floating exchange rate system • Country runs a balance-of-payments deficit • Supply of its currency offered on world financial markets exceeds the demand • The currency will be depreciated in value relative to other markets • This adjustment brings the international payments into equilibrium 11 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-31 Fixed Versus Floating Exchange Rates (Cont.) • How Fixed Rates Are Supposed to Work (Cont.) – However, under a fixed exchange rate system these fluctuations are prevented from occurring through government intervention – Figure 10.6(a) (Floating Rate System) • The supply curve of British Pounds shifts to the right because British tastes have shifted toward increased purchases of American goods • This increased supply of pound would put downward pressure on the value of the Pound • Under a floating rate system the new lower equilibrium point would be reached where quantity supplied of pounds equals the quantity demanded of pounds Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-32 Fixed Versus Floating Exchange Rates (Cont.) • How Fixed Rates Are Supposed to Work (Cont.) – Figure 10.6(b) (Fixed Rate System) • Under this system, the British government would intervene in the foreign exchange market and purchase the excess pounds available at the predetermined fixed (pegged) rate • Britain’s international reserves are used to purchase the excess pounds which prevents the exchange rate from falling below the pegged rate • Traditionally these international reserves consist of gold, U.S. dollars, other major currencies, and now the Euro Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-33 FIGURE 10.6 In (a), with floating rates, the pound depreciates; in (b), with pegged rates, the British central bank prevents the decline by buying up the excess supply of pounds. 12 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-34 FIGURE 10.6 In (a), with floating rates, the pound depreciates; in (b), with pegged rates, the British central bank prevents the decline by buying up the excess supply of pounds. (Cont.) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-35 International Financial Crises • Major problem with a fixed rate system is that it contains no self-correcting exchange rate mechanism to eliminate a country’s persistent balance-of-payment deficit • A continual balance-of-payment deficit suggests domestic economic structural problems relative to the rest of the world • Eventually the country will run out of international reserves and be forced to devalue which will eliminate the deficit Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-36 International Financial Crises (Cont.) • The expectation of a devaluation will cause the international financial community to take actions that will increase the likelihood of the anticipated devaluation – Individuals will sell the threatened currency in the international market – This increases the supply of the currency which increases the downward pressure on the value – This capital flight will further deplete the country’s international reserve and speed up the devaluation 13 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10-37 International Financial Crises (Cont.) • Currently industrialized countries practice a managed float system – The exchange rate is permitted to vary within a predetermined band – If foreign exchange markets attempt to push the value of the currency outside the band (both above or below), central bank will intervene – However, if the central bank is intervening an excessive amount, it is likely that country will be forced to devalue or revalue its currency to recognize structural changes in local economy