International Economics

Eighth Edition

Chapter 10
Exchange Rates and Exchange
Rate Systems

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Learning Objectives (1 of 2)
10.1 List the reasons for holding foreign exchange and the main
institutions in the foreign exchange market.
10.2 Diagram the effects on the home currency of a change in
the supply or demand for foreign currency.
10.3 Differentiate short-run, medium-run, and long-run forces
that help determine the value of a currency.

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Learning Objectives (2 of 2)
10.4 State the three rules of the gold standard.
10.5 Compare and contrast hard pegs, crawling pegs, and
flexible exchange rate systems
10.6. Explain in words and with an equation the relationship
between price changes and the real exchange rates.
10.7 State the necessary conditions for two or more countries to
form a single currency area.

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Fixed, Flexible, or In-between?
• Every country must choose an exchange rate system to
determine how prices in the home country currency are
converted into prices in another country’s currency.
• Countries have numerous choices among exchange rate
systems on a continuum from fixed to completely flexible
systems.
• Each exchange rate system requires that governments and
central banks have credible policies to support the system they
select.

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Exchange Rates and Currency Trading
(1 of 6)

• Exchange rate: The price of a currency stated in terms of a

second currency
– U.S. dollars per Mexican peso = 0.05 dollars per peso, or
– Mexican pesos per U.S. dollar = 20 pesos per dollar.
– Exchange rates are reported in every newspaper with a
business section and on numerous web sites.

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Exchange Rates and Currency Trading
(2 of 6)

• In general, exchange rates are either

Units of domestic currency/unit of foreign currency,
or
Units of foreign currency/unit of domestic currency,
• In the newspaper and elsewhere, the ratio is usually
whichever one is above 1; so its pesos per dollar and dollars
per euro.
• For consistency, we will define the exchange rate as domestic
over foreign, so its dollars per peso and dollars per euro.

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Exchange Rates and Currency Trading
(3 of 6)

• Appreciation: A currency becomes more valuable; foreign

currency costs less.
• Depreciation: A the currency becomes less valuable; foreign
currency costs more.

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Exchange Rates and Currency Trading
(4 of 6)

• The most frequently used currencies in world trade and finance are:
– U.S. dollar;
– EU euro;
– Japanese yen;
– British pound.
• All three are flexible exchange rate systems;
– Their value changes day to day, even minute to minute.
• A majority of the world’s countries have fixed exchange rate
systems;
– The value of their currency is fixed to the dollar, the euro, the
pound, or another currency, or even a basket of currencies, and
does not move in value.
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Exchange Rates and Currency Trading
(5 of 6)

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Exchange Rates and Currency Trading
(6 of 6)

• Exchange rates are scales, like miles and kilometres, or

degrees Fahrenheit and Celsius.
– They do not tell us which currency is weak and which is
strong by their value alone.
– To know relative strengths, we have to look at changes
over time.

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Reasons for Holding Foreign Currencies
1. Trade and investment: Traders (importers and exporters),
investors, and travellers routinely transact in foreign
currencies.
2. Interest rate arbitrage: Financial arbitrageurs will take
advantage of interest rate differentials between countries;
they borrow money where interest rates are low and lend it
where interest rates are high.
3. Speculation: Speculators buy and sell currency in anticipation
of changes in the currency’s value; speculators sell overvalued
currencies and buy undervalued ones.

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Participants in Markets for Foreign
Exchange
• Retail customers: Firms and individuals hold foreign currency
to buy goods and services, to travel, to adjust their portfolios,
and to speculate.
• Commercial banks hold currencies as part of their services for
their customers; they are the largest participant in currency
markets.
• Foreign exchange brokers are middlemen between banks and
buyers and sellers of foreign exchange.
• Central banks hold foreign exchange as reserves and to supply
domestic banks that need it.

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Exchange Rate Risk (1 of 3)
• Businesses operating in multiple countries encounter
exchange rate risk due to the possibility of currency
fluctuations.
• Future payments or receipts in a foreign currency may be
worth something different from expectations when the
contract was signed.
• Business people protect their interests by purchasing a
contract to buy or sell the foreign currency in the future at a
price agreed today.

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Exchange Rate Risk (2 of 3)
• Forward exchange rate: The price of a currency that will be
delivered in the future.
• Forward market: The market for the buying and selling of
currencies for future delivery.
– Businesses needing foreign currency or receiving foreign
currency payments can sign a contract that guarantees a
set price either 30, 60, 90, or 180 days in the future.
• Spot market: The market for the buying and selling of
currencies in the present.

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Exchange Rate Risk (3 of 3)
• When investors and speculators use the forward market to
protect against unanticipated currency fluctuations, they are
hedging.
– They can buy a forward contract to sell foreign currency at
the same time that their foreign assets will be sold.
• Investors and speculators engage in interest rate arbitrage
when they borrow in markets with low interest rates and lend
in markets with high ones.
– When they hedge against currency fluctuations, they are
engaging in covered interest arbitrage.

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Foreign Exchange Supply and Demand
(1 of 6)

• Supply and demand analysis is useful for analyzing exchange

rates.
– Increases in supply lower the price, decreases raise the
price.
– Increases in demand raise the price, decreases lower the
price.
• Price changes for foreign currency assumes there is a flexible
exchange rate system; if there is a fixed exchange rate system,
then changes in supply and demand must be offset by the
monetary authority.
– Usually the central bank or the finance ministry.

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Foreign Exchange Supply and Demand
(2 of 6)

• The graph of supply and demand has price on the vertical axis,
quantity on the horizontal.
– Price is the exchange rate: units of domestic currency per
unit of foreign.
– Quantity is the quantity of foreign exchange.
• Demand slopes down to the right: as foreign exchange is
cheaper, more is demanded, all else equal.
• Supply slopes up to right: as foreign exchange is more
expensive (domestic currency cheaper), foreigners are willing
to supply more.

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Foreign Exchange Supply and Demand
(3 of 6)

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Foreign Exchange Supply and Demand
(4 of 6)

An increase in the demand for British pounds.

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Foreign Exchange Supply and Demand
(5 of 6)

An increase in the supply of British pounds

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Foreign Exchange Supply and Demand
(6 of 6)

• The previous graphs assume a flexible exchange rate.

• Demand changes are related to anything that might cause an
increase in the demand for British pounds by U.S. residents.
– Trading, travel, investing, speculating.
• Supply changes are related to anything that might cause an
increase in the supply of British pounds to the U.S.
– Trading, travel, investing, speculating.

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Exchange Rate Determination (1 of 9)
• Exchange rates are exceedingly difficult to predict. One
reason is that there are many factors that vary over the long
run, medium run, and short run.
• Four factors:
– Long run: Purchasing power parity.
– Medium run: Business cycle.
– Short run: Interest parity and speculation.

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Exchange Rate Determination (2 of 9)
• Purchasing power parity: Hypothetical Price of the same
The exchange rate allows example basket of goods
the same quantity of goods Dollars (U.S.) $1,000
to be bought in either Pounds (U.K.) £500
currency when converted PPP Exchange rate $2/£
from one to another.
• PPP exchange rate depends
on goods arbitrage, which
works slowly, if at all.

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Exchange Rate Determination (3 of 9)
• Medium run force: The business cycle.
• Consider impacts via exports and imports.
– Faster growth at home means more imports, more
demand for foreign currency. All else equal, the home
currency depreciates as demand for foreign currency shifts
right.
– Faster growth abroad means more home country exports,
more supply of foreign currency. All else equal, the home
country currency appreciates as the supply of foreign
currency shifts right.

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Exchange Rate Determination (4 of 9)
• Short run forces: Interest parity condition and speculation.
– Interest parity holds that exchange rate movements should
be sufficient to counteract any differences in interest rates
between countries.
– Speculation is the buying and selling of assets in
anticipation of a change in value.
• The interest parity condition can be estimated from today’s
interest rates and the exchange rate in the spot and forward
markets.

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Exchange Rate Determination (5 of 9)
• Interest rate arbitrageurs take advantage of interest rate
differences in different countries.
– They borrow in the low interest rate market and lend in
the high interest rate market.
• Let i = home interest rate, i* = foreign; and i > i*.
• The problem for the investor is that changes in the exchange
rate will affect their overall rate of return.

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Exchange Rate Determination (6 of 9)
• Assume, an interest rate arbitrageur in the U.S. can earn i at
home or i* in the U.K.
– If they invest $1, after one year, they have $(1+i) at home.
– If they invest abroad, they change dollars for pounds and
receive 100/R. After a year, it becomes:
£(1/R)(1+i*),
which has to be changed back into dollars.
– An interest rate arbitrageur who knows how many pounds
they will have in the future could sign a forward contract
to sell the pounds for dollars:
(1/R)(1+i*)F,

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Exchange Rate Determination (7 of 9)
• The equilibrium exchange rate is the one that equalizes
returns in the U.S. and U.K.:
(1+i) = (1/R)(1+i*)F = (F/R)(1+i*)
• Divide both sides by (1+i*):
(1+i)/(1+i*) = F/R.
• Algebraically, this equation can be rearranged:
i – i* ≈ (F – R)/R.
• The relationship is approximate, for low values of i*.

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Exchange Rate Determination (8 of 9)
• The equation i – i* ≈ (F – R)/R has the interest rate
differential on the left and the expected change in the
exchange rate on the right.
– If (F – R)/R > 0, the home country currency is expected to
depreciate, and i > i* .
– If (F – R)/R < 0, the home country currency is expected to
appreciate, and i < i*.
– The percentage appreciation or depreciation is expected to
be equal to the interest rate differential; investors are
indifferent between home and abroad.

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The Effects of an Increase in Home’s
Interest Rate

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Exchange Rate Determination (9 of 9)

Blank R rises: Appreciation in R falls: Depreciation in

home currency home currency
Long run: Purchasing Home goods are less Home goods are more
power parity expensive than foreign expensive than foreign
Medium run: The business Domestic economy grows Domestic economy grows
cycle slower than foreign faster than foreign
Short run (1): Interest Interest rates rise at home Interest rates fall at home
parity and/or fall abroad and/or rise abroad
Short run (2): Speculation Expectations of future Expectations of future
appreciation depreciation

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Case Study: The Largest Market in the
World (1 of 2)
Currency Percent of trades Currency Percent of trades
U.S. dollar 88.3 Swiss franc 5.0
EU euro 32.3 Canadian dollar 5.0
Japanese yen 16.8 Chinese renminbi 4.3
U.K. pound 12.8 Hong Kong dollar 3.5
Australian dollar 6.8 Other 25.2

• Trading foreign currency is the largest market in the world: In

2019 it was worth $6,595 billion per day.
• The U.S. dollar is involved in 88.3 percent of all trades.
• The numbers add to 200 percent because every transaction
involves 2 currencies.
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Case Study: The Largest Market in the
World (2 of 2)
Location Percent of trades Location Percent of trades
United Kingdom 43.1 Switzerland 3.3
United States 16.5 France 2.0
Singapore 7.7 China 1.6
Hong Kong 7.6 Other 13.7
Japan 4.5 Blank Blank

• In 2019, nearly 60 percent of all trades occur in the United

Kingdom (London) or the United States (New York).
• The U.K. market is more than twice the size of the U.S.
market.
• China is not yet a major player, although Hong Kong is.

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Alternatives to Flexible Exchange Rates
(1 of 2)

• Flexible exchange rate systems let the home currency change

in value relative to other currencies.
– The exchange rate is a price, prices can change over time.
– Flexible or floating rates have varying degrees of flexibility;
some governments intervene occasionally, others very
infrequently, to control the movement.
• Fixed exchange rates, also called pegged exchange rates come
in a variety of formats.
– Hard pegs are not allowed to change in value at all.
– Soft pegs are allowed to change within some limit, but not
beyond that limit.

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Alternatives to Flexible Exchange Rates
(2 of 2)

Exchange rate system, 2014 Countries

Hard pegs 24
Soft pegs 88
Managed floating 35
Independently floating 30
Other 13
Total 190

• Most countries have some form of a fixed exchange rate

system.
• Managed float implies some level of government intervention
to control the currency, but much less than with a pegged
system.
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Fixed Exchange Rate Systems (1 of 6)
• A gold standard is one type of fixed exchange rate: the value
of currency is set to a quantity of gold.
• Under the Bretton Woods exchange rate system (1947-1973)
nearly all countries had fixed exchange rates.
– The U.S. dollar was fixed to gold;
– Other countries were fixed to the U.S. dollar.

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Fixed Exchange Rate Systems (2 of 6)
• Rules of the gold standard:
– Fix the currency to a given quantity of gold; e.g., $35 per
ounce;
– Keep a fixed ratio of domestic money to gold;
– Be willing and able to convert domestic money to gold,
and vice versa.
• Under the gold standard:
– The money supply is determined by the quantity of gold;
– Countries cannot use monetary policy; the money supply
is fixed to the quantity of gold.
– Central banks or monetary authorities must be willing and
able to supply gold when the demand increases.

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Fixed Exchange Rate Systems (3 of 6)
• Fixed exchange rates are similar to gold standards but instead
of pegging the home currency to gold, it is pegged to another
currency or to a basket of currencies.
• The monetary authority must be willing and able to convert
the national currency into the currency it pegs to, at the
official rate of exchange.
– This limits the ability to use monetary policy since the
money supply must not grow beyond the point where it
can be converted.

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Fixed Exchange Rate Systems (4 of 6)
• Consider the case of a sudden increase in demand for foreign
exchange in a country with a fixed exchange rate system.
– Normally, a rightward shift of the demand curve leads to a
depreciation of the home currency.
– However, the monetary authority cannot let that happen,
so they must counter the demand shift with a supply shift.
▪ The supply shift must be large enough to keep the
exchange rate constant.
▪ The monetary authority must have enough foreign
exchange on hand to be able to supply the increase
demand.

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Fixed Exchange Rate Systems (5 of 6)

To maintain R1 the central bank must increase the demand for pounds by AB

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Fixed Exchange Rate Systems (6 of 6)
• Fixed exchange rates come in various forms:
– Some countries adopt a foreign currency as their own.
– Some peg to a foreign currency and keep it fixed.
– Some peg to a basket of foreign currencies.
– Some peg to a foreign currency and adjust it periodically.
This is called a crawling peg.
– Some peg to another currency, but let it float up or down
by some percentage before they intervene.

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Case Study: The End of the Bretton
Woods Exchange Rate System (1 of 2)
• The Bretton Woods exchange rate system was created at the
Bretton Woods Conference in 1944, along with the IMF and
World Bank.
• The goal was to create a money supply that could be used to
make international payments.
– The U.S. dollar was selected as the reserve currency for the
countries that participated.
– The dollar was tied to gold at $35 per ounce and other
counties tied their currencies to the dollar.
– The U.S. was required to exchange its dollars for gold
whenever other countries asked.

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Case Study: The End of the Bretton
Woods Exchange Rate System (2 of 2)
• The system worked relatively well until the late 1960s.
– The world payments system had adequate liquidity;
– As the 1960s progressed, too many U.S. dollars
accumulated in Europe and elsewhere.
– In 1971, the Smithsonian Agreement allowed the U.S. to
devalue by changing the gold value of the dollar from $35
per ounce to $38.02.
– In the same year, President Nixon announced that the
dollar would no longer be exchanged for gold.
• In 1973, there was another devaluation, countries began to let
their currencies float against each other, and the Bretton
Woods exchange rate system was dead.

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The Real Exchange Rate (1 of 4)
• The market exchange rate, or nominal exchange rate is the
price of a unit of foreign currency.
– It does not tell the value of the goods and services that can
be purchased.
– The value of the goods and services depends on foreign
prices.
• The real exchange rate is the nominal rate adjusted for price
differences at home and abroad.

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The Real Exchange Rate (2 of 4)
• Define the following:
– Rr = the real exchange rate;
– Rn = the nominal exchange rate;
– P* = foreign price level
– P = domestic price level.
• The real exchange rate:
Rr = Rn(P*/P).

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The Real Exchange Rate (3 of 4)
• The real exchange rate shows whether a currency is
depreciating or appreciating in its purchasing power over
foreign goods and services.
– Nominal appreciation or depreciation is not always the
same as real.
– Businesses and households that use foreign exchange are
more concerned about the real value of their currency
than the nominal.

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The Real Exchange Rate (4 of 4)
• Assume the following values:
– The dollar/euro exchange rate = $1.10 per euro.
– Base year price index in both countries = 100.
• The real exchange rate in the base year:
– $1.10(100/100) = $1.10 = the nominal rate.
• Next year: Assume inflation is 10% in U.S. and 0 in EU and
nominal rate is unchanged.
• The real exchange rate:
– $1.10(100/110) = $1.
– US dollar has appreciated in real terms: The nominal rate
has not changed, but in comparison to the base year,
dollars buy more in Europe relative to what they buy in the
U.S.
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Choosing the Right Exchange Rate
System (1 of 2)
• Fixed rates provide:
– Greater certainty about the future exchange rate;
– A more certain environment for business planning.
• Fixed rates do not:
– Protect against outside shocks, such as a sudden drop in
commodity prices;
– Let countries have an independent monetary policy; all
monetary policy must support the currency, not the domestic
economy.
• Fixed rates require:
– Caution in the creation of new money;
– A high level of credibility; the rate must be perceived as stable
and correct in value.
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Choosing the Right Exchange Rate
System (2 of 2)
• Flexible rates provide:
– Insulation from shocks that originate outside the economy,
such as a sudden fall in commodity prices or a decline in
foreign demand for domestic output;
– The conditions for an independent monetary policy, which
gives greater flexibility in addressing domestic concerns
about economic growth, unemployment.

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Single Currency Areas (1 of 2)
• A single currency area, also called an optimum currency area,
is a region that adopts a single currency.
– Best example: The euro.
• There are three conditions that must be met in order for a
single currency to be better than multiple currencies:
– Business cycles must be synchronized;
– Labor and capital must be mobile between countries;
– There must be policies for addressing regional differences
in growth when the business cycles do not match.

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Single Currency Areas (2 of 2)
• The benefits of a single currency are:
– Reduced transaction costs in currency conversions and
accounting.
– Data on increased trade and investment is mixed.
• The largest potential cost of a single currency is that countries
sharing a currency give up their independent monetary
policies.
• Consequently, some analysts argue that there must be a fiscal
union of some kind that can transfer resources from regions
doing well to regions not doing well. This requires that the
goal is more than simply increased trade and investment.

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