Week 4 discussion

Floating  Exchange   Rates  

Money  Into  Other  Money  

Exchange  Rate   The rate, ratio or price at which one currency trades

or exchanges for another currency.

!   Say  you  want  to  buy  a  British  car,  a  Land  Rover  for  example.     You  go  to  your  local  dealer  and  you  buy  the  car  in  US  Dollars.  

!   The  dealer,  however,  has  to  pay  the  car’s  British  manufacturer  in   British  Pounds  -­‐  GBP  (£).  

!   The  manufacturer  wants  British  Pounds  because  they  pay  their   workers,  their  rent,  their  British  suppliers  and,  of  course,  their   taxes  in    British  Pounds.  

!   How  does  the  car  dealer,  to  whom  you  paid  US  Dollars,  get   British  Pounds?  

Sell  US  Dollars/Buy   British  Pounds  

!   Let’s  say  the  car  dealer  needs  to  pay  the  auto  manufacturer  GB   £100,000.    How  does  the  dealer  pay  the  manufacturer?  

!   The  dealer  will  go  to  the  bank  and  ask  the  bank  to  send  GB   £100,000  to  the  manufacturer.  

!   The  bank  will  go  into  the  Foreign  Exchange  Market  (the  market   where  currencies  are  bought  and  sold)  and  buy  GB  £100,000.     How  does  the  bank  buy  British  Pounds?  

! They  buy  British  Pounds  by  selling  US  Dollars.   !   (The  official  name  is  Great  Britain  Pounds  or  GBP  and  the  

symbol  is  £.  But  the  common  term  is  British  Pounds.  This   presentation  uses  all  of  these  interchangeably.    Learning  things   like  this  is  part  of  learning  the  language  of  foreign  currencies.)  

What  Is  The  Price?   !   Both  the  US  Dollar  and  the  British  Pound  are  freely  

floating  currencies.  

!   The  price  of  a  floating  currency  changes  based  on   supply  and  demand  of  the  currency.    The  price  can   change  several  times  in  a  day,  but  usually  not  by   much.  

!   For  floating  currencies,  the  Foreign  Exchange  Market   works  like  any    other  supply  and  demand  driven   market.  

BUT  What  IS  The  Price?   !   It  is  what  the  market  says  it  is  at  the  time  the  bank  

wants  to  buy  GB  £100,000.  

!   For  example,  if  1  US  $  =  GB  £0.58  (the  actual  exchange   rate  on  July  1,  2014);  

!   Then,  to  buy  GB  £100,000  will  cost  US  $172,413.79   (100,000/.58).    

!   The  bank  will  pay  the  auto  manufacturer  GB  £100,000   and  deduct  US  $172,413.79  from  the  account  of  the   auto  dealer.  

What  About  The  Other   Way  Around?  

!   It  works  the  same  way  –  basically.  

!   A  British  bank,  say  Barclays  (they  loaned  Thomas   Jefferson  the  money  so  the  US  could  make  the   Louisiana  Purchase),  wants  to  buy  computer  routers   from  Cisco,  a  US  company.  

!   Barclays  tells  Cisco  what  it  needs  and  asks  for  a  price.  

!   Cisco  tells  Barclays  that  the  routers  will  cost  US   $100,000.  

What  Happens  Next?   !   Since  Barclay’s  is  a  bank,  it  goes  directly  into  the  foreign  

exchange  market  and  demands  (offers  to  buy)  100,000  US   Dollars  from  whomever  has  US  Dollars  and  wants  to  have   GB  Pounds.  

!   In  other  words,  Barclay’s  offers  to  supply  (sell)  British   Pounds  and  to  buy  (demand)  US  Dollars.   !   The  Land  Rover  dealership  had  their  bank  do  the  same  thing,  

only  they  were  offering  to  supply  (sell)  US  Dollars  in   exchange  for  (buy  or  demand)  GB  Pounds.  

!   Like  any  market,  there  has  to  be  a  buyer  and    a  seller  in   order  to  make  an  exchange.  

So?  What’s  The  Price?   !   Using  the  same  exchange  rate:  1  US  $  =  GB  £0.58;  

!   Barclay’s  will  go  into  the  foreign  exchange  market   and  pay  GB  £58,000  and  receive  in  return  US  $100,000   (100,000  X  .58).  

!   Which  Barclay’s  will  pay  to  Cisco  for  the  routers.      

!   Cisco  wants  US  Dollars  for  the  same  reasons  that   Land  Rover  wanted  British  Pounds.  

Two  Things  Happen  To  Make  One   Thing  Happen  

!   All  international  trade  involve  two  separate  but  mutually   dependent  exchanges.  

!   First,  there  is  the  goods  trade.    Someone  in  one  country   buys  a  good  from  someone  else  in  another  country.  

!   Second,  the  currencies  are  traded.    The  buyer  pays  in  his/ her  domestic  currency,  but  the  seller  wants  to  be  paid  in   his/her  domestic  currency.  

!   Thus,  foreign  exchange  rates  are  born.    And  international   trade  occurs.  

What  Changes  The   Exchange  Rate?  

!   For  a  floating  currency,  and  all  the  major  currencies   (except  the  Chinese  Yuan)  are  floating  currencies,  the   exchange  rate  changes  in  response  to  changes  in  the   supply  of  and  the  demand  for  the  currency.  

!   Say,  Australian  businesses  start  to  buy  more  goods  and   services  from  the  US.    That  means  that  Australian  imports   from  the  US  have  increased.  

!   To  pay  for  the  increased  imports,  the  Australians  will  have   to  sell  (supply)  more  Australian  Dollars  (AU$)  and  buy   (demand)    more  US  Dollars.     !   You  see  why  we  can’t  just  say  “dollars”,  we  have  to  specify  

the  country  as  well.  

Supply  and  Demand   !   Remember  what  you  know  about  supply  and  

demand?  

!   When  the  demand  for  anything  increases,  the  price   increases.  

!   When  the  supply  increases,  the  price  decreases.  

!   What  has  happened  in  the  US  -­‐  Australian  example?     How  has  the  exchange  rate  changed?  

The  Exchange  Rate   Changes  

!   When  the  Australian  demand  for  US$    increased  (because   of  the  increased  imports  from  the  US),    more  AU$  were   supplied  to  the  foreign  exchange  market  to  pay  for  the  US $  demanded  by  the  Australians  to  pay  for  the  increased   imports  from  the  US.    

!   The  increased  supply  of  Australian  Dollars  has  caused  the   price  of  the  Australian  Dollar  to  fall  -­‐    depreciate  -­‐  relative   to  the  US  Dollar.  Now  it  will  take  more  AU$  to  buy  1  US$.    

!   This  also  means  that  the  US  Dollar  has  appreciated  relative   to  the  Australian  Dollar.    Because  it  now  takes  fewer  US$   to  buy  1  AU$.  

What  Does  This  Mean   For  The  Yen?  

!   Nothing!  

!   Currencies  appreciate  (gain  value)  or  depreciate  (lose  value)  by   currency  pair.  

!   In  the  previous  example,  the  US$  appreciated  relative  to  the  AU $.    And  the  AU$  depreciated  relative  to  the  US$.  

!   This  happens  at  the  same  time  in  the  foreign  exchange  market.   !   Remember  the  price  of  one  currency  is  the  amount  of  another  

currency  that  must  be  paid  to  obtain  the  first  currency.  

!   No  other  currencies  were  involved.    Therefore,  no  other   exchange  rates  change  because  of  the  change  in  Australian   imports  from  the  US.  

But  I  Thought…   !   Yes,  a  currency  can  appreciate  or  depreciate  relative  

to  multiple  currencies  at  the  same  time.  

!   Yes,  a  currency  can  appreciate  relative  to  some   currencies  while  depreciating  relative  to  other   currencies  at  the  same  time.  

!   Which  is  why  we  study  exchange  rates  by  examining   one  pair  of  countries  at  a  time.       !   If  we  tried  to  examine  all  countries  and  currencies  at  

the  same  time,  that  would  really  get  confusing!  

Are  These  Strong   Currencies?  

!   Yes,  the  US  Dollar  and  the  GB  Pound  are  both  strong  currencies.   !   The  British  Pound  is  the  stronger  currency  as  1  GB  £  buys  more  US  

Dollars  than    1  US  $  buys  of  GB  Pounds.    The  exchange  rate  shows  that.     It  is  actually  a  very  stable  exchange  rate.  

!   The  Australian  Dollar  and  the  US  Dollar  are  also  both  strong   currencies.  

!   The  exchange  rate  as  of  July  1,  2014  was  1.06  Australian  Dollars  for  1   US  Dollar.    So  the  Australian  Dollar  was  slightly  stronger  than  the   US  Dollar  on  that  date.    But  our  example  would  change  than  and   make  the  US  Dollar  somewhat  stronger  than  the  Australian  Dollar.       !   These  two  currencies  tend  to  switch  position  a  lot,  but  only  within  a  

fairly  narrow  range.    So  their  exchange  rate  is  pretty  stable.  

¥  Like  most  things  in  the  real  world  there  is  always  a  qualification.    And  here  that  is  the   Japanese  Yen  (you  see  the  symbol  at  the  start  of  this  paragraph).    The  Yen  is  a  strong   currency,  but  it  usually  trades  at  about  100  Yen  to  1  US  Dollar.    So  don’t  let  the  ratio  mislead   you,  as  we’ll  will  see  later,  the  strength  of  the  economy  plays  an  important  role  in  exchange   rate  determination.      (Purchasing  Power  Parity  plays  a  role  also,  but  let’s  not  include  that   yet.)  

Key  Points  To   Remember  

!   An  exchange  rate  always  involves  two  countries  and  two   currencies.  

!   The  exchange  rate  is  the  price  of  one  currency  in  terms  of   another  currency.  

!   When  a  currency  appreciates,  it  gains  value  -­‐  will  buy  more   of  another  currency.  

!   When  a  currency  depreciates,  it  loses  value  -­‐  will  buy  less   of  another  currency.  

!   When  one  currency  in  a  currency  pair  appreciates  the   other  must  depreciate  –  that’s  the  way  the  math    works.  

More  Key  Points   !   A  strong  currency  is  one  that  has  a  stable  exchange  rate.    

Yes,  the  exchange  rate  changes,  but  it  does  not  do  so  by   large  amounts  or  very  suddenly.  

!   Strong  currencies  are  normally  ones  issued  by  countries   that  are  politically  stable  and  economically  developed.    

!   They  are  stable  currencies  issued  by  stable  countries.  

!    The  major  strong  currencies  are:    the  US  Dollar,  the  Euro,   the  British  Pound,  the  Japanese  Yen,  the  Swiss  Franc,  the   Canadian  Dollar  and  the  Australian  Dollar.    These  are  not   the  only  strong  currencies,  but  they  are  the  ones  that  are   most  commonly  used  internationally.  

Key  Points  Keep  Coming   !   A  weak  currency  is  one  that  is  subject  to  sudden  and  

often  large  changes  in  its’  exchange  rate.    These  are   normally  issued  by  developing  countries  many  of   which  are  not  very  democratic  in  their  governmental   structure.      

!   Most  of  the  world’s  currencies  are  considered  to  be   weak  currencies.  

But  The  Assignment   Says…  

!   Yes,  the  assignment  says  to  select  the  US  Dollar  and  another   currency  of  your  choice  (other  than  the  Chinese  Yuan);  

!   Collect  12  months  worth  of  exchange  rate  data  (follow  the   instructions  on  the  course  web  site  carefully);  

!   Then,  examine  the  12  months  worth  of  data  and  decide  which   currency  has  appreciated  over  that  period  and  which  has   depreciated  over  that  period.  

!   Or  have  both  happened?  

!   Or  has  the  exchange  rate  been  mostly  stable  over  the  time   period  with  not  a  lot  of  change?  

How  Do  I  Do  That?   !   Remember  what  we  said  about  the  number  of  units  of  a  

currency  needed  to  buy  1  unit  of  another  currency?      

!   Or  looked  at  from  the  other  side,  how  many  units  of  a   currency  will  1  unit  of  another  currency  buy?      

!   These  would  be  different  numbers,  but  they  are  just  two   different  perspectives  or  views  of  the  same  currency   exchange.  

!   You  don’t  need  both  sets  of  numbers  to  see  how  the   exchange  rate  is  changing.    Pick  one  view  and  observe   how  those  numbers  change.    The  simplest  thing  is  to   select  the  view  the  data  gives  you.  

HUH??   !   OK,  let’s  take  a  fake  example.    Let’s  look  at  the  

exchange  rate  of  the  US  Dollar  and  the  Blogslovian   Blob.    

!   To  make  this  easier,  the  Blob  is  going  to  be  a  weak   currency  that  has  sudden  changes  in  its’  exchange   rate.    Otherwise,  the  numbers  require  too  many   decimals.   !   To  make  it  easier,  the  changes  will  be  predictable.    That  

is  not  always  the  case  in  the  real  world.  

Blogslovian  Blobs  Per  1  US   Dollar:  The  Exchange  Rate*  

It  would  seem  that  the  Blob  is  not  a  very  stable  currency  and  isn’t  worth  a  lot  in   terms  of  US  Dollars.      But  it  ends  the  year  in  the  same  place  that  it  began.    So  what   happened  in  between  January  and  December?    To  know  that  we  have  to  know  more   about  the  Blogslovian  economy.  

*1  Blob  =  100  Slobs  and  1  US  Dollar  =  100  Cents  

Month   1   2   3   4   5   6   7   8   9   10   11   12  

Blobs   per  US   $  

50   200   40   30   20   70   150   200   50   60   60   50  

But  before  we  explore  the  Blogslovian  economy,  use  the  information  in  the  table   above  and  calculate  the  US  $  -­‐  Blob  exchange  rate  for  each  month  (1$/Blobs).  

Blogslovian  Economy   ! Blogslovia  is  governed  by  its’  weather  which  is  given  

to  extremes.  

!   It  is  a  mostly  agricultural  economy  with  a  modest   amount  of  seasonal  tourism  –  better  hotels  would   help.  

!   So  we  will  trace  the  Blogslovian  economy  through   the  seasons  and  see  how  the  economic  activity  in   each  season  impacts  the  demand  for  the  Blob.    And   how  the  Blogslovian  demand  for  imports  impacts  the   supply  of  the  Blob.  

Winter  In  Blogslovia   !   December  and  January  are  good  months  for  snow  

which  brings  in  a  modest  number  of  tourists.    More   would  come  if  the  hotels  weren’t  so  bad  and  the   roads  worse.  

!   February  is  all  ice  and  sleet  and  the  Blogslovians   would  leave  if  they  weren’t  so  poor  and  the  roads  so   bad.  

!   So  when  the  tourists  come,  the  Blob  appreciates,   when  they  leave  in  February  and  goods  must  still  be   imported,  the  Blob  depreciates.  

Springtime  in   Blogslovia!  

!   But  the  Spring  is  lovely  in  Blogslovia.  

!   Warm  with  enough  rain  to  produce  early  and   continual  harvests  for  fruits  and  vegetables.  

!   During  these  months  Blogslovia  exports  a  lot  of   agricultural  products  to  the  US  and  to  Europe.  

!   This  increases  the  demand  for  the  Blob  and  the  Blob   appreciates!  

Summer  In  Blogslovia   !   The  Summers  are  horrid.  

!   The  winds  bring  in  very  hot  and  humid  air  from  the   south.  

!   The  harvest  season  is  over  as  the  land  dries  up.  

!   Nobody  in  the  right  mind  comes  to  visit.  

!   But  goods  must  still  be  imported.  

!   So  the  Blob  depreciates.  

Fall  In  Blogslovia   !   The  Fall  tends  to  be  cool  and  dry  as  the  winds  once  again  

shift.  

!   Apple  trees  and  winter  wheat  produce  agricultural   products  for  export.  

!   But  after  the  fall  harvest,  people  mostly  stay  home  and  do   as  little  as  possible.  

!   So  some  exports  occur  with  the  harvest,  but  not  much  is   imported  as  people  go  home,  sit  by  the  fire  ad  consume   the  national  beverage:    Slovia  apple  ale  with  wheat  cakes.  

What  Is  the  Blob  Doing?   !   For  Blogslovina  it  depends  on  the  season.  

!   During  the  Spring  Blogslovina’s  exports  are  high  and  the   Blob  appreciates.  

!   During  the  Summer  exports  are  almost  none  existence,   but  imports  are  still  needed,  so  the  Blob  depreciates.  

!   During  the  Fall  not  much  happens  in  the  economy  –  some   exports  and  some  imports,  so  the  Blob  is  fairly  stable.  

!   During  the  Winter  some  tourists  come  to  ski  and  that   causes  the  Blob  to  appreciate.  

Simply  Put:   ! When  money  flows  into  the  country,  the  currency  appreciates.  

!   This  can  happen  when  exports  exceeds  imports,  when  more  tourist   come  to  Blogslovia  or  when  inflows  of  financial  investment  occur  (not   that  that  last  one  happens  much  to  poor  Blogslovia)  

! When  money  flows  out  of  the  country,  the  currency  depreciates.   !   This  can  happen  when  imports  exceed  exports,  when  Blogslovians  go  

to  visit  other  countries  (they  wish)  or  when  outflows  of  financial   investments  occur.  

!   It  is  the  flow  of  money  in  all  it’s  forms  and  for  all  of  it’s  many   purposes  that  drives  the  demand  and  the  supply  of  a  currency  and   thereby  the  currency’s  exchange  rate.  

!   Money  does  make  the  world  go  around  or  at  least  the  exchange   rates!  

!   See,  it  is  not  that  hard!  

Now,  Back  To   Blogslovia!

!   Review  the  seasonal  information  about  Blogslovia’s   economy.   !   For  each  season  determine  if  more  money  is  flowing  into  the  

country  than  is  flowing  out  of  the  country;   !   Or  if  more  money  is  flowing  out  of  the  country  than  flowing  

into  it;   !   Or  if  about  the  same  amount  is  flowing  in  as  is  flowing  out.  

!   Use  that  information  to  decide  when  you  think  the  Blob  is   appreciating  ,  when  it  is  depreciating  and  when  it  is   holding  steady.  

!   Compare  what  you  project  with  the  earlier  table  of   exchange  rates  by  month.  

Were  You  Right?   !   If  so,  then  congratulations  you  have  a  good  understanding  of  

how  floating  exchange  rates  work!  

!   If  not,  go  back  to  slide  1  and  try  again!  

!   Either  way,  be  sure  you  have  a  good  understanding  of:   !   What  exchange  rates  are;   !   How  floating  exchange  rates  change  and  the  role  of  supply  and  

demand  in  causing  those  changes;   !   How  changes  in  imports  and  exports  change  the  supply  and  the  

demand  for  the  two  currencies  involved.  

!   Do  all  of  this  and  then  you  will  have  a  new  and  better   understanding,  not  only  of  how  the  world  works,  but  of  why   you  pay  what  you  do  for  so  much  of  what  you  consume.  

Intermission   !   This  presentation  has  covered  Floating  Exchange  Rates.    

The  floating  system  is  the  most  important  for   international  trade  purposes.  

!   But  it  is  not  the  only  system  of  exchange  rates.    A  separate   presentation  will  explore  other  approaches:   !   Managed  Floats   !   Fixed  Exchange  Rates   !   Currency  Pegs   !   Currency  Boards  

!   But  that  is  for  another  day  –  perhaps  tomorrow!