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UNIT5 CH8 OBS359 THE INTERNATIONAL MONETARY SYSTEM AND FINANCIAL FORCES CAUSES OF EXCHANGE RATE MOVEMENTS A. VARIABLES AT PLAY IN THE FX MARKET: 1. Law of One Price And Arbitrage a. One price in an efficient market, like products will have like prices arbitrage will b. Arbitrage The process of buyin...

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UNIT5 – CH8

OBS359

THE INTERNATIONAL MONETARY SYSTEM AND FINANCIAL FORCES CAUSES OF EXCHANGE RATE MOVEMENTS A. VARIABLES AT PLAY IN THE FX MARKET: 1. Law of One Price And Arbitrage a. One price  in an efficient market, like products will have like prices [otherwise, arbitrage will occur]

b. Arbitrage  The process of buying and selling instantaneously to make profit with no risk A currency that uses a floating exchange rate = a floating currency. A floating currency is contrasted with a fixed currency Fixed currency = whose value is tied to that of another currency, material goods or to a currency basket. ex floating currency yen, USD, British Pound, Euro = hard currencies

2. International Fisher Effect a. Fisher Effect  The higher the inflation in a country, the higher interest rates will be (an investor will want to earn more in a high-inflation environment to compensate for the effect of inflation on the investment)

b. International Fisher Effect  the interest rate differentials for any two currencies will reflect the expected change in their exchange rates

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(countries with higher interest rates will have higher inflation, which leads to a currency’s depreciation)

the two different currencies that reflect the expected change= in exchange rate 3. PPP  The amount of adjustment that must be made in the exchange rates for two currencies in order for them to have equivalent purchasing power  If they don’t have equivalent purchasing power, arbitrage  would lead to buying of undervalued currencies and purchasing undervalued goods

4. Exchange Rate Forecasting a. efficient market approach*  Assumption that current market prices fully reflect all available relevant information  Based on: Random walk hypothesis: Assumption that the unpredictability of factors suggests that the best predictor of tomorrow’s prices is today’s prices

b. fundamental approach  Exchange rate prediction based on econometric models that attempt to capture the variables and their correct relationships

c. Technical analysis o An approach that analyzes data for trends and then projects these trends forward d. trend analysis

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B. Monetary policy Current controls  Government policies that control the amount of money in circulation and its growth rate 

Governments can control currency exchange of their currency and other currencies within their borders

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Motivation is to manage foreign reserves

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With currency controls, exchange rates usually above open market rates

 Convertible currencies can be exchanged for other currencies without restrictions.  When a currency is nonconvertible its value is arbitrarily fixed, typically at a rate higher than its value in the free market, and the government imposes exchange controls to limit or prohibit the legal use of its currency in international transactions.  The government also requires that all purchases or sales of other currencies be made through a government agency.

C. Fiscal policy: taxation, interest rates  Policies that address the collecting and spending = money by the government  One major aspect of fiscal policies is taxation

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TAXATION 1. Income  direct tax on corp. and individual income 2. Value-added really a sales tax, and collected at each step of value added, then credited back on earlier payments 3. Withholding tax  indirect tax on passive income  Effective tax management can yield a competitive advantage  Management techniques involve o profit shifting (often through transfer pricing) and o

inversion (moving to a lower-tax environment)

HOW DOES THIS AFFECT FX? To move account to CH, you need to exchange your ZAR for CHF.  This means more demand for CHF = APPRECIATION.

D. Inflation rates  sustained increase in prices  How is inflation related to exchange rates?  Determines real cost of borrowing  Rising rates encourage borrowing  Inflated currencies tend to weaken  Interest rates rise with inflation

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 DETERMINES REAL COST OF BORROWING IN CAPITAL MARKETS  via the Fisher Effect: an increase in the expected inflation rate will lead to an increase in the interest rate  A higher interest rate means that it is costlier to raise capital in this currency, and firms will opt to raise capital in other currencies  Therefore, there will be less demand for the inflated currency, leading it to DEPRECIATE  The International Fisher Effect also states that a higher interest rate leads the currency to DEPRECIATE

 Balance of Payment accounts • What does it tell us about I. the country’s currency, and II. the country’s likely monetary and fiscal policies?  Political developments and other important events in the country

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Rising rates encourage borrowing 

on the other hand, if the inflation rate is higher than the interest rate, (inf>int) an inflated currency may encourage borrowing, because LOANS can be repaid in the future with inflated, cheaper money

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This means an increase in demand for the domestic currency  leading it to APPRECIATE

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 Inflated currencies tend to weaken: 

High inflation in one country = that its goods increase in price quicker than goods in other countries.

Therefore, domestic goods become less competitive. Demand for exports of domestic goods will FALL. Therefore, there will be less demand for the domestic currency.

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Also, consumers in the country in question will find it more attractive to buy imports from OTHER COUNTRIES.

Therefore, they will sell domestic currency  to be able to buy foreign currency and imports. This INCREASE in the supply of domestic currency DECREASES value of the domestic currency.

 Interest rates rise with inflation  Via the Fisher Effect: The higher the inflation in a country, the higher interest rates will be (an investor will want to earn more in a high-inflation environment to compensate for the effect of inflation on the investment)

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E. Balance of payments (BOP)

BALANCE OF PAYMENT ACCOUNTS 

Record of a country’s transactions w/ rest of the world

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Shows flow of capital in and out of the country

 Current account  tracks tangible goods - trade balance, services  Intangibles – services  Unilateral transfers (gifts, aid, migrant worker earnings)  Capital account  tracks financial assets and liabilities,  direct investment,  portfolio investment,  short-term capital flows (credit when resident sells stock to nonresident)  Official reserves  Gold imports and exports  Foreign exchange  Liabilities to foreign central banks

BALANCE OF PAYMENTS – CURRENT ACCOUNT

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 If a country EXPORTS > IMPORTS    

there will be a high demand for its currency in other countries, so its customers can pay for the exported goods. This demand may well create pressure on the exporter's currency, in which case it might be expected to strengthen.

 Conversely, when a country IMPORTS > EXPORTS, its currency might be expected to weaken, or if it is NOT a floating currency, to be devalued, that is, its value reduced by the government.  

 CURRENT ACCOUNT DEFICIT = may mean economic problems (inflation, low productivity, inadequate saving) OR that demand into the country (Treasury bills, investment property) exceeds outward flows (as in U.S.) = INFLOW>OUTFLOWS  To give meaning to a DEFICIT, you need to look at total picture.

F. Political developments and other important events  Consumer and investor confidence are affected 

greater/lower consumption/investments in the country = greater demand for the currency = appreciation = lower demand for currency = depreciation

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TERMS  Gold standard (1717)  A monetary system that defines the value of its currency in terms of a fixed amount of gold  Bretton Woods System (1945-1971)  Par (stated) value of currencies based on gold and the U.S. dollar  Unsustainable  Central reserve / national currency conflict  Floating exchange rates (Jamaica agreement, 1976)  Exchange rates determined by supply and demand that allow currency values to float against one another

CURRENT CURRENCY ARRANGEMENTS From least flexibility to most flexibility

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1. No separate legal tender 

One country adopts the currency of another, or a group of countries adopt a common currency

Exchange arrangement with no separate legal tender = rephrase

Examples of the first strategy are the adoption of the U.S. dollar in El Salvador, Panama, Zimbabwe, and Ecuador, and Kosovo and Montenegro’s adoption of the euro (both countries wish to join the European Union). An example of the second strategy, a common currency, is the euro, the shared currency in 18 EU member-countries.

2. Currency board  Fixed rate with foreign currency commits the country’s government to holding foreign reserves of a  specific currency in an amount EQUAL to its domestic currency supply and exchange the two at a fixed rate. Hong Kong, St. Kitts, Nevis, Grenada, Dominica, and Djibouti use the U.S. dollar. Bulgaria, Lithuania, and Bosnia Herzegovina use the euro.

3. Conventional fixed-peg 

allows a currency's exchange rates with one or a basket of currencies to fluctuate around a fixed rate within a narrow band of less than 1 percent

A fixed-peg or fixed-rate relationship  allows a currency’s exchange rates with one or a basket of currencies = to fluctuate around a fixed rate within a narrow band of less than 1 percent. Saudi Arabia, Jordan, Oman, Turkmenistan, the United Arab Emirates, and the Bahamas are among the countries pegged to the U.S. dollar. Denmark, Latvia, Benin, Burkina Faso, Côte d’Ivoire, and the Republic of Congo are among the countries pegged to the euro.

4. Stabilized arrangement: Pegged exchange rate within a horizontal band

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Fixed rate, but exchange rate fluctuations greater than 1 percent are allowed

Pegged exchange rate within a horizontal band: In a different peg arrangement, exchange rate fluctuations greater than 1 percent are allowed. Cambodia and Trinidad and Tobago have this arrangement with the Macedonia and Vietnam have this arrangement with the euro. 1.

periodically

from time to time; occasionally.

5. Crawling peg 

a currency is pegged to another currency or a basket of currencies, but the peg is readjusted periodically at a fixed, preannounced rate (e.g....