Class Note for ECON 311 at UMass(4)
Class Note for ECON 311 at UMass(4)
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Date Created: 02/06/15
Economics 311 Winter 2009 Money and Banking Adam S Hersh Handout on Foreign Exchange The exchange rate is the price at which one country39s national currency is exchanged for the national currency of another currency This process is called foreign exchange There are several kinds of foreign exchange transactions possible 0 spot transactions 7 the immediate buying and selling of currencies 0 forward transactions 7 the immediate commitment to buy sell at a given price at some speci ed time in the future 0 swaps 7 an agreement to exchange currencies at a given price and time and then to exchange back at another time and possibly price in the future While foreign exchange is traded on exchanges most notably in London and the Chicago Mercantile Exchange futures the vast majority of foreign exchange transaction take place in overthecounter OTC interbank electronic markets Foreign exchange comprises by far the most traded asset in the world in volume terms Most currencies of the world cannot be directly exchanged for one another but must be traded indirectly through vehicle or key currencies7currencies that are perceived to be stable and reliable and thus are widely accepted internationally as means of payment units of account and stores of value Currencies that can be used as international money are referred to as hard currencies and include the US dollar the British Found the Euro and the Japanese Yen These also are often held by central banks as foreign exchange reserves and so are called reserve currencies Some empirical evidence does indeed suggest that these are related to di erent measures of national military power though most theories of international reserve currencies ignore this also military power seems to be correlated with economic size and stability so analytically the causality is murky Papaioannou Portes and Siourrounis 2006 estimate the currency composition of foreign exchange reserves in an assortment of countries The US dollar accounts for between 5971 Euro for 1825 Yen for 47 Pound for 34 and for very little the Swiss Franc and some others The composition of foreign exchange reserves is driven largely by 0 a currency s acceptance as international money 0 currency denomination of foreign debts public and private 0 a country39s trading partners The existence of large funds of central bank foreign exchange reserves present a delicious target for currency speculation7betting on the future appreciation or depreciation of a currency Sizable speculators most famously George Soros may be able to exert such intense pressure as to overwhelm central bank reserves which are captured by the speculators Models of exchange rates Just as institutions give structure and shape financial exchange in the domestic economy countries create institutions to govern international financial activities movements of goods and capital across their national boundaries These can take a number of dilTerent forms with various costs and benefits but it is a fundamental principle that a country may have at most 2 of the following 3 institutions 0 fixed exchange rate managed by government policy rather than freely oatingdetermined by market mechanisms 0 free ows of capital as opposed to controls on the ow of capital 0 macroeconomic policy autonomy These are known as the international trilemma and are covered extensively in Economics 321 International Monetary Theory The first real exchange rate model was developed by Scottish Enlightenment philosopher David Hume who was a close friend of Adam Smith dubbed the price specie ow mechanism At the time gold or currency backed directly by gold was the primary means of international payments At the time and in modern incantation too of sorts people advocated for a policy to hoard gold accumulate it from other countries In practice this could be achieved by manipulating the exchange rate which was tied to gold to depreciate making their export goods more competitive internationallyiso they could exchange goods produced at home for gold Hume s was essentially a early statement of the quantity theory of money An in ow of gold adds to the monetary base the increased quantity of money chasing around the same xed quantity of goods leads to in ation recall from Econ 204 that MP real balances P will rise proportional to M The rise in domestic prices means the domestic goods would not be so competitive anymore they would export less and import more and thus gold would ow back out of the country Presumably back to some equilibrium point While Hume39s theory has provided the basis for liberal free market policies for several centuries the mercantilist practice has seemed to work quite good for many countries throughout history including the US Britain Japan Germany and most recently China Modern parlance views money and therefore foreign money as an asset giving us a basis for a model of exchange rate determination known as the interest parity condition given by iD ZIF7Eet1 EIJEt Which says that the dollar interest rate should equal the foreign interest rate less some expected change in the exchange rate Through algebraic manipulation we can get the expression for the exchange rate as a function of the two interest rates EE21iF7iD1 Thus assuming we have some knowledge about the future expected direction of the exchange rate we can determine the present exchange rate More complex expressions of this interest parity condition covered interest parity use known forward exchange rates as a substitute for the expected future rate These models provide a basis in economic fundamentals for predicting equilibrium exchange rates what exchange rates should be However neither has had much luck in forecasting exchange rate movements They work for some currency pairs over some periods of time but all in all these models are not very good at describing exchange rate behavior Exchange rates can move away from these predicted equilibrium rates for very long periods of time They do however provide us an analytical framework for trying to understand the interaction of national financial systems
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