The Determination of Exchange Rates

The International Monetary Fund (IMF) was organized in 1944 to promote exchange rate stability, maintain orderly exchange-rate arrangements, avoid competitive c urrency devaluations, establish a multilateral system of payments, eliminate exch ange restrictions, and create standby reserves. The Special Drawing Right (SDR) was instituted by the IMF to increase internation al reserves. The exchange-rate arrangements of countries that are members of the IMF are divi ded into three categories: pegged exchange rates, limited-flexibility arrangemen ts, and more flexible arrangements. The European Monetary System (EMS) had a major crisis in 1993, jeopardizing the EU goal of establishing a common currency by 1999. Many countries that strictly control and regulate the convertibility of their cu rrency have a black market that maintains an exchange rate that is more indicative of supply and demand than is the official rate. The Bank for International Settlements (BIS) in Switzerland acts as a central ba nker's bank. It facilitates communication and transactions among the world's cen tral banks. Central banks use foreign-exchange reserves to support their countries' currencie s and to earn a profit. The demand for a country's currency is a function of the demand for its goods an d services and the demand for financial assets denominated in its currency. A central bank intervenes in money markets by creating a supply of its country's currency when it wants to push the value of the currency down or by creating a de mand for the currency when it wants to strengthen its value. Devaluation of a currency occurs when formal governmental action causes the fore ign-currency equivalent of that currency to fall (or that currency's equivalent for the foreign currency to rise). A depreciation occurs when a change in the sa me direction is permitted by the government but not formally acted on as such. Some factors that determine exchange rates are purchasing-power parity (relative rates of inflation), differences in real interest rates (nominal interest rates reduced by the amount of inflation), confidence in the government's ability to m anage the political and economic situation, and certain technical factors that r esult from trading. The major determinant of the forward exchange rate is the interest-rate different ial between currencies. Major factors managers should monitor when trying to predict the direction, magn itude, and timing of an exchange-rate change include balance-of-payments statist ics, foreign-exchange reserves, relative inflation rates, interest-rate differen tials, and trends in exchange-rate movements. Also, they must look at the politi cal-situation. Exchange rates can affect business decisions in three major areas: marketing, pr oduction, and finance.