International Financial Management

THE DETERMINATION OF EXCHANGE RATES

Group 6
Esa Restu Kusuma (1210534001)
M. Alvicky Satyawardana (1210534006)
Wahyunda Risa Putri (1210534008)
Resti Malisa (1210534017)
Luthfia Hidayani (1210534019)
Dewi Fitrah Illahi (1210534025)
M. Irhas Ervan (1210534027)

Lecturer: Masyhuri Hamidi, SE., M.Si., Ph.D

International Class
Faculty of Economics
Andalas University
2015

THE DETERMINATION OF EXCHANGE RATES

I.

Equilibrium Exchange Rate

An exchange rate at a given point in time represents the price of a currency, or the rate
at which one currency can be exchanged for another. While the exchange rate always
involves two currencies, our focus is from the U.S. perspective. Thus, the exchange rate of
any currency refers to the rate at which it can be exchanged for U.S. dollars, unless specified
otherwise. The price of a currency is determined by the demand for that currency relative to
supply.
Equilibrium Exchange Rate occurs when the quantity supplied equals the quantity
demanded of a foreign currency at a specific local price.
Equilibrium
For all currencies, the equilibrium exchange rate is reached through transactions in the
foreign exchange market, but for some currencies, the adjustment process is more volatile
than for others. The liquidity of a currency affects the sensitivity of the exchange rate to
specific transactions. If the currencys spot market is liquid, its exchange rate will not be
highly sensitive to a single large purchase or sale of the currency.
The equilibrium exchange rate will change over time as supply and demand schedules
change. Equation summarizes the factors that can influence a currencys spot rate:

1. Relative Inflation Rates

Changes in relative inflation rates can affect international trade activity, which
influences the demand for and supply of currencies and therefore influences exchange rates.
the actual demand and supply schedules, and therefore the true equilibrium exchange rate,
will reflect several factors simultaneously.
2. Relative Interest Rate

Changes in relative interest rates affect investment in foreign securities, which

influences the demand for and supply of currencies and therefore influences the equilibrium
exchange rate.
3. Relative Income Levels
Changing income levels can also affect exchange rates indirectly through their effects
on interest rates. When this effect is considered, the impact may differ from the theory
presented here, as will be explained shortly.
Impact of Rising U.S. Income Levels on the Equilibrium Value of British Pound

4. Goverment Control
The governments of foreign countries can influence the equilibrium exchange rate in
many ways, including :
(1) imposing foreign exchange barriers,
(2) imposing foreign trade barriers,
(3) intervening (buying and selling currencies) in the foreign exchange markets, and
(4) affecting macro variables such as inflation, interest rates, and income levels.
5. Expectations
Like other financial markets, foreign exchange markets react to any news that may
have a future effect. News of a potential surge in U.S. inflation may cause currency traders to
sell dollars, anticipating a future decline in the dollars value. This response places immediate
downward pressure on the dollar.
Role of Expectations:
A.
Currency = financial asset
B.
Exchange rate = simple relation of two financial assets

How Exchange Rates Change :

1. Increased demand
as more foreign goods are demanded, the price of the foreign currency in local currency
increases and vice versa.
2. Home Currency Depreciation
a. Foreign currency becomes more valuable than the home currency.
b. The foreign currencys value has appreciated against the home currency.
Summary of How Factors Can Affect Exchange Rates

Interaction of Factors
Transactions within the foreign exchange markets facilitate either trade or financial
flows. Trade-related foreign exchange transactions are generally less responsive to news.
Financial flow transactions are very responsive to news, however, because decisions to hold
securities denominated in a particular currency are often dependent on anticipated changes in
currency values. Sometimes trade-related factors and financial factors interact and
simultaneously affect exchange rate movements.
Capital flows have become larger over time and can easily overwhelm trade flows.
For this reason, the relationship between the factors (such as inflation and income) that affect
trade and exchange rates is not always as strong as one might expect. An understanding of
exchange rate equilibrium does not guarantee accurate forecasts of future exchange rates
because that will depend in part on how the factors that affect exchange rates change in the
future.

Movement in Cross Exchange Rate

The movement in a cross exchange rate over a particular period can be measured as
its percentage change in that period, just like any currencys movement against the dollar.
You can measure the percentage change in a cross exchange rate over a time period even if
you do not have cross exchange rate quotations. The cross exchange rate changes when either
currencys value changes against the dollar.

The International Monetary System

International monetary system - the institutional arrangements that govern exchange rates
A floating exchange rate system exists when a country allows the foreign
exchange market to determine the relative value of a currency
A pegged exchange rate system exists when a country fixes the value of its
currency relative to a reference currency
A dirty float exists when a country tries to hold the value of its currency within
some range of a reference currency such as the U.S. dollar
A fixed exchange rate system exists when countries fix their currencies against
each other at some mutually agreed on exchange rate
What Was The Gold Standard?
The gold standard refers to a system in which countries peg currencies to gold and
guarantee their convertibility
in the 1880s, most nations followed the gold standard
$1 = 23.22 grains of fine (pure) gold
the gold par value refers to the amount of a currency needed to purchase one
ounce of gold
Why Did The Gold Standard Make Sense?
The great strength of the gold standard was that it contained a powerful mechanism
for achieving balance-of-trade equilibrium by all countries
The gold standard worked well from the 1870s until 1914
but, many governments financed their World War I expenditures by printing
money and so, created inflation
People lost confidence in the system
By 1939, the gold standard was dead
What Was The Bretton Woods System?

In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design
a new international monetary system that would facilitate postwar economic growth
Under the new agreement
a fixed exchange rate system was established
all currencies were fixed to gold, but only the U.S. dollar was directly
convertible to gold
devaluations could not to be used for competitive purposes
a country could not devalue its currency by more than 10% without IMF
approval
What Institutions Were Established At Bretton Woods?
The Bretton Woods agreement also established two multinational institutions
1. The International Monetary Fund (IMF) to maintain order in the international
monetary system through a combination of discipline and flexibility
2. The World Bank to promote general economic development
also called the International Bank for Reconstruction and Development
(IBRD)
Why Did The Fixed Exchange Rate System Collapse?
Bretton Woods worked well until the late 1960s
It collapsed when huge increases in welfare programs and the Vietnam War were
financed by increasing the money supply and causing significant inflation
other countries increased the value of their currencies relative to the U.S.
dollar in response to speculation the dollar would be devalued
However, because the system relied on an economically well managed U.S., when the
U.S. began to print money, run high trade deficits, and experience high inflation, the
system was strained to the breaking point
the U.S. dollar came under speculative attack
What Was The Jamaica Agreement?
A new exchange rate system was established in 1976 at a meeting in Jamaica
The rules that were agreed on then are still in place today
Under the Jamaican agreement
floating rates were declared acceptable
gold was abandoned as a reserve asset
total annual IMF quotas - the amount member countries contribute to the IMF
- were increased to $41 billion today they are about $300 billion
What Has Happened To Exchange Rates Since 1973?
Since 1973, exchange rates have been more volatile and less predictable than they
were between 1945 and 1973 because of
the 1971 and 1979 oil crises

the loss of confidence in the dollar after U.S. inflation in 1977-78

the rise in the dollar between 1980 and 1985
the partial collapse of the EMS in 1992
the 1997 Asian currency crisis
the decline in the dollar from 2001 to 2009

Which Is Better Fixed Rates Or Floating Rates?

Floating exchange rates provide
1. Monetary policy autonomy
2. Automatic trade balance adjustments
But, a fixed exchange rate system
1. Provides monetary discipline
2. Minimizes speculation
3. Reduces uncertainty
What Type of Exchange Rate System Is In Practice Today?
Various exchange rate regimes are followed today
14% of IMF members follow a free float policy
26% of IMF members follow a managed float system
22% of IMF members have no legal tender of their own
the remaining countries use less flexible systems such as pegged
arrangements, or adjustable pegs
Countries with a pegged exchange rate system peg the value of its currency to that of another
major currency.
Countries using a currency board commit to converting their domestic currency on demand
into another currency at a fixed exchange rate.
What Is The Role Of The IMF Today?
IMF focuses on lending money to countries in financial crisis
There are three types of financial crises:
1. A currency crisis
Brazil 2002
2. A banking crisis
3. A foreign debt crisis
Greece and Ireland 2010
How Has The IMF Done?
By 2010, the IMF was making loans to 68 countries all of which require tight macroeconomic
and monetary policy
However, critics worry

 the one-size-fits-all approach to macroeconomic policy is inappropriate for

many countries
the IMF is exacerbating moral hazard
the IMF has become too powerful for an institution without any real
mechanism for accountability

However, in recent years, the IMF has started to change its policies and be more flexible
urged countries to adopt fiscal stimulus and monetary easing policies in
response to the 2008-2009 global financial crisis
What Does The Monetary System Mean For Managers?
Managers need to understand how the international monetary system affects
1. Currency management - the current system is a managed float - government
intervention can influence exchange rates
2. Business strategy - exchange rate movements can have a major impact on the
competitive position of businesses
3. Corporate-government relations - businesses can influence government policy
towards the international monetary system