EXCHANGE RATES AND EXCHANGE RATE SYSTEMS

An exchange rate is simply the value of one currency in terms of a second currency.
It is always calculated as a ratio. e.g. if we say the C$ is at 0.9195 U.S. dollars,
we mean that one Canadian dollar will buy 0.9195 worth of goods in the U.S..
So the exchange rate is really: US$.9195
C$1.00

This is what we mean by US$ =0.9195

C$

If we want to find out how much one U.S. dollar will buy of Canadian dollars,
we simply invert the ratio as shown below.
C$1.00
US$.9195

when we calculate this

1 = 1.0875 = C$1.0875
0.9195
US$ 1.0

So US$1.0 buys C$1.0875 worth of Canadian goods, or it costs C$1.0875 to buy US$1.00.
UNDERSTANDING EXCHANGE RATES: Fill in the blanks below the table.
Currency

Foreign
C$
Direct Quote

U.S. dollar (USD)

0.9195 = US$0.9195
C$1

Euro ()

C$
Foreign
Indirect Quote
1
= 1.0875
1.9195

.6764

1.4784

Japanese Yen ()

96.6329

.01068

U.K. Pound ( )

0.5502

1.8176

South African rand (ZAR)

9.6077

.1041

Mexican new peso (MXP)

11.8343

0.0845

Norwegian krone
5.4945
.1820
* Fill in the blanks: One Canadian dollar equals __________ Euros.
One U.K. pound equals
__________ Canadian goods.(*.6764, 1.8176)
It is not the level of a currency that indicates strength or weakness but whether it is
rising or falling in value relative to another currency.
In a direct quote, the exchange rate is the number of units of foreign currency per unit of domestic.
In an indirect quote, the exchange rate is the number of units of domestic currency per unit of
foreign currency. An exchange rate that does not have the domestic currency as one of the two
currency components is known as a cross currency, or cross exchange rate.

Example of Cross Exchange Rate: From the above table what is the Yen'Euro exch. rate?
C$ =

C$

So: 1.4784 x 96.6329 = 142.862 yen per euro.

This chapter quotes U.S. dollar exchange rates in indirect terms.

231

Practice with cross rates:

1.

From the table on the previous page, what is the U.K pound'South African Rand cross
rate?
C$ = So .5502 .1041 = .0573 pounds per rand.
C$
ZAR
ZAR

2.

Suppose the US$/C$ exchange rate is US$0.85 and the Malaysian ringgit'C$
exchange rate is 2.94 ringgits per C$. What is the US$'ringgit exchange rate?
To calculate this cross rate you need US/C$ and C$/ringgit so you have to invert the
Malaysian rate. 1'2.94 = 0.34 C$ per ringgit. Therefore US'ringgit = 0.85.34=0.289

EXCHANGE RATE SYSTEMS

Every country must choose an exchange rate system to determine how prices in the
home country currency are converted into prices in another countrys currency.
Fixed or pegged exchange rate regime: Some countries peg their exchange rate at
a fixed rate either against a precious metal like gold, or against another countrys
currency (like U.S. dollars or Euros), or against a weighted basket of other currencies,
or they completely give up domestic currency and adopt the currency of a different
country. If the exchange rate is not allowed to vary, then it is called a hard peg. If the
can fluctuate within a set band its a soft peg, and soft pegs can take several forms
depending on the amount of variation allowed.
Floating exchange rate regime: Exchange rates are determined by global market
forces of demand and supply. In floating systems, a central bank can periodically
intervene to prevent dramatic swings in a currencys value (managed float), or the
currency can be independently floating with no central bank intervention.
Each exchange rate system requires that governments and central banks have
credible policies to support the system because demand for a countrys currency
depends on trade, financial capital flows, and other factors such as investment
speculation.
Currency Regime
Hard Pegs
Soft Pegs
Managed Floating
Independently Floating
Total:

# of Countries (source IMF, 2007)

23
82
48
35
188

232

REASONS FOR HOLDING FOREIGN CURRENCIES

1.

Trade and investment purposes

When you buy a good or service or a stock or a bond from another country you
must pay in the currency of that country. Therefore importers and exporters and
investors routinely transact in foreign currencies, either receiving or making
payments in another countrys money. Tourists are included in this category
because they hold foreign currency to buy goods and services.

2.

To take advantage of interest rate differentials or interest rate arbitrage

Arbitragers borrow money where interest rates are relatively low and lend it
where interest rates are relatively high. Interest rate arbitrage keeps interest
rates from diverging too far and is a primary linkage between national
economies.

3.

Speculation
Businesses that buy or sell a currency because they expect its price to rise or
fall. They hope to realize profits or avoid losses through correctly anticipating
changes in a currencys value. If they are correct they contribute to realigning
exchange rates that have become over or under valued. If they are wrong they
risk financial losses.

INSTITUTIONS'PARTICIPANTS:
1.

Retail Customers
Firms and individuals that hold foreign exchange for any of the 3 reasons above.
Usually they buy or sell through commercial banks.

2.

Commercial Banks - the most important participants

Commercial banks in many parts of the world hold inventories of foreign
currencies as part of the services offered to customers. There are relationships
between these banks so that if one develops a surplus or shortage in a currency
it can trade with another commercial bank to adjust their holdings.

3.

Foreign Exchange Brokers

It is not very common for U.S. banks to trade currency with foreign banks.
Usually U.S. banks go through foreign exchange brokers who act as middlemen
between buyers and sellers that do not usually hold foreign exchange. Brokers
also serve as agents for central banks.

4.

Central Banks
Central banks intervene in foreign exchange markets to maintain relative stability
of a countrys domestic currency (partial intervention if floating, full intervention if
pegged.)

233

Examples of interactions between participants:

1.

An individual or firm that needs to buy foreign currency calls its bank.

2.

The bank quotes a price at which it will sell the currency.

The price is based on one of two sources of supply:
The bank may have an account with another bank in the country where the
currency is used, or
the bank may call a foreign exchange broker.

3.

The broker keeps track of buyers and sellers of currencies and acts as a deal
maker by bringing together a seller and a bank that is buying for its customer.

In most cases currency trades take the form of credits and debits to a firms bank
accounts. For example a U.S. importer must pay a company in Japan. The U.S. firm
will ask its bank to credit the Japanese companys account with the yen, and debit the
equivalent amount in U.S. dollars from its own U.S. bank account.
EXCHANGE RATE RISK
The spot foreign exchange market is the market for buying and selling foreign
currency in the present. Contracts are executed in one or two days.
Because exchange rates are constantly changing, expected future payments that will
be made or received in a foreign currency will be executed at a different exchange rate
from the one that existed at the time the contract was signed. For example:
A U.S. semiconductor firm signs a contract to export a shipment to a British company
in six months. If the shipment is to be paid in U.K. pounds then the U.S. exporter
does not know what those pounds will be worth in 6 months, so the U.S. company
bears the exchange rate risk. If the shipment is to be paid in U.S. dollars then the
British firm does not know what the U.S. dollars will cost in 6 months so the British
company bears the exchange rate risk.
The forward exchange rate (F) market is a way of dealing with exchange rate risk.
It is a market where the exchange rate and amounts for the buying and selling of
currencies for future delivery is specified on contracts. The contracts guarantee a set
price for the foreign currency, usually 30, 90 or 180 days into the future.
In our example, if the price for the semiconductors is in U.K. pounds, the American
manufacturer can sign a forward contract to sell U.K. pounds 6 months from now, in
exchange for U.S. dollars at a price agreed upon today. This way the American
company know today what the future incoming payment in pounds will be worth in
dollars, and avoids the risk that comes from exchange rate fluctuations.
234

SUPPLY AND DEMAND FOR FOREIGN EXCHANGE

(NOTE: In a flexible or floating foreign exchange rate regime the value of a currency is largely or
wholly determined by the forces of global demand and supply for that currency. In a fixed exchange
rate regime the currency is held at a constant value by the actions of its countrys central bank which
counteracts the forces of global supply and demand. Therefore supply and demand analysis can be
applied for all currency regimes.)

FLEXIBLE FOREIGN EXCHANGE RATE REGIME

In a flexible regime an increase in the demand for the dollar will raise its price
(appreciation) ,while an increase in its supply will lower its price (depreciation).
MARKET FOR U.K. POUNDS
US$

MARKET FOR U.S. DOLLARS

US$

S1

B
$1.72'
$1.6'

0.625'$

S2

D2
0.58'$

D1

B
D

Quantity of

Quantity of US$

When a currency is being sold, its supply increases (supply shifts right).
When a currency is being bought, its demand increases (demand shifts right).
If we know where the increase in demand is coming from we can see the effects on
both currencies as in the example of the above diagrams.
Start at point A with hypothetical exchange rate of US$1.6 per U.K. pound or 0.625 per $.
If there is a net increase in U.S. demand for U.K. exports, then, since the U.K. goods must be
paid for in pounds, the U.S. importers will have to purchase U.K. pounds and sell U.S. dollars.
This is represented as an increase in D for pounds and an increase in supply of U.S. dollars.
This will cause an appreciation of the U.K. pound (say to US$1.72 per pound - or .58'$.
and a simultaneous depreciation in the U.S. dollar (point B). In this case we can show both
markets because the increased demand for pounds is clearly coming from the U.S.
If there is a decrease in demand for U.K. exports and therefore a decrease in demand for U.K.
pounds by the U.S., the demand curve in the diagram above left will shift left.

In problems you are asked to draw only one diagram, for the foreign currency, and
show just the impact within that market.
Examples involving long-run, medium run and short-run exchange rate determinants
follow.

235

EXCHANGE RATE DETERMINATION - LONG-RUN - PPP

Purchasing Power Parity (PPP)
The equilibrium value of an exchange rate is the level that allows a given amount of
money to buy the same quantity of goods abroad that it will buy at home.
This theory suggests that exchange rates between any two currencies will (eventually) adjust
to reflect changes in the price levels (meaning price indexes like CPI) of the two countries.
The relative price index is the price index of one country divided by the price index of the
other, having adjusted both to have the same base year. This theory links fluctuations in the
exchange rate between two countries to changes in their relative price indexes. (You can also
base it on inflation rate differentials.)

In other words US$100 should buy the same basket of goods whether it is in the U.S.
or the U.K.
Example: Suppose a Panasonic TV, 52 inch advanced model, costs US$1000 in the United
States and 500 in England. Then, if PPP holds, the US$' should be
US$1000'500, or $2'1.
If the exchange rate is more than $2'1, say $3'1, then the U.K. pound is overvalued (the
T.V. is too expensive in England) and the U.S. dollar is undervalued. Exchange rates of less
than $2'1, say $1.5'1 would mean the opposite that the U.K. pound is undervalued and
the U.S. dollar is overvalued.
Arbitrage should either drive the price of the good to an equilibrium level if TVs are a traded
good, or (more usually) drive the exchange rate to its equilibrium level based on purchasing
power parity. But research indicates that currencies can deviate for long years away from
their PPP levels, but do eventually converge toward these levels.
Practice: If U.S. visitors to Japan can buy fewer goods in Japan than they can in the United
states when they convert their dollars to yen, is the U.S. dollar undervalued or overvalued?
Answer: The U.S. dollar is undervalued. A dollar, when translated into yen, buys too few
goods.

Why PPP Cannot Fully Explain Exchange Rates:

1.
Transportation costs prevent goods from moving entirely freely.
2.
Barriers to trade like import quotas and tariffs may be too high.
3.
Many goods and services whose prices are included in a countrys price index,
cannot be traded, such as housing, restaurant meals, golf lessons, etc. So even
though the prices of these items might rise and lead to a higher price level
relative to another countrys there would be little effect on the exchange rate.
Other reason (not in your text so not for marks):
4.
Manufactured goods may not necessarily be identical between countries. A
Toyota 4-door compact car in Japan may have significantly different
specifications from a Chevy 4-door compact car in Canada.
236

Example from your homework using Supply & Demand for Canadian $ by the U.S.
US$
C$

MARKET FOR CANADIAN DOLLARS

D1 D2 S1 S2

S1
R1= US$0.90
C$1
R2= US$0.85
C$1

D2

D1
Quantity of C$

Price levels:
If goods are more expensive in Canada than the United States, then there will be less
demand for Canadian exports by the U.S. and there will be less purchasing of C$ by
the U.S. Therefore the demand for Canadian dollars will shift to the left. The
Canadian dollar will therefore depreciate which implies the U.S. dollar will appreciate.
If goods are less expensive in Canada than the United States then there would be
more demand for Canadian exports by the U.S. and demand for C$ would shift right.
Inflation:
If the Canadian inflation rate is higher than in the U.S. then Canadian exports are
relatively more expensive and the demand for Canadian exports will fall and the
demand for Canadian dollars will shift to the left.
If the Canadian inflation rate is lower than in the U.S. then Canadian exports are
relatively cheaper than U.S. goods and the demand for Canadian exports will rise and
the demand for Canadian dollars will shift to the right.

237

REAL EXCHANGE RATE = cost of foreign goods in domestic currency

We can use a concept called the Real Exchange Rate to also reflect the link between
relative inflation rates and exchange rates. The real exchange rate is the market
exchange rate (or nominal exchange rate) adjusted for price differences. It gives an
indication of the purchasing power of domestic currency when translated into foreign
currency.
Real Exchange Rate (Rr)
Rr = Nominal Exchange Rate ( Rn) Foreign Price (P*)
Domestic Price (P)
Example:

A case of wine of same quality costs 200 in France or US$180 in the U.S.
The nominal exchange rate ( Rn) = US$1.2
1.0
Rr = $1.2 per euro x (200 per case of French wine)'($180 per case of US wine)
Rr = 1.33 meaning the cost of a case of wine is 33% higher in France than the U.S.
This is because the purchasing power of the dollar is less in France than in the US.

The Real Exchange rate will equal the nominal exchange rate if the cost of a basket of
goods is the same in both countries. (This is long run equilibrium in purchasing
power parity.)
Example:

A case of wine of same quality costs 100 in France or US$100 in the U.S.
The nominal exchange rate ( Rn) = US$1.2
1.0
Rr = Rn 100'$100. Similarly Rn = Rr $100'100

Real exchange rates using price index numbers:

Suppose we start with Rn = US$1.2'. The price index in both countries is 100.
In that case Rr = $1.2 x 100'100 = $1.2.
Something that costs $1 in the U.S. costs $1.2 in Europe.
Suppose that since the base year, prices have risen 10% in the U.S. and 0% in
Europe. Then the Real US$' would be:
Rr = $1.2 per euro 100'110 = $1.0909
Something that costs $1 in the U.S. now costs $1.0909 in Europe.
So European goods are relatively cheaper than before because U.S. inflation was
faster than in Europe.
Practice Problem with Real Exchange Rates:
Suppose one U.K. pound costs US$0.75 (Rn = US$' = $1.75). Since the base year inflation
has been 8% in Britain and 2% in the U.S. What is the real exchange rate?
Rr = $1.75 per peso 102'108 = $1.65
238

EXCHANGE RATE DETERMINATION - MEDIUM-RUN - ECONOMIC GROWTH

(Usually less than 5 to 7 years)
A countrys imports are a positive function of Real GDP growth. As an economy grows
its individuals and businesses buy more of everything including imports and there is
also more travel abroad. In our example a U.S. economic expansion would up upward
pressure on the pound and depreciation of the US$. A slowdown in Real GDP growth
would do the opposite.
More rapid growth in the U.K. would mean more U.S. exports to the U.K. which would
put upward pressure on the dollar and downward pressure on the pound.
MARKET FOR U.K. POUNDS
US$

If the U.S. economy grows more slowly than the U.K.

B
$1.72'
$1.6'

economy, then there will be a net increase in exports

from the U.S. to the U.K. and the US$ will appreciate.

A
D2

If the U.S. economy grows more quickly than the U.K.

economy, then there will be a net increase in imports
from the U.K. into the U.S. and the US$ will
depreciate. (Increase in D for U.K. pounds.)

D1
Quantity of

Other Examples - from your homework - using Supply & Demand for Canadian $ by the U.S.:
MARKET FOR CAN. DOLLARS
US$
C$

Canadian GDP faster than U.S. GDP

S1

If the Canadian economy grows more rapidly

than the U.S. economy, then Canada will buy
more U.S. goods, than the U.S. will buy of Canadian.
So there will be a net increase in demand for U.S.$
which will require sales of Canadian dollars - this
means an increase in the supply of Canadian $.
This will mean a depreciation of the C$ and an
appreciation of the U.S. dollar.

R1=.90
S2

C$1

R2=.85
C$1

D1
Q of C$
MARKET FOR CAN. DOLLARS
US$
C$

Recession in the U.S.

S1

If the U.S. economy goes into recession, then

the U.S. will buy fewer imports from Canada.
The demand for Canadian dollars will shirt to the left.
This will mean a depreciation of the C$ and an
appreciation of the U.S. dollar.

R1=.90
C$1

R2=.85
C$1

D2

D1

An expansion in the U.S. would have shifted D

for C$ to the right.

Q of C$
239

EXCHANGE RATE DETERMINATION - SHORT-RUN: Interest parity & Speculation

(Periods of 1 year or less)
There are two inter-related influences on short-run capital flows:
interest rates and expectations about future exchange rates.

Part 1 - INTEREST RATE PARITY and COVERED INTEREST ARBITRAGE

(This is covered in the appendix to the chapter in your e-text. You should do the
problems on MyEconLab under Study Plan.) In these problems I am using the
Canadian dollar as the home currency, rather than the U.S. dollar.
The Interest Parity Condition
You want to decide whether to invest $1000 of your money in Canada or Germany
Suppose the domestic interest rate in the U.S. is I = 3%
the interest rate in Germany is
I*= 2%
The nominal spot exchange rate

R=

US$ = $1.2

or

1 = 1 = 0.833
R
1.2
C$1

The future exchange rate R1 in US$ terms = unknown !

Investing in Germany requires converting dollars to , and then converting the

investment return back to dollars at the end of the year. This entails exchange rate
risk because the spot price of the Euro a year from now is uncertain.
First you have to calculate the future exchange rate (ER1) that would make an investor
indifferent between investing in Germany of the U.S..
Assuming investment of $1 million:
Return 1 year from now from U.S. deposit: $1,000 (1+.03)

= US$1,030

Return 1 year from now from German deposit: $1,000 (.8333)(1+.02) = 850

To be indifferent between either investment $1,030= 850

you need the future exchange rate (R1) to be = US$ = 1,030 = C$1.2118

850
1
ER1 = (1+i) x R This is the future exchange rate that is expected by the investor and is
(1+ i*)
the rate that would make the investor indifferent between investing in the
home country or the foreign country for a year.

The has to appreciate from US$1.2 to C$1.2118 to break even.

This represents an appreciation of the Euro of about 1% which makes sense because
the interest rate is 1% higher in the U.S. than in Germany.
If you think the Euro will appreciate by more than 1% you would invest in Germany and borrow in the
U.S..If you think the Euro will appreciate by less than 1%, or even depreciate, you would invest in the
U.S. and borrow in Germany.
240

INTEREST RATE PARITY

is the relationship between the spot FX rate, the interest rate differentials and the
forward exchange rate. If interest parity holds, then an investor will realize the same
return in domestic currency, regardless of which country the investment was placed in.
It implies that interest rate differentials should be an unbiased forecast of future
exchange rate changes. (works imperfectly)
R

spot exchange rate which is units of domestic currency per 1 unit of FX

ERt the spot exchange rate t periods from now - which is unknown.
F

the forward exchange rate available by contract today

interest rate on an investment at time t in home country

i*

interest rate on an investment maturing at time t in foreign country

The difference between F and R is the expected appreciation or depreciation.

If F > R then the dollar is expected to depreciate and is said to be selling at a discount.
If F < R then the dollar is expected to appreciate and is selling at a premium.
Example: If R = $1.2' and F = US$1.3' Then the US$ is expected to depreciate.
The investors choice (imagine the investment is in bonds):
Invest $1000 in the U.S. and earn: $1000 x 1.03 = $1,030 in one year, OR
Invest in Germany and earn $1,000 (.8333)(1.02) = 850 in one year, then
translate the 850 back into US dollars at the forward rate of US$1.3'= $1,105.
You are comparing returns in Germany vs U.S.: (ER1'R)*(1+i*) vs. (1+i)
Use ER1 in formula when future exchange rate unknown, and F if using forward contract.
The German investment is better and will attract capital. Capital inflows to Germany will
increase the value of the Euro. Also as demand for German bonds rises the price of the
bonds will rise and German interest rates will fall. Both changes will reduce earnings on the
German bonds until, in the end we reach the interest parity condition:

i - i* = (F - R)
R

which means interest rate differentials are approximately

equal to the expected % change in the exchange rate.

If i > i* then F > R (The forward rate shown an expected depreciation of the home currency).
e.g. if I = .03 and I* = .02 then .03-.02 = .01 = 1% depreciation expected in the U.S.$.
The higher domestic interest rates will attract foreign purchases of U.S. bonds, driving bond
prices up and interest rates down. At the same time the spot rate R will rise because of
capital flowing into the country to buy bonds. The process will continue until the difference
between I and I* is about the same as the % difference between the forward and spot rates.
Similarly if i< i* then F < R (The forward rate shows an expected appreciation of home currency).
241

Short Run Impact on Demand and Supply

US$

MARKET FOR U.K. POUNDS

S1
S2

R1
R2
D1
Q of
US$

MARKET FOR U.K. POUNDS

S

R1

If U.S. interest rates rise or U.K. interest rates fall,

there will be selling of in order to purchase U.S.
dollars and bonds. The supply of pounds will
increase, causing depreciation of the pound and
appreciation of the U.S. dollar.
(If U.S. interest rates fall or U.K. interest rates rise,
supply of pounds would shift left and the pound
appreciates while the dollar depreciates.)
Expectations of a future depreciation of the
The demand for pounds will decrease in response to
its expected loss in value. Demand for pounds
shifts left, so the pound depreciates and the dollar
appreciates. (Demand would shift right if the pound
is expected to appreciate.)

R2
D2

D1
Q of

Expectations can be driven by pure speculation or by

political events, or by changes in interest rates.

Interest parity theory tells us that if the domestic interest rates are higher than the foreign
interest rates, both of the above effects will occur (S shifts right while D shifts left), reinforcing
the depreciation of the pound and the appreciation of the dollar.
Similarly if domestic interest rates are lower than foreign interest rates, supply of foreign
currency would shift left and demand for foreign currency would shift right causing an
appreciation of the pound and depreciation of the dollar.

SUMMARY of FX RATE DETERMINATION in a FLEXIBLE REGIME:

Long Run:
Purchasing Power Parity
Medium Run:
Business Cycle
Short Run:
1. Interest Parity
2. Speculation

R falls
Domestic Currency
Appreciates
Home goods less
expensive than foreign.

R rises
Domestic Currency
Depreciates
Home goods more expensive than
foreign.

Domestic economic
growth slower than
foreign.

Domestic economic growth faster

than foreign.

Home interest rise or

foreign rates fall.
Expectations of a
future appreciation.

Home interest rates fall, or

foreign rates fall.
Expectations of a future depreciation.

242

FIXED EXCHANGE RATE SYSTEMS

Pure gold standard:
Nations keep gold as their international reserve. Gold is used to settle most
international obligations and nations must be prepared to trade it for their own
currency for regular transactions.
Modified gold standard - example the Bretton Woods System (1947-1971)
Each U.S. dollar was backed by gold with the gold price fixed at US $35/oz. The U.K.
pound was fixed at 12.5 pounds per ounce. Since both currencies were fixed in
terms of gold, they were implicitly fixed against each other.
US$35'oz. and 12.5'oz. so $35'12.5 = US$2.8'.
Three rules for maintaining a gold standard:
1.
The currency must have a fixed value in terms of gold (as in Bretton Woods)
2.
Nations must keep the supply of domestic currency in a fixed proportion to their
supply of gold.
3.
Nations must provide gold in exchange for their home currency.
In a fixed exchange rate system, demand and supply for foreign currencies may vary
but the central bank must intervene to offset these movements in order to keep the
exchange rate at a fixed level.
Example: Imagine Switzerlands currency, the Swiss franc, is backed by gold.
If there is a decrease in demand for the franc, the central bank must prevent the franc
from weakening by selling some of its gold reserves in order to purchase francs. (Note
the Swiss franc is no longer backed by gold.) If a country with a gold-backed currency
runs out of gold, it can devalue its fixed exchange rate (lower its value).

243

Pegged Fixed Exchange Rates (not backed by gold)

Example: If Thailand decides to peg its currency at a value of 25 baht per U.S. dollar,
then the Thai central bank has to supply U.S. dollars in exchange for baht.
Problems:
If the U.S. dollar appreciates against the Japanese yen, then so does the baht and at
the same rate. Appreciation of the baht against the yen may or may not be a problem
depending on how much it needs to export to Japan.
To avoid problems like this a country can peg its currency not to one, but to a weighted
basket of other currencies.
Another problem for pegged currencies is sudden large changes in the inflation rates
between its country and that of the currencies it is pegged to. If Thailands inflation
rate suddenly rose sharply, it would have to devalue its currency (lower the peg).
A way of dealing with inflation differentials is to have a crawling peg, which is a kind of
soft peg in the sense that it is fixed but periodically adjusted to offset any differences
in inflation, keeping the real exchange rate constant and avoiding problems in
maintaining competitiveness.

244

Single Currency Areas:

Reasons why a group of countries might want to share a common currency:
1.

It reduces transaction costs (bank fees, accounting costs) from trading multiple
currencies.

2.

It eliminates price fluctuations caused by changes in exchange rates.

3.

It can reduce political friction between countries stemming from currency

misalignment (keeping your currency too low to favour your own exports etc.)

4.

It can reduce exchange rate fluctuations and create greater confidence in the
financial system of the country.

Adopting a common currency means giving up your central bank to a group central
bank. This means giving up a major policy arm which is a tool that can help economic
growth.
Four criteria for evaluating whether to adopt a common currency:
1.

The business cycle must be synchronized and national economies must enter
recessions and expansions at more or less the same time. If this is the case a
single monetary policy would work.

2.

If there is a high degree of mobility of financial capital between the countries,

allowing workers and capital to move between countries, then again a single
monetary policy has a better chance of working.

3.

There need to be regional policies in place to handle imbalances in employment

and other problems that may arise.

4.

The nations involved must be seeking a deeper level of integration than simple
free trade (lowering tariffs and import quotas). Harmonization of national
economies, agreement on levels of debt as a % of GDP that can be tolerated,
etc.

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Choosing the Right Exchange Rate System:

Both fixed and flexible exchange rate systems have advantages and disadvantages.
The kind of system chosen usually grows out of a countrys level of economic
development, trade relationships and political characteristics. There is no one size
fits all prescription for which type of exchange rate regime a country should have.
To be successful a system must generate investor confidence and a belief that the
system is sustainable. In a fixed exchange rate system credibility is made evident only
if there is strong control of the money supply by the central bank. Floating systems
are vulnerable due to lack of monetary discipline and the temptation to finance
government deficits with increases in the money supply. How a country establishes
credibility depends on the characteristics of the individual country and its exchange
rate system.

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EXTRA PROBLEMS: You are responsible for all formulas, theory, diagrams and
calculations in this chapter. Problems will be similar to those on MyEconLab under Study
Plan (except for #15&16).
Covered Interest Parity Equation:
1.
F (1+i*) = (1+i) This compares the return in the foreign country to return at home.
R
when using known forward exchange rate F.
Uncovered Interest Parity Equation:
ER1(1+i*) = (1+i) This compares the return in the foreign country to return at home.
2.
when using unknown expected future exchange rate ER1.
R

ER1 = (1+i) x R
(1+ i*)

3.

This is the future exchange rate that is expected by the

investor and is the rate that would make the investor
indifferent between investing in the home country or the foreign country for a year.

4.

F = (1+i) x R
(1+ i*)

5.

i-i* = (F-R)/R This is the expected % appreciation or depreciation in the domestic

This is the actual one year forward exchange rate

available in the market today.

(home) currency. If i > i* then F > R (The forward rate shows an expected depreciation of
the home currency).

Practice Problems with solutions:

Problem 1:
The spot exchange rate today is 1.8175 per Canadian dollar.
The expected future exchange rate one year from now is 1.8625 per C$.
The interest rate on a one year bond is 2.5% in Britain and 5% in Canada
a)
What is the expected return in dollars of the U.K. bond?
b)
What is the expected appreciation or depreciation of the Canadian dollar?
Solution:
a)
The wording means for every dollar you invest in the bond, what do you
earn in dollars. Use equation 2: 1.8625'1.8175(1.025) = 1.0504
For every dollar invested you earn $5.04.
b)
The forward rate shows an expected 2.5% depreciation of the Canadian $.

Problem 2:
If the spot exchange rate is 98 yen per Canadian dollar, and the forward rate is 115 yen
per Canadian dollar, and the Canadian interest rate is 5%, if interest parity holds, what
should be the interest rate in Japan?
Solution:

Remember the spot rate should be number of units of Canadian dollar per unit of
yen, so you have to invert the exchange rates.
R = 1'98 = C$.0102 per yen, and F = 1'115 = C$.0087 per yen.
Rearranging the terms of equation 1:
(1+i*) = (1+i)*R'F = (1.05)*.0102'.0087 = 1.231 so i* = 23.1%
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The following 2 problems are more complicated than those on MyEcon Lab (Study
Plan), but are included in case you want extra practice.
Problem 3:
The one-year interest rate is 3.5% in Canada and 2.5% in Australia.
The spot price of one Australian dollar today is C$1.210.
The known one-year forward price of an Australian dollar today (F) is C$1.225.
a) What is the expected value of the Australian dollar in one year?
What is the expected % appreciation or depreciation of the Australian dollar?
b) What arbitrage profits are possible with an investment of C$1 million?

Solution:
a)

1.035 x 1.210 = 1.2218 = ER1 This is the expected value of the A$ in one year.
1.025
3.5 > 2.5 so Canadian dollar is expected to depreciate by 3.5-2.5 = 1%

b) 1.225 x 1.025 = 1.03771 > 1.035

1.210

so borrow in Canada and invest in Australia.

Strategy
Borrow C$1 million at 3.5% and owe C$1,035,000 in one year.
Use the C$1 million to buy Australian dollars: 1/R = 0.826446 x C$1 million = A$826,446 and
invest the Australian dollars at 2.5% to earn 1.025 x 826,446 = A$847,107 in one year.
Sell A$847,107 forward at the current forward exchange rate of 1.225 so that you will receive
C$1,037,707 in one year.
Next year: Take the C$1,037,707 received from the forward contract which has now
matured and pay off the loan of C$1,035,000.
Arbitrage profit = 1,037,707-1,035,000 = C$2,707.

248

Problem 4:
The one-year interest rate is 4.5% in Canada and 3.75% in the U.S.
The spot price of one U.S. dollar today is C$0.985.
The known one-year forward price of a U.S. dollar today is C$1.025.
a) What is the expected value of the U.S. dollar in one year?
What is the expected % appreciation or depreciation of the U.S. dollar?
b) What arbitrage profits are possible with an investment of C$1 million?

Solution:
a)

1.045 x 0.985 = 0.99212 = Ep1

1.0375
3.75 < 4.5 The Canadian dollar is expected to depreciate by 0.75%

b) 1.025 x 1.0375 = 1.07963 > 1.045

0.985
Strategy
today:

so borrow in Canada and invest in the U.S.

Borrow C$1 million at 4.5% and owe C$1,045,000 in one year.

Use the C$1 million to buy U.S. dollars: 1/p0 x C$1 million :
1/R = 1.015228 x C$1 million = US$1,015,228 and invest the U.S. dollars at
3.75% to earn 1.0375 x 1,015,228 = US$1,053,300 in one year.
Sell US$1,053,300 forward at the current forward rate of 1.025 so that you will
receive C$1,079,632 in one year.

Next year: Take the C$1,079,632 received from the forward contract which has now
matured and pay off the loan of C$1,045,000.
Arbitrage profit = 1,079,632 - 1,045,000 = C$34,632.

249