The Determination of

Exchange Rates
 Learning Objectives
Describe the International Monetary Fund and its
role in the determination of exchange rates
Discuss the major exchange-rate arrangements
that countries use
Explain the European Monetary System and how
the euro became the currency of the euro zone
Identify the major determinants of exchange
rates
Show how managers try to forecast exchange-
rate movements
Explain how exchange-rate movements influence
business decisions
 BIS
Founded in 1930, BIS is the oldest global
financial institution. Changing role:
Responsible for collection, administration
and distribution of reparations from
Germany.
1970s and 1980s- monitored cross-border
capital flows in wake of oil and debt crisis.
Emerged as an emergency funder to
nations in trouble, coming to aid of
countries such as Mexico, Brazil during
debt crisis of 1982 and 1998 resp. 9-3
 1979 to 1994, BIS was the agent of
European Monetary System, which was
administration that paved the way for
single European currency.
Promoter of central bank cooperation in an
effort to ensure global monetary and
financial stability.
Lender of last resort , to support global
monetary and financial stability.
Forum of cooperation among among
member central banks. 9-4
 Produces research and statistics, and
organises seminars and workshops
focused on international financial issues.
As a bankers bank BIS serves the
financial needs of member central banks.
BIS is also a banker and fund manager for
other international financial institutions.
BIS unit of accounts is IMFs SDR which
are a basket of convertible currencies.

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 The International Monetary Fund
The goals of the International Monetary Fund
(IMF) , (founded in 1945) are to:
ensure stability in the international monetary
system
promote international monetary cooperation
and exchange-rate stability
facilitate the balanced growth of international
trade
provide resources to help members in balance-
of-payments difficulties or to assist with
poverty reduction
 International Monetary Fund
The Bretton Woods Agreement
established a par value, or benchmark value,
for each currency initially quoted in terms of
gold and the U.S. dollar
The dollar became the world benchmark
for trading currencies and continues in
that role today
 The IMF Today
189 members.
The Quota System
every member contributes a quota
Assistance Programs
the IMF lends money to ease balance-of-
payments difficulties
Special drawing rights (SDRs)
the IMFs unit of account
Special drawing rights (SDR) are supplementary
foreign exchange reserve assets defined and
maintained by the International Monetary Fund
(IMF). Their value is based on a basket of key
international currencies reviewed by IMF every five
years.
 As of March 2016, 204.1 billion SDRs (equivalent
to about $285 billion) had been created and
allocated to members. SDRs can be exchanged
for normal currencies.
The SDR was created in 1969 as a
supplementary international reserve asset, in
addition to gold and $, to purchase its domestic
currency in foreign exchange markets, as
required to maintain its exchange rate.

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 Only recently, the 2009 SDR allocations totaling
SDR 182.6 billion played a critical role in
providing liquidity to the global economic system
and supplementing member countries official
reserves amid the global financial crisis.
The SDR is neither a currency, nor a claim on the
IMF. Rather, it is a potential claim on the freely
usable currencies of IMF members.

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 Holders of SDRs can obtain these currencies in
exchange for their SDRs in two ways: first,
through the arrangement of voluntary exchanges
between members; and second, by the IMF
designating members with strong external
positions to purchase SDRs from members with
weak external positions.
The value of the SDR was initially defined as
equivalent to 0.888671 grams of fine gold
which, at the time, was also equivalent to one
U.S. dollar. After the collapse of the Bretton
Woods system in 1973, the SDR was redefined as
a basket of currencies. 9-11
 The value of the SDR is determined daily
& is calculated as the sum of specific
amounts of each basket currency valued
in U.S. dollars, on the basis of exchange
rates quoted at noon each day in the
London market.

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 The basket composition is reviewed every five
years by the Executive Board, or earlier if the IMF
finds changed circumstances.
The respective weights of the U.S. dollar, euro,
Chinese renminbi, Japanese yen, and pound
sterling are 41.73 percent, 30.93 percent, 10.92
percent, 8.33 percent, and 8.09 percent. These
weights were used to determine the amounts of
each of the five currencies included in the new
SDR valuation basket that took effect on October
1, 2016.

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 Since currency amounts are fixed, the relative
weight of currencies in the SDR basket can
change during a valuation period, with weights
rising (falling) for the currencies that appreciate
(depreciate) relative to other currencies over
time.
The next review is currently scheduled to take
place by September 30, 2021

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 The SDR interest rate provides the basis for
calculating the interest charged to borrowing
members, and the interest paid to members for
the use of their resources for regular (non-
concessional) IMF loans.
The SDR interest rate is determined weekly and
is based on a weighted average of representative
interest rates on short-term debt instruments in
the money markets of the SDR basket currencies

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 SDR allocations to IMF members are in proportion
to their IMF quotas . Such an allocation provides
each member with a costless, unconditional
international reserve asset.
If a member does not use any of its allocated
SDR holdings, the charges are equal to the
interest received.
However, if a member's SDR holdings rise above
its allocation, it effectively earns interest on the
excess. Conversely, if it holds fewer SDRs than
allocated, it pays interest on the shortfall.

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 General allocations of SDRs have to be based on
a long-term global need to supplement existing
reserve assets. Decisions on general allocations
are made for successive basic periods of up to
five years (the last report is from June 2016).
IMF members often need to buy SDRs to
discharge obligations to the IMF, or they may
wish to sell SDRs in order to adjust the
composition of their reserves.

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 The IMF may act as an intermediary between
members and prescribed holders to ensure that
SDRs can be exchanged for freely usable
currencies.
For more than two decades, the SDR market has
functioned through voluntary trading
arrangements. Under these arrangements a
number of members and one prescribed holder
have volunteered to buy or sell SDRs within limits
defined by their respective arrangements.
However, in the event that there is insufficient
capacity under the voluntary trading

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 The Global Financial Crisis
and the IMF
The global crisis in 2008-2009 raised
concerns over global liquidity
prompted the G20 to inject huge amounts of
cash into the IMF
Greeces 2010-2011 financial crisis
required assistance from the IMF and the
EU
the IMF required Greece to adopt very
unpopular austerity measures
 Evolution to
Floating Exchange Rates
The Smithsonian Agreement
December, 1971
8% devaluation of the dollar
revaluation of other currencies
widening of exchange rate flexibility
Dollar again devalued by 10% in 1973
1972-1981: end of brettonwoods system
The Jamaica Agreement
provided greater exchange rate flexibility
eliminated the use of par values
Exchange Rate Arrangements
Under the Jamaica Agreement countries
selected and maintained their own
exchange rate arrangements
The IMF monitors the exchange rate
policies of countries to see if they are
acting openly and responsibly
 Exchange Rate Regimes (Hard Peg,
Soft Peg and Floating)
Each country depending on their economic
expectation and their political view has
applied different types of exchange rate
regimes. Although there are too many
classifications on this issue, we will use
the following classification which is
summarized under three titles:
Hard peg system
Soft peg system
Free floating system
 Currency Peg
A country or government's exchange-rate
policy of pegging the central bank's rate of
exchange to another country's currency.
Currency has sometimes also been pegged
to the price of gold.
Exchange Rate Arrangements
Exchange Rate Arrangements and Anchors
 Three Choices:
Hard Peg, Soft Peg, or Floating
The IMF classifies currencies into three categories
Hard peg
value is locked into something and does not change
dollarization
currency boards
Soft peg
more flexible than hard peg
Chinese Yuan is an example
Floating
floating or free floating
change according to market forces
 Hard Peg
Hard peg regimes are the exchange rate systems
in which the national currency is either fixed to a
respectable foreign currency or the government
completely gives up its national currency and
start to use a strong one.
Panama, which has long used the U.S. dollar, is
an example of full dollarization, and Hong
Kong SAR operates a currency board.
hard exchange rate peg has no independent
monetary
 Soft Peg
currencies that maintain a stable value against an
anchor currency or a composite of currencies.
The exchange rate can be pegged to the anchor
within a narrow (+1 or 1 percent) or a wide (up
to +30 or 30 percent) range
Costa Rica, Hungary, and China are examples of
this type of peg.
they allow for a limited degree of monetary policy
flexibility to deal with shocks
However, soft pegs can be vulnerable to financial
criseswhich can lead to a large devaluation
 Floating exchange rates
Floating exchange rate is mainly market
determined. In countries that allow their
exchange rates to float, the central banks
intervene, mostly to limit short-term exchange
rate fluctuations.
However, in a few countries (for example, New
Zealand, Sweden, Iceland, the United States, and
those in the euro area), the central banks almost
never intervene to manage the exchange rates.
Floating regimes offer countries the advantage of
maintaining an independent monetary policy.
Independently Floating

The exchange rate is market-determined, with

any official foreign exchange market
intervention aimed at moderating the rate of
change and preventing undue fluctuations in
the exchange rate, rather than at establishing
a level for it.
Exchange Rate Anchor
The monetary authority stands ready to
buy/sell foreign exchange at given quoted
rates to maintain the exchange rate at its pre-
announced level or range
 The Euro
Learning Objective:
Explain the European Monetary System
and how the euro became the currency of
the euro zone
 The Euro
The European Monetary System (EMS)
established to create exchange rate stability
within the European Community
European Monetary Union (EMU)
outlined the criteria for euro applicants
the U.K., Sweden, and Denmark opted not
to adopt the euro
The European Central Bank (ECB)
sets monetary policy for the adopters of the
euro
 Foreign Exchange
Convertibility and Controls
Hard currencies
U.S. dollar, euro, British pound, Japanese yen
Soft currencies
developing countries
Countries can control convertibility
through
licenses
multiple exchange rate systems
advance import deposits
quantity controls
 Exchange Rates and
Purchasing Power Parity
Purchasing power parity (PPP)
a change in relative inflation between two
countries must cause a change in exchange
rates to keep the prices of goods in the
countries fairly similar
The Big Mac Index
 Exchange Rates
and Interest Rates
The Fisher Effect
links inflation and interest rates
The International Fisher Effect (IFE)
links interest rates and exchange rates
Other Factors in Exchange Rate
Determination
confidence
Information

https://www.stlouisfed.org/on-the-economy/2016/february/rate-
hikes-affect-dollars-exchange-rate
 Nominal interest rate is real interest rate +
inflation.
Country with higher interest rate should have
higher inflation
Currency of a country with the lower interest rate
will strengthen in future in the long run.
In short run it could be reverse or anything.
The international Fisher effect - expected change
in the current exchange rate between any two
currencies is approximately equivalent to the
difference between the two countries' nominal
interest rates for that time.
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 Forecasting
Exchange Rate Movements
Learning Objective:
Show how managers try to forecast
exchange-rate movements
 Fundamental and Technical
Forecasting
Forecasting exchange rates
Fundamental forecasting
uses trends in economic variables to predict
future rates
Technical forecasting
uses past trends in exchange rates to spot
future trends
Biases can skew forecasts
Timing, direction, and magnitude of exchange
rate movements are important to consider
 Fundamental Factors
to Monitor
Monitor
The institutional setting
Fundamental analyses
Confidence factors
Circumstances
Technical analyses
 Business Implications of
Exchange Rate Changes
Learning Objective:
Explain how exchange-rate movements
influence business decisions
 Business Implications of
Exchange Rate Changes
Marketing Decisions
when the value of a countrys currency rises, exporting
becomes more difficult as the product becomes more
expensive in foreign markets
Production Decisions
might locate production in a weak currency country
because the initial investment is cheap and it will make
a good base for exports
Financial Decisions
currency rates influence sourcing, cross-border
remittance of funds, and the reporting of financial
results
 The Future: The Dollar, The
Euro, The Yen, The Yuan
Europe
the euro should take market share away from
the dollar as the prime reserve asset assuming
the problems in Greece and other countries are
controlled
Asia
China is moving forward to establish the yuan
as a major world currency
Latin America
emerging market currencies should strengthen
as commodity prices recover