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Chapter 7: Foreign Exchange and International Financial Markets

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... the supply and demand of a currency for fixed exchange rates to be sustainable. ... currency revaluations which often occur after a fixed exchange rate ... – PowerPoint PPT presentation

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Title: Chapter 7: Foreign Exchange and International Financial Markets


1
Chapter 7 Foreign Exchange and International
Financial Markets
2
Lesson Outline
  • Basic Facts about Foreign Exchange Markets
  • Supply demand as drivers of foreign exchange
    (forex) rates
  • Fixed versus flexible exchange rate regimes
  • The mechanics of how each regime functions
  • Benefits and drawbacks of each
  • Relative production costs and forex rates
  • Nations cannot be net exporters in everything,
    but foreign exchange rates find a level at which
    some exports can take place

3
Lesson Outline
  • International Fisher Effect
  • - inflation and real, nominal interest rates
  • Globalization of Currency Markets
  • Applying Todays Material to Understanding the
    Prospects of Nations
  • - various effects of appreciation and
    depreciation of national currencies
  • - ties between economic development, exchange
    rates, and trade and investment flows

4
Basic Facts about Forex Markets
  • About 1.2 trillion per day in transactions
  • US is most heavily traded, as oil must be paid
    for in US . Others which are important include
    the Japanese yen, the UK pound, the Swiss Franc,
    and the Euro.
  • Banks do most of the trading (about 80) and its
    mostly done over bank phone lines. Trading goes
    on 24 hours per day.

5
Basic Facts about Forex Markets
  • Currency trading is very lightly regulated,
    especially compared to stock bond markets.
  • Countries tend to find it very difficult to
    control exchange rates.  
  • Why do currencies change in value?
  • Short term speculation
  • Long term economic fundamentals

6
Basic Facts about Forex Markets
  • Traders like to invest in countries with steady
    economic growth, low inflation, high interest
    rates, a trading surplus, and low budget
    deficits.
  • Winners in the marketplace are the currency
    trading desks of banks, while central banks
    trying to prop up the value of their currency are
    the losers.

7
Supply and Demand as Drivers Of Forex Rates
  • Foreign exchange markets can be thought of as
    pass through markets. That is, people pass
    through foreign exchange markets to buy or sell
    goods, services, or assets denominated in
    currencies other than their own.
  • This means that to understand why foreign
    exchange rates vary, you need to understand what
    drives international trade and investment flows.
    You also need to know how national governments
    and central banks can influence foreign exchange
    markets.

8
Supply and Demand as Drivers Of Forex Rates
  • See Figure 7.1, 7.2, and 7.3 on pages 189 and 190
    to trace the "pass-through" effect of demand for
    Japanese products on the price of the Japanese
    yen.

9
Fixed versus Flexible Exchange Rate Regimes
  • The mechanics of how each regime works
  • Flexible exchange rates are determined wholly by
    supply and demand, as described in the diagrams
    given in the previous section.
  • To maintain a fixed exchange rate, a nations
    central bank acts as a guarantor, publicly
    announcing it will buy or sell its own currency
    at a set price.

10
Fixed versus Flexible Exchange Rate Regimes
  • The mechanics of how each regime works
  • In the short run, central banks can use their own
    currency and its foreign currency reserves to
    intervene in foreign exchange markets.
  • In the long run, persistent and significant
    differences in the supply and demand for a
    currency would overwhelm the ability of the
    relevant central bank to intervene. In the long
    run, there needs to be a close balance between
    the supply and demand of a currency for fixed
    exchange rates to be sustainable.

11
Fixed versus Flexible Exchange Rate Regimes
  • The mechanics of how each regime works
  • To maintain fixed exchange rates over the long
    term, nations need to be willing to adjust their
    domestic money supply to roughly match the
    inflation rate of other nations.
  • (also see notes on the International Fisher
    Effect, later in this lesson)

12
Fixed versus Flexible Exchange Rate Regimes
  • Benefits and Drawbacks of Each Regime
  • Flexible exchange rates cannot be broken by
    external shocks or internal policy dilemmas.
    Also, neither governmental nor central bank
    intervention is likely to lead to serious
    distortions in currency value that can eventually
    lead to sharp currency revaluations and all the
    associated problems.

13
Fixed versus Flexible Exchange Rate Regimes
  • Benefits and Drawbacks of Each Regime
  • As well, national governments have more freedom
    to look only at their own internal concerns,
    whereas under fixed exchange rates a lot of
    policy-related autonomy is given away, especially
    concerning monetary policy.
  • However, flexible exchange rates lead to
    substantial uncertainty regarding international
    transactions and also about where to locate
    plants and factories.

14
Fixed versus Flexible Exchange Rate Regimes
  • Benefits and Drawbacks of Each Regime
  • Fixed exchange rates reduce the riskiness of
    international transactions. Reducing uncertainty
    about foreign exchange rates tends to increase
    the flow of international trade and investment,
    which is believed to help increase overall
    economic growth.

15
Fixed versus Flexible Exchange Rate Regimes
  • Benefits and Drawbacks of Each Regime
  • They can also be an anti-inflationary tool, a way
    of disciplining governments which have a tendency
    to overspend and print money to pay their bills.

16
Fixed versus Flexible Exchange Rate Regimes
  • Benefits and Drawbacks of Each Regime
  • However, when external shocks occur or when
    imbalances in inflation rates or economic growth
    rates are persistent over time, fixed exchange
    rate regimes can fall apart. And, sudden, large
    currency revaluations which often occur after a
    fixed exchange rate regime fails can have sharply
    negative consequences.

17
Fixed versus Flexible Exchange Rate Regimes
  • Benefits and Drawbacks of Each Regime
  • Also, nations seeking to maintain a fixed
    exchange rate give up a lot of policy autonomy.
  • In addition, if they are pegging their currency
    to a currency that floats (ie the US dollar),
    then their exchange rate in terms of currencies
    other than the US will be driven by whatever
    drives changes in the US dollar, rather than by
    what is happening in their own country.

18
Fixed versus Flexible Exchange Rate Regimes
  • Benefits and Drawbacks of Each Regime
  • This disconnect between national conditions and
    the value of a nations currency can cause
    problems, as outlined in the article on the
    Argentinean currency board.

19
Relative Production Costs and Foreign Exchange
Rates
  • Nations cannot be net exporters in everything
    because foreign exchange rates find a level at
    which nations will be net exporters in some goods
    and net importers in other goods.
  • This occurs because there is a rebound effect
    from a substantial currency appreciation or
    depreciation.

20
Relative Production Costs and Foreign Exchange
Rates
  • For example, when a currency depreciates
    substantially, land and workers in that country
    become substantially less expensive to employ in
    terms of other currencies.
  • This change in relative production costs tends to
    pull in overseas investment for some national
    industries and to tip the competitive balance in
    favor of some national industries which were
    formerly not competitive in world markets.
  • see article on Russian timber

21
Relative Production Costs and Foreign Exchange
Rates
  • If a currency continues to appreciate further and
    further due to strong demand for goods produced
    in that country, formerly competitive national
    industries will no longer be as strong on a
    global scale. Industries which are net exporters
    may become net importers.
  • These newly beleaguered industries will, in turn,
    often receive less inward foreign direct
    investment, will be likely to invest more in
    production facilities abroad, and the nations
    current account balance will be under pressure to
    shift further towards or into a deficit. All of
    these responses to a currency appreciation put
    downward pressure on the value of a currency in
    the long term.

22
The International Fisher Effect
  • The International Fisher Effect (IFE) explains
    why interest rates vary across nations by
    explaining the link between interest rates and
    inflation. Because inflation rates differ across
    nations, interest rates also differ, according to
    the IFE.
  • The IFE equation is
  • nominal interest rate real interest rate
    inflation

23
The International Fisher Effect
  • There is also evidence suggesting that real
    interest rates vary across nations. The larger
    and deeper are internal debt and equity markets
    and the greater the certainty about future
    inflation and interest rates, the smaller the
    real rate of return (sans inflation) lenders
    may be willing to accept.

24
Globalization of Currency Markets
  • Regarding the globalization of currency markets,
    covered-interest arbitrage links together
    interest rates and both spot and forward currency
    rates. By the terms of the International Fisher
    Effect, national inflation rates, national
    interest rates, and both spot and forward foreign
    exchange rates are therefore all linked together.
  • (Note that the above is the main reason why under
    fixed exchange rates national autonomy over
    monetary policy is severely reduced)

25
Globalization of Currency Markets
  • 2-way and 3-way arbitrage in currency markets
    links currency markets together across different
    nations.
  • Essentially, the presence around the world of
    foreign exchange trading sites, together with the
    activities of arbitrageurs, has brought about a
    global market for currencies both in spot and
    forward currency markets.

26
Applying Todays Material to Understanding the
Prospects of Nations
  • The effects of currency revaluation
  • Currency depreciation puts upward pressure on
    inflation and interest rates and drives down
    living standards. Debt denominated in foreign
    currencies becomes more expensive to service.
    Portfolio investors who believe a nations
    currency will depreciate will often shun that
    country. Goods produced in that nation become
    cheaper on world markets. The overall effect on
    national economic growth needs to be examined on
    a case by case basis.

27
Applying Todays Material to Understanding the
Prospects of Nations
  • As the article on the Indonesian firm suggests,
    the overhang from a sudden, sharp currency
    devaluation takes a while to disappear,
    especially if that country and its firms are
    carrying a lot of debt denominated in foreign
    currencies.
  • Comparing the articles on Russian timber and on
    the Indonesian firm struggling with its dollar
    denominated debts helps underscore the
    complicated effects of currency devaluation.

28
Applying Todays Material to Understanding the
Prospects of Nations
  • Currency appreciation has the opposite effect.
    Again, the overall effect on national economic
    growth varies on a case by case basis.

29
Applying Todays Material to Understanding the
Prospects of Nations
  • Economic development, exchange rates, and trade
    and investment flows
  • The article Newly Muscular Euro Hurts Some
    highlights the possibly beneficial effects on
    overall economic growth of currency devaluation,
    as it suggests that the weakness of the Euro may
    have added 0.5 to the economic growth rate of
    the Euro-area members.

30
Applying Todays Material to Understanding the
Prospects of Nations
  • Economic development, exchange rates, and trade
    and investment flows
  • With the weak Euro, the lower cost for Euro-area
    exports around the world added to EU economic
    growth, the article is implying.

31
Applying Todays Material to Understanding the
Prospects of Nations
  • Economic development, exchange rates, and trade
    and investment flows
  • Given a higher economic growth rate brought about
    in part by the Euro's slide in value through much
    of last year, the Euro area may now begin to
    attract more inward foreign direct investment,
    and keep more investment capital at home, which
    should in turn spur an increase in asset values
    and investment.

32
Applying Todays Material to Understanding the
Prospects of Nations
  • Economic development, exchange rates, and trade
    and investment flows
  • This in turn may help EU economic growth expand
    faster than it otherwise would have and may also
    help the Euro maintain over even further increase
    its value in the near to medium term.

33
Applying Todays Material to Understanding the
Prospects of Nations
  • Economic development, exchange rates, and trade
    and investment flows
  • However, the Euros slide was not all good news.
    It also put upward pressure on inflation and gave
    rise to civil disorder when oil prices shot
    upwards. Sectors dependent on oil to carry on
    their business were hit very hard by the Euros
    slide.
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