Exchange Rates and the Euro

transcript

Dr. Katie Sauer

Metropolitan State College of Denver

Presented at the “Discovering the European Union” Workshop

Sponsored by the Colorado Council for Economic EducationAnd the Colorado European Union Center of Excellence

August 4th, 2010 Denver, CO

Outline:

I. Currency II. Foreign Exchange

A. Exchange Rate BasicsB. Exchange Rate Fluctuations:C. Types of exchange ratesD. Exchange Rate ChoiceE. Historical EU Monetary Developments

III. Fun with Exchange Rates: The Economist’s Big Mac Index

I. Currency

Currency is a unit of exchange. It is exchanged for:- goods- services- other currency

Most countries have control over the supply and production of their own currency.

Usually Central Banks or Ministries of Finance control the currency.

There are about 175 currencies in current circulation.

There are about 195 countries in the world.

- several countries use the same currencyex: the euro is used by Portugal, Spain, France, Italy, Ireland, Belgium, Luxembourg, Germany,Netherlands, Austria, Slovenia, Slovakia, Finland,Malta, Greece and Cyprus

- some countries declare another country’s currency to belegal tender

ex: Panama and El Salvador use the US dollar as legal tender

Several countries use the same name for their currency:

“dollar”United StatesBelizeCanadaHong Kong

“peso”PhilippinesUruguayMexico

To avoid confusion, the ISO 4217 classification system is used. (three letter currency code)

USDBZDCADHKD

PHPUYUMXN

II. Foreign Exchange

When making international transactions (like paying for imports or buying foreign assets), currencies are exchanged as well.

A. Exchange Rate Basics

The foreign exchange rate (exchange rate, forex rate, FX rate) specifies how much one currency is worth in terms of another currency. (abbreviated “e”)

The current exchange rate is also called the spot rate.

Example Spot Rates:

USD GBP EUR

USD 1.0000 1.5421 1.2889

GBP 0.6485 1.0000 0.8357

EUR 0.7759 1.1966 1.0000

July 25,2010oanda.com

With 1 US dollar you could get how many British pounds?0.6485

With 1 British pound you could get how many US dollars?1.5421

(actually just the reciprocal… 1/1.5421 = 0.6485)

You could get this amount of this currency

With one of this currency

spot exchange rates July 15, 2010

1 currency unit equals ? EUR Float

Czech Republic CZK koruna 0.03892Hungary HUF forint 0.00339Poland PLN zloty 0.23987

Romania RON new lei 0.22801Sweden SEK krona 0.10376

UK GBP pound 1.19660 Peg

Bulgaria BGN lev 0.49698Denmark DKK krone 0.13148

Estonia EEK kroon 0.06263Latvia LVL lats 1.35712

Lithuania LTL litas 0.27865

0.5152

0.5136

0.5119

0.5103

0.5086

0.5070

4/26 5/11 5/26 6/10 6/25 7/10 7/25

Bulgaria’s pegged exchange rate versus the euro:

Using exchange rates to convert prices into another currency:On June 18, 2007, our meal in Vienna, Austria cost €19.70 and the exchange rate was 1 USD = 0.73169EUR.

How many US dollars did it cost?

€19.70 x 1$ . = $ 0.73169 €

$26.92

On August 3, 2005 in Nice, France a kilo of peppers cost €2.20.The exchange rate was 1 EUR = 1.19501 USD.

How much did a kilo of peppers cost in US dollars?

€2.20 x 1.19501$ = 1 €

Salzburg, AustriaJune 2007

1$ = 0.74270euro1 € x 1$ = $1.35 0.74270 €

Prague, Czech RepublicJune 2007

1$ = 21.3830 koruna(CZK)

20kc x $1 = $0.94 21.3830kc

B. Exchange Rate Fluctuations:

When one unit of currency A can buy more of currency B, then currency A has appreciated versus currency B.

When one unit of currency A can buy less of currency B, then currency A has depreciated versus currency B.

For example:7/25/2009 1 USD = 0.718692 EUR7/25/2010 1 USD = 0.790398 EUR

Has the US dollar appreciated or depreciated versus the euro in the past year?

dollar has appreciated versus the eurothe euro has depreciated versus the dollar

Some implications of an appreciating currency:- import more (currency is strong, buying power is strong)- export less- trade balance worsens (more of a deficit, less of a surplus)- travel abroad is “cheaper”

Some implications of a depreciating currency:- import less - export more- trade balance improves (less of a deficit, more of a surplus)- travel abroad is “more expensive”

Economists don’t believe that appreciating/depreciating currencies are inherently good or bad… it depends on the circumstances.

C. Types of exchange rates

floating (aka flexible): the currency’s value is determined by market forces

fixed (aka pegged): the currency’s value is set at a fixed value of another currency

pegged float: the currency’s value is kept within a certain range of predetermined values with another currency

The Foreign Exchange Market for British pounds (exchange rate between $ and £)

Demand for £ for foreign exchange- investors who have $ and wish to buy £-denominated assets- investors who are selling $-denominated assets and wish to convert back to £- US importers of British goods (have $ but need to pay for theorder in £)

Supply of £ for foreign exchange- Investors who have £ and wish to buy $-denominated assets- Investors who are selling £–denominated assets and wish to convert back to $ - British importers of US goods (have £ but need to pay in $)- government policy (Central Banks or Ministries of Finance), and bank practices

the Foreign Exchange Market for British pounds:

e $/£

Q£ for forex

The notation e$/£ indicates the exchange rate in terms of dollars per pound.

As the value of e$/£ increases,the £ is appreciating against the $.

As the value of e$/£ decreases,the £ is depreciating against the $.

the Foreign Exchange Market for British pounds:

e $/£

Q£ for forex

D£ slopes downwardbecause as the £ depreciates, it is “cheaper” to buy £ using $ (as the “price” of a £ falls, the quantity demanded of it rises).

S£ is vertical because there is a certain quantity of £ available for foreign exchange at any given time.

1. Floating Exchange Rates (flexible)

e $/£

Q£ for forex

The intersection of the supply and demand for £ determines the exchange rate.

When supply or demand changes, so does a floating exchange rate.

e $/£

Q£ for forex

Suppose that $-denominated assets are paying a higher return than £-denominated assets.

- D£ will decrease as people sell £ assets in favor of $ assets

- the exchange rate falls (£ depreciates vs the $)

2. Fixed (Pegged) Exchange Rates

Flexible (floating) exchange rates fluctuate with market forces and may be quite volatile. To reduce the uncertainty associated with a floating forex rate, a country might choose to peg its currency to a certain value.

The main benefit of a pegged exchange rate is stability. - investors are more certain of a return- import/export transactions have less risk

The drawback of a pegged exchange rate is it causes a lack of flexibility for other policies.

- the Central Bank / Ministry of Finance has to take steps to maintain the peg

- need to have reserves of the currency you arepegging to

A pegged rate higher than the market rate:

Dkroon

eeuro/kroon

Suppose Estonia pegs the kroon to the euro at a rate of e1.

- at e1, Qs > Qd which means there is a surplus of kroon in the market - normally, the kroon would depreciate

-the Estonian Central Bank must intervene to keep the kroon from depreciating

Skroon

Qkroon

Surplus of kroon

“overvalued”

The Estonia Central Bank must use its reserve of euros to buy up the surplus of kroon.

- needs to be willing to do so at the fixed exchange rate

Dkroon

eeuro/kroon

Skroon

Qkroon

Surplus of kroon

- The Central Bank ends up with more kroon

- Depletes reserves of euros

Pull kroon out of the market

Put euros into the market

Implications:

An overvalued currency can lead to a trade deficit:- decreases exports (they are “more expensive”)- increases imports (they are “cheaper”)

It benefits imports at the expense of exports

The Central Bank reduces its foreign exchange reserves.

If a currency is overvalued for a long period of time, then a balance of payments crisis could be on the horizon.

- run out of reserves- can’t pay for imports

Options if running out of foreign reserve currency:

- borrow foreign exchange from another central bank or the IMF to maintain the peg - re-set the peg to a lower level, more consistent with the market rate - allow the exchange rate to depreciate down to the market level

If investors think that a currency will be devalued, they may sell all of their assets in that currency.

- the demand for currency falls- This would put more pressure on the peg.

- the market equilibrium is even further below the peg- the surplus is larger

- A government may be forced to devalue the currency.- “self fulfilling prophecy”

The investors could then move back into the currency, but since it has depreciated, they can buy much more of it.

A pegged rate lower than the market rate:

Suppose China pegs the yuan to the US dollar at a rate of e1.

- at e1, Qd > Qs which means there is a shortage of yuan in the market

- normally, the yuan would appreciate

- to keep the currency from appreciating, the central bank must intervene

shortage of yuan

“undervalued”

shortage of yuan

The Central Bank must put yuan into the market.- will be spending yuan to buy up dollars- needs to be willing to do so at the fixed exchange rate

- China ends up with more reserves of dollars

Pull dollars out of the market

Put yuan into the market

Implications:

An undervalued currency can lead to a trade surplus:- increases exports - decreases imports

It benefits exports at the expense of imports

The government will increase its foreign currency reserves.

If a currency is undervalued for a long time, then the government may be forced to expand the domestic money supply to get more domestic currency.

- domestic inflation

If currency speculators think that the government may re-value the currency, then “hot money” may flow into the country.

- increases demand for the currency- the peg is now even further below market equilibrium

- more of a shortage- need more domestic currency- inflation increases

- the government re-sets the peg higher, or lets the currencyfloat- speculators make a profit

D. Exchange Rate ChoiceFor the vast majority of countries (except for the very largest economies), the choice of exchange rate policy is probably their single most important macroeconomic policy decision.

The Mundell-Fleming Trilemmaaka:

- The Unholy Trinity- The Incompatible Triangle- The Irreconcilable/Incompatible Trinity

An economy can only have 2 of the following 3 policies at any given time:

- fixed exchange rates- control of monetary policy- free movement in capital markets

Suppose a nation decides to fix its exchange rate.

It can either have free capital markets or control over monetary policy.

If it chooses free capital markets, then monetary policy must be used to keep the peg stable.

- capital flows in and out freely --- changes the demand forthe currency --- pressure on the peg

If it chooses to keep flexibility in monetary policy, then it has to put restrictions on capital flows.

For nations with small or underdeveloped capital markets (most nations), it is usually impossible to have

- free capital markets- floating exchange rate- control of monetary policy

The choice is usually either- capital restrictions- floating exchange rates- control of monetary policy

Or - free capital markets- fixed exchange rates- no control of monetary policy

Free movement of capital is one of the “Four Freedoms” in the European Union.

When a nation pegs to the euro and has open capital markets, then it must give up control monetary policy.

E. Historical EU Monetary Developments

1870 - 1914: gold standard- each currency was based on gold- fixed exchange rates between all currencies

1914 – 1945: great variation- exchange and capital controls- floating exchange rates

1946 – 1973: Bretton Woods System- commitment to keep currencies convertible for current account transactions- fixed exchange rates

1973-1979: EMS/ERM- European Monetary System creates the ecu- Exchange Rate Mechanism is a system of quasi-fixed exchange rates

Belgium, Denmark, Germany, France, Ireland, Italy, Luxembourg, Netherlands join EMS/ERM

UK joins EMS only

1981 – 1986 Greece, Portugal, Spain join EMS

1987 – 1990 Spain and UK join ERM

1990 Capital controls abolished in EC

1991 The plan for a European Monetary Union includes a common currency – will use ERM as an entry route.

1992 Portugal joins ERM, UK leaves ERM

1995 Austria, Finland join EMS/ERM Sweden joins EMS

1998 European Central Bank is created- euro nations freeze exchange rates on Dec 31

Austria, Belgium, Netherlands, Finland, France, Germany, Ireland, Italy, Luxembourg, Portugal, Spain

1999 Euro is introduced as unit of account. Greece, Denmark join ERM

2001 Greece joins euro zone

2004 Estonia, Lithuania, Slovenia join ERM

2005 Cyprus, Latvia, Malta, Slovakia join ERM

2007 Slovenia joins euro zone

2008 Cyprus, Malta join euro zone

2009 Slovakia joins euro zone

III. Fun with Exchange Rates: The Economist’s Big Mac Index

The index is a lighthearted attempt to gauge how far currencies are from their fair value.

It is based on the theory of purchasing-power parity (PPP), which argues that in the long run exchange rates should move to equalize the price of an identical basket of goods between two countries.

Our basket consists of a single item, a Big Mac hamburger, produced in nearly 120 countries.

The fair-value benchmark is the exchange rate that leaves burgers costing the same in America as elsewhere.

The price you’d see on the menu board.

The price converted into US dollars.

The exchange rate that would make the foreign price equal to the US price.

Big Mac Prices actual over/underin local price in implied PPP exchange rate valued vscurrency US$ of the US$ per US$ the US$

US $3.73 $3.73 …. …. ….Czech 67.6kr $3.43 18.1 19.7 - 8Rep_____________________________________________________

To calculate the price in US$:Multiply the local price by the actual exchange rate.

67.6kr x 1$ = $3.43 19.7kr

If you bought a Big Mac in the Czech Republic, it would cost you 67.6kr . Which means it really costs you $3.43.

- It is more expensive to buy a Big Mac in the US than Czech..

US $3.73 $3.73 …. …. ….Czech 67.6kr $3.43 18.1 19.7 - 8Rep_____________________________________________________

To calculate the implied PPP of the US$:Divide the local price in the foreign country by the local price in the US

PPP rate = 67.6 / 3.73 = 18.1

US $3.73 $3.73 …. …. ….Czech 67.6kr $3.43 18.1 19.7 - 8Rep_____________________________________________________Compare the PPP rate to the actual exchange rate to see if the currency is over or undervalued versus the US$.

To calculate how much the real is overvalued by:

(PPPrate – actual exchange rate) / actual exchange rate x 100

(18.1 – 19.7) / 19.7 x 100 = -8.12

Because the koruna is undervalued vs the dollar, we expect the koruna to appreciate vs the dollar in the future.

Given the price in local currency and the actual exchange rate, you can calculate - price in dollars - implied PPP rate - over/under valuation

Summary:

The exchange rate is also called the spot rate.

Countries can choose to have a pegged exchange rate or a floating exchange rate.

If a nation pegs its exchange rate to another currency, it must be prepared to buy and sell currency as needed to maintain the peg.

The EU has a long history of both fixed and floating exchange rates.

The Big Mac Index is a way of predicting currency appreciations and depreciations.

Exchange Rates and the Euro

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