Lecture 11 Exchange Rate

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Exchange Rate

Course: International Economics

Teacher: Snjeana Brki, Ph.D.

SCHOOL OF ECONOMICS AND BUSINESSUNIVERSITY OF SARAJEVO


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Objectives

After the presentation students will be able:

to define and to calculate exchange rate;

to understand the role of exchange rates in international economics;


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Content

1. Introduction

2. Definition and Functions of Exchange Rate

2.1.Quotation

2.2. Cross Exchange Rates

2.3. Functions of Exchange Rate

3. Determination of Exchange Rate

4. Conclusion

5. Literature


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1. Introduction

For their interdependence, the balance of payments and the exchange

rates cannot be analysed separately.

The exchange rate depends on the balance of payments and its

accounts.

The exhange rate policy influences the balance of payments policy,

because changes in the exchange rate lead to changes in the balance of

payments accounts.

Changes in the exchange rate affect producers, importers and exporters,

investors, consumers, tourists and others.


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Definition:

Exchange rate is the price of one countrys currency in term of anothercountryscurrency.

Foreign exchange rate is the price of a foreign currency in term of thedomestic currency.


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Foreign exhange rate shows how many units of the domestic currencyshould be paid for an unit of a foreign currency:

if the foreign exchange rate increases, we have to pay more units ofthe domestic currency for an unit of the given foreign currency (the

domestic currency becomes weakerit depreciates); if the foreign exchange rate decreases, we have to pay fewer units

of the domestic currency for an unit of the given foreign currency(the domestic currency becomes strongerit appreciates);


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2.1. Quotation

The exchange rate in the foreign exchange market of a given country can be

quoted in two ways:

Direct quotation

Indirect quotation


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2.1. Quotation

Direct quotation - the price of a foreign currency in terms of the domestic

currency:

1 EUR = 2 KM (1 EUR = 1,95583 BAM)

Indirect quotation - the price of the domestic currency in terms of a foreign

currency:

1 KM = 0,50 EUR (1 BAM = 0,51129 EUR)

Exchange rate with indirect quotation is the reciprocal value of exchange

rate with direct quotation:

ER= 1 / ER

ER= 1 / (2 BAM/EUR) = 0,50 EUR/BAM


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2.1. Quotation

Functions of money:

medium of exchange;

unit of account (measure of value);

store of value;

In the domestic foreign exchange market:

a foreign currency is a good (although a specific one) and has its

pricethe exchange rate;

the domestic currency is not a good than a measure of value and

serves to express prices of other goods.


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2.1. Quotation

a currency that is being bought or sold is a reference currency; in direct

quotation - the second currency in a currency pair;

a currency in which transaction is denominated is base or accounting

currency; the first currency quoted in a currency pair on forex;

ER(X/Y)

ER(accounting currency/reference currency)

ER(domestic currency/foreign currency)

(the price of currency Y is expressed in a number of units of currency X;

therefore currency Y is a traded good which price is denominated in

currency X)


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2.2. Cross Exchange Rate

Cross exchange rate

Numerical Example:

1 USD = 1,450912 BAM 1,450912 BAM/USD

1 EUR = 1,955830 BAM 1,955830 BAM/EUR

Calculate exchange rate of EURhow many dollars for one euro (USD/EUR)?

value of EUR in BAM / value of USD in BAM

(new reference valute in BAM / new accounting value in BAM)

1,955830 BAM/EUR / 1,450912 BAM/USD

1,955830 / 1,450912 x BAM/EUR x USD/BAM = 1,3480 USD/EUR


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2.3. Functions

Exchange rates play a central role in international trade, because they

enable us to compare the prices of goods and services produced in

different countries and conversion of value.

Exchange rate is an important factor for investment decision making

process.

Exchange rate serves as an instrument for adjustment.


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Exchange rates are determinated in the foreign exchange market by

market forces - both supply and demand conditions.

The real (equilibrium) exchange rate is the exchange rate that equalizes

supply and demand in the foreign exchange market; it is the rate thatclearsthe market.


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D

eviznikurs(izraen

uKMz

a)

Iznos inozemne valute

D SKM /

Potranja

za Ponuda

2

E

E the equilibrium exchange rate;


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Supply of foreign exchange:

supply of foreign exchange refers to the amount of foreign exchange

that will be offered to the market at various exchange rates, all other

factors held constant.

Supply of foreign exchange results from credit (active) transactions ofthe balance of payments, such as:

export of goods,

export of services,

unilateral transfers from abroad,

income from investment,

inflow of foreign capital;

supply schedule has a positive slope, because supply increases when the

exchange rate increases;


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Demand for foreign exchange:

Demand for foreign exchange is derived from debit (passive)

transactions of the balance of payments, such as:

import of goods,

import of services,

unilateral transfers from a country, income of foreign investment,

outflow of capital;

demand schedule has a negative (declining) slope, because it varies

inversely with the exchange rate;


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Two components:

par value relation of the domestic currency to some conventionalcommon denominator (gold, dollar or SDR); the external value of acurrency;

purchasing power parity - value of a currency expressed in the quantity

of goods that could be buy for an unit of the currency; internal value of acurrency;


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Terms depreciation and devaluationas well as appreciation and

revaluationare not synonyms:

depreciationa real decrease in a currency value; decreasing of

its internal value (purchasing power);

appreciationa real increase in a currency value; increasing ofits internal value (purchasing power);

devaluation an official reduction of a currency value

(reduction of the external value - par value) by a formal act of

monetary authorities;

revaluation an official increasing of a currency value(increasing of the external valuepar value) by a formal act of

monetary authorities;


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depreciation/devaluation weakening of domestic currency (increase

of exchange rate) domestic goods cheaper for foreigners increase

in export

appreciation/revaluation strengthening of domestic currency (decline

of exchange rate) domestic goods more expensive for foreigners

increase in import


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Quotation Change in

exchange rate

Apreciat ion/

Revaluat ion

Depreciat ion/

Devaluat ion

Direct

quotation

ER foreign

currency

domestic

currency

ER domestic

currency

foreign

currency

Indirect

quotation

1/ER domestic

currency

foreign

currency

1/ER foreign

currency

domestic

currency


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the real (equilibrium) exchange ratestimulates a rational allocation ofresources and shows level of competitiveness of a country;

overvalued currency:

official value (par value) > purchasing power

makes import cheaper, stimulates import and consumption; works

inflatory;

method of correctiondevaluation;

undervalued currency:

official value (par value) < purchasing power

makes domestic goods cheaper for foreigners thus stimulates export

and allocation of resources towards export industries;

method of correctionrevaluation;


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4. Conclusion

A prominent interdependence exists between balance of payments

accounts and exchange rate.

Exchange rate is a price of one currency (a reference currency) in terms

of another currency (a base or accounting currency).

Exchange rates could be quoted directly or indirectly.

Exchange rates are determinated in the foreign exchange market by

supply and demand conditions.

Depreciation/devaluation means decrease in a currency value, and

apreciation/revaluation means increase in a currency value.

http://www.youtube.com/watch?v=xwtgByffoUw


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5. Literature

Carbaugh Robert, International Economics, Eighth Edition, South-Western,

2002

KovaeviRadovan, Meunarodnefinansije,Ekonomski fakultet Univerziteta u

Beogradu, Beograd, 2011.

Krugman Paul, Maurice Obstfeld, InternationalEconomics: Theory and Policy,

8th Edition, Prevod, MATE, Zagreb, 2009. Salvatore Dominick, InternationalEconomics,Ninth Edition, Wiley, 2007

Stojanov Dragoljub, Meunarodne finansije u globalnoj ekonomiji, IV

izmijenjeno i dopunjeno izdanje, Ekonomski fakultet u Sarajevu, Sarajevo, 2000.


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Literature, Lessons for Exam and Essay Questions

Literature:

Paul Krugman, Maurice Obstfeld, InternationalEconomicsTheory

and Policy,Seventh Edition;

Slides;

Lessons for Exam: pp. 306-334.; slides;

Essay Questions:

Exchange Rate and Foreign Exchange Market

Exchange Rate Regimes

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Lecture 11 Exchange Rate

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