Chapter 10 – Exchange Rates



Chapter 10 – Exchange Rates THE EXCHANGE RATE Represents the international value of domestic money Exchange rate = e Can be defined as the price of the foreign currency as measured in domestic currency units (rationale: all prices are measured in the same unit) The domestic currency unit becomes stronger if e goes down – one need less local money to buy 1 foreign currency unit. The domestic currency is ‘appreciating’ Equivalently, the domestic currency unit gets stronger if e goes up: one local money unit buys more foreign money EXCHANGE RATE REGIMESFixed The exchange rate is decided by the government. The CB buys / sells foreign exchange in order to maintain the parity at the agreed rate Devaluation / revaluation (legal changes of the parity) is an open optionDollarization, euroization (impossible to alter the parity) A single currency area – can be analysed as a super fixed regime. Between euro area countries: the regime – fixed rates Flexible The exchange rate is determined only by the interplay between supply and demand in the foreign currency market. The CB does not intervene (buy/sell FX) in the market Changes of the parity are referred to as appreciation / depreciationClean floating: no intervention of the CB allowed Managed float: sometimes the CB intervenes to buy / sell currency The euro against major currencies flexible These days fixed exchange rate regimes are out of fashion. Many countries have liberalized currency trades. fixed exchange rates are prone to speculative attacks (example slide 4)Still fixed: Oil exporters, Denmark, a few small countries candidate to the euro (Bulgaria) while Equator has dollarized its economy When analysing interactions between countries that belong to a monetary union, everything goes as if the exchange rate is fixed Euro/dollar, euro/pound, dollar/yen etc: flexible to buy or sell currency THEORIES OF EXCHANGE RATE Long runNo trade off in the goods market (under free trade The ‘law of one price’: for a good i, Pi = e Pi*If Pi < e Pi* buy 1 shirt Short run No trade-off in the capital markets (under free movement of capital) ................
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