Exchange rate definition, determinants, regimes, and crises

The exchange rate is the most important price in any economy. When the currency appreciates, the country becomes more expensive and less competitive internationally. At the same time its citizens enjoy a greater standard of living as they can buy international products at lower prices. When the currency depreciates, local products become more competitive and exports grow but incomes do not stretch as far when one buys international products. In addition, currency values can change rapidly and drastically as in South East Asia in 1997, wrecking havoc on the economy. Trying to limit the changes in currency values, on the other hand, by implementing, for example, a monetary union as in Europe brings another set of problems. The countries find it difficult to adjust to various economic pressures. We sort out these issues on the following pages.

1. What is the exchange rate?

The exchange rate is the price of one currency expressed in units of another currency. For example, on July 1, 2012, one euro exchanged for 1.25 U.S. dollars. Equivalently, one dollar exchanged for 1/1.25 = 0.80 euro. We say that a currency is appreciating if it becomes more expensive. For example, on July 1, 2003, one euro exchanged for exactly one dollar. From then until 2012, the euro appreciated by 25 percent, i.e. its price increased from 1 dollar to 1.25 dollars. Equivalently, we can say that the dollar depreciated by 25 percent against the euro.

2. Why do we care about exchange rates?

The changes in exchange rates affect us in many ways. Consider the consequences of a depreciating dollar:

- U.S. products become cheaper on international markets and U.S. companies can increase their exports.
- The exporting firms hire more employees and employment increases.
- Foreign-made products become more expensive when they are sold in the U.S. and imports decline.
- The U.S. becomes cheaper for foreign tourists and tourism revenues increase.
- However, it becomes more expensive for Americans to travel internationally.
- The prices of some imported products increase leading to higher inflation.

In short, when the dollar depreciates we could expect an increase in exports and production, a decline of imports, and an increase in prices. The trade deficit will decline. Appreciation of the dollar would have the opposite effects.
3. What factors influence the exchange rate?

As any other price, the price of a currency is determined by demand and supply. Some people, firms or governments want to buy dollars and other people, firms and governments want to sell dollars for other currencies. If the demand for dollars increases, then the dollar would appreciate. If the supply of dollars increases, the dollar would depreciate. So, who wants to trade currencies and for what purpose?

Exporters and importers. For example, in order to buy Japanese cars and to bring them to the U.S., American importers have to buy Japanese yen. They exchange dollars for yen at a bank and then buy the Japanese cars. That transaction creates supply of dollars. Similarly, a Japanese importer who wants to buy American cars would create demand for dollars. In that case, the Japanese has to buy dollars and sell yen.

International investors. To continue with our example, when American investors buy shares on the Japanese stock exchange, they first need to buy Japanese yen. They sell dollars for yen and create supply of dollars. Similarly, when Japanese investors invest in the U.S. they first buy dollars and create demand for the dollar.

Governments. Every country keeps reserves of gold and foreign currencies to be able to pay its international debts, to pay for imports, and other purposes. When the Japanese government decides to increase its reserves of dollars, it sells yen for dollars and creates demand for the dollar. When the U.S. government increases its reserves of yen, it sells dollars for yen and creates supply for the dollar.

Therefore, the dollar appreciates if:

- U.S. exports increase,
- foreign investment in the U.S. increases, or
- governments increase their dollar reserves.

The dollar depreciates if:

- U.S. imports increase,
- foreign investment by U.S. investors increases, or
- governments decrease their dollar reserves.

Consider a few examples:

Example 1: Japan introduces a new tariff on U.S. products making them more expensive on the Japanese market. The Japanese consumers lower their purchase of U.S. products and don’t need as many dollars. The demand for the dollar declines and it depreciates.

Example 2: Interest rates in the U.S. increase, making investment in U.S. financial assets more attractive to foreign investors. They decide to increase their investments in the U.S. bonds and buy dollars to do so. That raises the demand for dollars and the dollar appreciates.

Example 3: Financial investors believe that the euro will depreciate in the near future. Since no one wants to hold investments in a depreciating currency, investors sell euro for dollars. That leads to greater demand for the dollar and it appreciates.

These examples trace the effect one change at a time. In reality, there are many simultaneous influences on the exchange rates that push currency values opposite directions. Interest rates may be changing in several countries at the same time, trade flows may be shifting, and various governments may be buying and selling currencies. Because of all these factors, exchange rate movements are difficult to predict over very short time horizons, e.g. days and weeks. International trade and investment do, however, influence the exchange rate in more predictable ways over months and years.

In the long-run …

In the very long-run, 5-10 years and longer, all of these factors become less important. Investment may first flow into the U.S., then out of it; exports may increase, then decline, imports may decline, then increase, etc. The various factors average out and their combined effect on the exchange rate is nil. Only one factor remains: the printing of money. A country that rapidly prints money and creates inflation will have a depreciating currency. The greater the creation of money, the greater the depreciation.
4. Exchange rate regimes

Countries may adopt various exchange rate regimes depending how much currency flexibility they want. At one extreme is the pure float, where the exchange rate is determined entirely by market conditions without any intervention by the government. The exchange rate changes in response to changes in the demand and supply.

At the other end of the spectrum are fixed exchange rate regimes. The government announces a fixed exchange rate to the dollar, the euro or another currency and intervenes in the currency markets to maintain that value. It will sell domestic currency for foreign currencies to cause depreciation of the domestic money and will buy the domestic currency using its foreign exchange reserves to cause appreciation. These transactions are called “foreign exchange market intervention” and their goal is to keep the exchange rate fixed. In the intermediate case, the government may allow the exchange rate to respond to market conditions and intervene only occasionally to prevent large changes. In that case, the country has a managed floating exchange rate regime.

We can mention a few additional interesting cases. Dollarization is the case when a country adopts the dollar as official money. An example is Ecuador which abandoned its own currency and switched to the dollar. A currency union is a group of several countries that have the same currency. The prime example is the European Monetary Union using the euro. A currency board is a fixed exchange rate regime where the government is obligated by law to maintain very large foreign exchange reserves. Hong Kong has such a policy. The gold standard is a policy where the money in circulation is backed by gold – people can exchange with the government money for gold and gold for money at a fixed rate. That was the prevalent currency policy more than a century ago.

There are very few countries with a pure floating exchange rate regime. Most countries either fix their exchange rates or manage them quite actively. The reason is that, if left to market forces, currency values can change rapidly and create problems. A depreciating currency leads to high inflation as the prices of imported products increase. A fluctuating exchange rate hampers international trade because exporting firms cannot predict what will be their revenue when expressed in local currency. They sell their products in a foreign currency and are interested in its local currency value. For these reasons, governments try to limit the changes in currency values or at least to prevent large changes.

5. Currency crises

A currency crisis, also called a devaluation crisis or an international financial crisis, is a sharp depreciation of the currency of a country. The depreciation usually comes after a period during which the exchange rate has been very stable, even fixed.

For example, in 1994, one dollar could buy about 3 Mexican peso and by the end of 1995 one dollar bought more than 6 peso. The value of the peso declined in half. That is a currency crisis. Another example is the devaluation of the Indonesian rupiah in 1997/98. The value of the rupiah relative to the dollar declined three times.

The inflation produced by the devaluation creates uncertainty and often leads to political unrest as people cannot afford food and other items. Because of that uncertainty, many businesses scale down their investments and their production and the economy slows down. In addition, in a typical emerging market economy, many of the businesses have debt denominated in dollars. When the local currency depreciates, these debts become very expensive to service. The firms collect revenue from sales in local currency but they have to service debt in the much more expensive foreign currency. Some businesses don't make it and close down.

Eventually, the positive effect of the devaluation kicks in. The products made for export are now much cheaper on the international markets because the domestic currency is cheaper. That makes them more competitive. Exports increase and the economy recovers. So, even the worst of crises have an end.

There are three main theories that explain currency crises. They are called the first, second, and third generation models of currency crises due to the timing of their development.

The first generation model was developed in the late 1970’s and attributes crises to fundamental policy problems. The government runs budget deficits and prints money to finance them. That leads to high inflation and lower competitiveness of the exporters. A large trade deficit emerges. Eventually the currency has to depreciate to restore international competitiveness.

The second generation model came into being during the 80’s. In that model, the fundamentals of the economy are relatively fine but a speculative attack may trigger a crisis. Speculators start selling a currency and to take their investments out of the country. To stop them, the central bank raises interest rates in an effort to make domestic investments more attractive. However, the high interest rates hurt consumers and businesses that have taken credit. Eventually, the government lowers the interest rates to help them but the currency depreciates.

The third generation model was developed in response to the Asian financial crisis of 1997. Here too the fundamental of the economy are fine but the country cannot pay its international debts. It has to borrow new money to pay back its old debts. If, however, investors are not willing to lend new money, then the country experiences a “liquidity crisis” and the currency depreciates.

Each of these models can explain different crises. However, it is very difficult to put the correct diagnosis on an unfolding crisis: is it a first, second or third generation type or a mix? Too many things are happening very fast: the currency is plummeting, the government is in disarray, prices are increasing rapidly, the economy is contracting. There is much disagreement about the appropriate response to the crisis. In a few years, then the dust settles down, one can better assess what exactly happened.

Additional resources

Current and historic currency values for all currencies. Available from: www.oanda.com

Information about the European Monetary Union with a lot of historic information, analyses and data. Available from: www.ecb.int

The International Monetary Fund, a wealth of information about all member countries and about international financial markets. Available from: www.imf.org

Recommended academic readings (advanced, with quite a bit of math)

Calvo, Guillermo and Carmen M. Reinhart “Fear of Floating”, National Bureau of Economic Research, Working Paper 7993, November 2000.

Dornbusch, Rudiger. “Expectations and Exchange Rate Dynamics” Journal of Political Economy, 1161-75, 1976.

Krugman, Paul. “A Model of Balance-of-Payments Crises” Journal of Money Credit and Banking, August 1979.

Mundell, Robert. “A Theory of Optimum Currency Areas.” American Economic Review, 657-65, 1961.

Obstfelt, Maurice. “Rational and Self-Fulfilling Balance-of-Payments Crises” American Economic Review, 72-81, March 1986.

Chang, Roberto and Andres Velasco.“The Asian Liquidity Crisis” Federal Reserve Bank of Atlanta Working Paper, July 1998.


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