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- Economics for Business and Management - Microeconomics
- Economics for Business and Management - Microeconomics
- Marketing Management - Strategic Marketing Planning
- Financial Management - Financial Accounting
- Strategic Management - Strategy and Competitive Advantage
- Economics for Business and Management - Macroeconomics
- General Management - Core Management Competencies
- The Art of Effective Business Negotiation
Exchange Rates and the Balance of Payments
TEACHER: The relative value of different currencies is highly variable. In 1985, a dollar was worth about 3 German marks; in 1994, it was worth only about 1.5 German marks. Why was this change of importance to tourists or to exporters or importers? This is one of the subjects of this Module. The Euro fluctuated from ca. 0.80 to 1.49 US dollar per EUR in the first five years of its existence (The euro was launched on 1 January 1999 as an electronic currency and became legal tender on 1 January 2002)
We must consider several other questions:
1. What are exchange rates, and how are they determined?
2. How are international business transactions carried out?
3. Should there be fixed or flexible exchange rates?
4. What problems have afflicted the international monetary system in recent years?
International Transactions And Exchange Rates
Suppose you want to buy a book from an European publisher, and the book costs 20 euros. To buy the book, you must somehow get euros to pay the publisher, since this is the currency in which the publisher deals. Or, if the publisher agrees, you might pay in dollars, but the publisher would then have to exchange the dollars for euros, because its bills must be paid in euros. Whatever happens, either you or the publisher must somehow exchange dollars for euros, since international business transactions, unlike transactions within a country, involve two different currencies.
If you decide to exchange dollars for euros to pay the European publisher, how can you make the exchange?
STUDENT: The answer is simple. I can buy European euros at a bank.
TEACHER: Correct. And the European euros have a price (expressed in dollars). The bank may tell you that each euro you buy will cost you $0.98. This makes the exchange rate between dollars and euros .98 to 1, since it takes .98 dollars to purchase 1 euro.
In general, the exchange rate is simply the number of units of one currency that exchanges for a unit of another currency.
STUDENT: What determines the exchange rate? Why is the exchange rate between European euros and U.S. dollars what it is?
TEACHER: Good questions. Let me answer them:
Exchange rates under the gold standard
We’ll discuss a bit of the history of exchange rates.
Let's see how exchange rates were determined under the gold standard, which prevailed before the 1930s. If a country was on the gold standard, a unit of its currency was convertible into a certain amount of gold. Before World War 1 the dollar was convertible into one-twentieth of an ounce of gold, and the British pound was convertible into one-quarter of an ounce of gold. Thus, since the pound exchanged for 5 times as much gold as the dollar, the pound exchanged for $5. The currency of any other country on the gold standard was convertible into a certain amount of gold in the same way; to see how much its currency was worth in dollars, you divided the amount of gold a unit of its currency was worth by the amount of gold (one-twentieth of an ounce) a dollar was worth.
The Foreign Exchange Market
The gold standard is long gone. After many decades of fixed exchange rates (discussed later), the major trading nations of the world began to experiment with flexible exchange rates in early 1973.
Let's consider a situation where exchange rates are allowed to fluctuate freely, like the price of any commodity in a competitive market. In a case of this sort, exchange rates, like any price, are determined by supply and demand. There is a market for various types of currencies - American dollars, European euros, British pounds, Japanese yen, and so on - just as there are markets for any other commodity.
The Demand And Supply Sides Of The Market
Let's look in more detail at the demand and supply sides of the market using the dollar vs. the euro as example. On the demand side are people who want to import European goods into the United States, people who want to travel in Europe (where they'll need European money), people who want to make investments in Europe, and others with dollars who want European currency for different reasons.
The people on the supply side are those who want to import U.S. goods into Europe, Europeans who want to travel in the United States (where they'11 need U.S. money), people with euros who want to invest in the United States, and others with euros who want U.S. currency for other reasons.
When Americans demand more European goods, the price (in dollars) of the European euro will tend to increase. Thus the result will be an increase in the equilibrium price (in dollars) of an euro. Conversely, when the Europeans demand more U.S. goods, the price (in dollars) of the European euro will tend to decrease.
Appreciation And Depreciation Of A Currency
Two terms frequently encountered in discussions of the foreign exchange market are appreciation and depreciation. When Country A's currency becomes more valuable relative to Country B's currency, Country A's currency is said to appreciate relative to that of Country B, and Country B's currency is said to depreciate relative to that of Country A. This use of terms makes sense. Since the number of dollars commanded by an euro increased, the euro became more valuable relative to the dollar and the dollar became less valuable relative to the euro.
Note that such a change in exchange rates would not have been possible under the gold standard. Unless a country changed the amount of gold that could be exchanged for a unit of its currency, exchange rates were fixed under the gold standard. Sometimes governments did change the amount of gold that could be exchanged for their currencies. For example, in 1933 the United States increased the price of gold from $21 an ounce to $35 an ounce. When a country increased the price of gold, this was called a devaluation of currency.
Determinants Of Exchange Rates
STUDENT: We saw that flexible exchange rates are determined by supply and demand. But what are some of the major factors determining the position of these supply and demand curves?
TEACHER: Let me describe the most important ones:
Relative price levels
In the long run, the exchange rate between any two currencies may be expected to reflect differences in the price levels in the two countries. To see why, suppose that Europe and the United States are the only exporters or importers of automobiles and that automobiles are the only product they export or import.
If an automobile costs $10,000 in the United States and 10,000 euros in Europe, what must be the exchange rate between the dollar and the euro? Clearly, an euro must be worth one dollar, because otherwise the two countries' automobiles would not be competitive in the world market. If an euro were set equal to 1.50 dollar, this would mean that a European automobile would cost $15,000 (that is, 10,000 times $ 1.50), which is far more than what a U.S. automobile would cost. Thus foreign buyers would obtain their automobiles in the United States.
Based on this theory, one would expect that if the rate of inflation in Country A is higher than in Country B, Country A's currency is likely to depreciate relative to Country B's.
Relative rates of growth
Although relative price levels may play an important role in the long run, other factors tend to exert more influence on exchange rates in the short run. In particular, if one country's rate of economic growth is higher than the rest of the world’s, its currency is likely to depreciate. If a country's economy is booming, this tends to increase its imports. If a country's imports tend to grow faster than its exports, its demand for foreign currency will tend to grow more rapid1y than the amount of foreign currency that is supplied to it. Consequently, its currency is likely to depreciate.
Relative interest rate levels
If the rate of interest in Europe is higher than in the United States banks, multinational corporations, and other investors in the United States will sell dollars and buy euros in order to invest in the high-yielding European securities. Also, European investors (and others) will be less likely to find U.S. securities attractive. Thus the euro will tend to appreciate relative to the dollar, since the demand curve for euros will shift to the right and the supply curve for euros will shift to the left. In general, an increase in a country’s interest rates leads to an appreciation of its currency, and a decrease in its interest rates leads to a depreciation of its currency. In the short run, interest rate differentials can have a major impact on exchange rates, since there is a huge amount of funds that is moved from country to country in response to differentials in interest rates.
STUDENT: I assume inflation is also a factor, except in the very short run. Otherwise the speculators would be falling into a trap, confusing nominal with real interest rates.
TEACHER: You are certainly right. This is an important consideration.
STUDENT: And under flexible exchange rates, what ensures a balance in the exports and imports between countries?
TEACHER: Let's take a look at:
The Adjustment Mechanism Under Flexible Exchange Rates
Under flexible exchange rates, the balance is achieved through changes in exchange rates. Suppose that for some reason Britain is importing far more from the US than the US is from Britain. This will mean that the British, needing dollars to buy American goods, will be willing to supply pounds more cheaply. Or, from Britain's point of view, the price (in pounds) of a dollar will have been bid up by the swollen demand for imports from the United States.
Because of the increase in the price (in pounds) of a dollar, American goods will become more expensive in Britain. Thus the British will tend to reduce their imports of US goods. At the same time, since the price (in dollars) of a pound has decreased, British goods will become cheaper in the United States, and this will stimulate Americans to import more from Britain. Consequently, as the US currency appreciates in terms of the pound -or, to put it another way, as the pound depreciates in terms of the dollar- the British are induced to import less and export more. Thus there is an automatic mechanism (just as there was under the gold standard) to bring trade between countries into balance.
Fixed Exchange Rates
Although many economists believed that exchange rates should be allowed to fluctuate, very few exchange rates really did so in the period from the end of World War II up to 1973. Instead, most exchange rates were fixed by government action and international agreement. Although they may have varied slightly about the fixed level, the extent to which they were allowed to vary was small. Every now and then, governments changed the exchange rates, for reasons discussed below, but for long periods of time, they remained fixed.
If exchange rates remain fixed, the amount demanded of a foreign currency may not equal the amount supplied, forcing government intervention to keep the exchange rate fixed.
Types Of Government Intervention
To maintain exchange rates at their fixed levels, governments can intervene in a variety of ways. For example, they may reduce the demand for foreign currencies by reducing defense expenditures abroad, by limiting the amount that their citizens can travel abroad, and by curbing imports from other countries.
When exchange rates are fixed, mismatches of this sort cannot be eliminated entirely and permanently. To deal with such temporary mismatches, governments enter the market and buy and sell their currencies in order to maintain fixed exchange rates. Take the case of post-World War II Britain. At times the amount of British pounds supplied exceeded the amount demanded. Then the British government bought up the excess at the fixed exchange rate.
At other times, when the quantity demanded exceeded the amount supplied, the British government supplied the pounds desired at the fixed exchange rate. As long as the equilibrium exchange rate was close to (sometimes above and sometimes below) the fixed exchange rate, the amount of its currency the government sold at one time equaled, more or less, the amount it bought at another time.
But in some cases governments have tried to maintain a fixed exchange rate far from the equilibrium exchange rate, but such a situation can not go on indefinitely.
Balance-of-Payments Deficits And Surpluses
Under a system of fixed exchange rates, economists and financial analysts look at whether a country has a balance-of-payments deficit or surplus to see whether its currency is above or below its equilibrium value.
STUDENT: What is a balance-of-payments deficit? What is a balance-of-payments surplus?
TEACHER: I will explain, since it is important that both these terms be clearly understood.
The Balance-Of-Payments Deficit
If a country's currency is overvalued (that is, if its fixed price exceeds the equilibrium price), the quantity supplied of its currency will exceed the quantity demanded.
In a situation of this sort, there may be a run on the overvalued currency. Suppose that speculators become convinced that the country with the balance-of-payments deficit cannot maintain the artificially high price of its currency much longer because its reserves are running low. Because they will suffer losses if they hold on to a currency that is devalued, the speculators are likely to sell the overvalued currency in very large amounts, and thus cause an even bigger balance-of-payments deficit for the country with the overvalued currency. Faced with the exhaustion of its foreign exchange reserves, the country is likely to be forced to allow the price of its currency to fall.
The Balance-of-Payments Surplus
If a country's currency is undervalued (that is, if its price is less than the equilibrium price), the quantity demanded of its currency will exceed the quantity supplied..
While a country with an overvalued currency is likely to be forced by the reduction in its reserves to reduce the price of its currency, a country with an undervalued currency is unlikely to be forced by the increase in its reserves to increase the price of its currency. And a country with an undervalued currency often is reluctant to increase the price of its currency, because of political pressures by its exporters (and their workers), who point out that such a revaluation would make the country's goods more expensive in foreign markets and thus would reduce its exports. Consequently, when exchange rates were fixed, countries with undervalued currencies were less likely to adjust their exchange rates than countries with overvalued currencies.
TEACHER: How do you think we could measure deficits and surpluses?
STUDENT: Well, if we are given the demand and supply curves for a country's currency, it is a simple matter to determine the deficit or surplus in its balance of payments. All we have to do is subtract the quantity demanded of the currency from the quantity supplied.
TEACHER: True, in theory. However, since we do not observe these demand and supply curves in the real world, this method of determining the deficit or surplus, while fine in principle, is not practical. The available data show only the total amount of the country's currency bought and the total amount of the country’s currency sold. Since each unit of the country's currency that is bought must also be sold, it is evident that the total amount bought must equal the total amount sold.
STUDENT: Given that this is the case, how can one identify and measure a balance-of-payments deficit or surplus?
TEACHER: The answer lies in the transactions of the country’s central bank. If the central bank’s purchases or sales of currency make up for the difference between the quantity demanded and the quantity supplied, it will purchase currency if there is a balance-of-payments deficit and sell currency if there is a balance-of-payments surplus. The amount it purchases or sells measures the size of the deficit or surplus. In other words, the official transactions of this country's government with other governments are used to measure the deficit or surplus. Rough1y speaking, this is how a balance-of-payments deficit or surplus was traditionally measured.
However, beginning in May 1976, the U.S. and other countries stopped publishing figures on the deficit or surplus in its balance of payments. Under the current regime of flexible exchange rates, changes in demand and supply for foreign exchange generally show up as changes in exchange rates, rather than in the transactions of the central bank.
Exchange Rates: Pre-World War II Experience
Now that we are familiar with a balance-of-payments deficit and surplus, we can begin to see how various types of exchange rates have worked out.
During the latter part of the nineteenth century, the gold standard seemed to work very well, but serious trouble developed after World War I. During the war, practically all the warring nations went off the gold standard to keep people from hoarding gold or from sending ¡t to neutral countries. After the war, some countries tried to reestablish the old rates of exchange. Because the wartime and postwar rates of inflation were greater in some countries than in others, under the old exchange rates the goods of some countries were underpriced and those of other countries were overpriced. According to the doctrines of David Hume, this imbalance should have been remedied by increases in the general price level in countries where goods were underpriced and by reductions in the general price level in countries where goods were overpriced.
But wages and prices proved to be inflexible, and, as one would expect, it proved especially difficult to adjust them downward. When the adjustment mechanism failed to work quickly enough, the gold standard was abandoned.
During the 1930s, governments tried various schemes. This was the time of the Great Depression, and governments were trying frantically to reduce unemployment. Sometimes a government allowed the exchange rate to be flexible for a while, and, when it found what seemed to be an equilibrium level, fixed the exchange rate there. Sometimes a government depreciated the value of its own currency relative to those of other countries in an attempt to increase employment by making its goods cheap to other countries. When one country adopted such policies, others retaliated; this caused a reduction in international trade and lending, but little or no benefit for the country that started the fracas.
The Gold-Exchange Standard
In 1944, the Allied governments (in World War II) sent representatives to the American city of Bretton Woods, New Hampshire, to work out a more effective system for the postwar era. It was generally agreed that competitive devaluations, such as occurred in the 1930s, should be avoided. Out of the Bretton Woods conference came the International Monetary Fund (IMF), which was set up to maintain a stable system of fixed exchange rates and to ensure that when exchange rates had to be changed because of significant trade imbalances, disruption was minimized.
The system developed during the postwar period was generally labeled the gold-exchange standard, as opposed to the gold standard. Under this system, the dollar -which had by this time taken the place of the British pound as the world's key currency- was convertible (for official monetary purposes only) into gold at a fixed price. And since other currencies could be converted into dollars at fixed exchange rates, other currencies were convertible indirect1y into gold at a fixed price.
During the early postwar period, the gold-exchange standard worked reasonably well. However, it was not too long before problems began to develop.
When exchange rates are fixed, a U.S. balance-of-payments deficit is evidence of pressure on the dollar in foreign exchange markets. During the period from 1950 to 1972 (the last on March 1973). representatives of the major trading nations met in Paris to establish a system of fluctuating exchange rates, and thus abandoned the Bretton Woods system of fixed exchange rates. This was a major break with the past, and one that was greeted with considerable apprehension as well as hope. However, the major trading nations did not go so far as to establish completely flexible exchange rates. Instead, the float was to be managed. Central banks would step in to buy and sell their currency. Thus the United States agreed that "when necessary and desirable" it would support the value of the dollar. Also, some European countries decided to maintain fixed exchange rates among their own currencies, but to float jointly against other currencies.
Fixed Versus Flexible Exchange Rates
STUDENT: Why, until 1973, did most countries fix their exchange rates rather than allow them to fluctuate?
TEACHER: One important reason was the feeling that flexible exchange rates might vary so erratically that it might be difficult to carry out normal trade. Thus U.S. exporters of machine tools to Britain might not know what British pounds would be worth six months from now, when they would collect a debt in pounds. According to the proponents of fixed exchange rates, fluctuating rates would increase uncertainties for people and firms engaged in international trade and thus reduce the volume of such trade. Moreover, they argued, the harmful effects of speculation over exchange rates would increase if exchange rates were flexible, because speculators could push a currency's exchange rate up or down and destabilize the exchange market. They argued further that flexible exchange rates might promote more rapid inflation, because countries would be less affected by balance-of-payments discipline.
Many economists disagreed, feeling that flexible exchange rates would work better. They asked why flexible prices are used and trusted in other areas of the economy, but not in connection with foreign exchange. They pointed out that a country would have more autonomy in formulating its fiscal and monetary policy if exchange rates were flexible, and they claimed that speculation regarding exchange rates would not be destabilizing. But until 1973, the advocates of flexible exchange rates persuaded few of the world's central bankers and policymakers.
STUDENT: How well have floating exchange rates worked?
TEACHER: Since 1973, exchange rates have been flexible, not fixed. However, there has been some intervention by central banks to keep the movement of exchange rates within broad bounds, but this intervention generally has not been very great. The result has been considerable volatility in exchange rates. The exchange rate between the dollar and the European euro has sometimes varied by 2 percent or more from one day to the next and by 15 percent or more over a period of several months. The value of the dollar (in terms of other major currencies) has gyrated substantially during the past 20 years.
Unquestionably, the variations in exchange rates, some of which are erratic and without fundamental economic significance, have made international transactions more difficult. Thus Renault, the French auto manufacturer, is reported to have hesitated to launch an export drive into the U.S. market because of the erratic behavior of the dollar-franc exchange rate.
- Sem1.Effective Business Negotiation (8)
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- Sem2.Economics for Business and Management - Macroeconomics (8)
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