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What is "Foreign Exchange Currency"?

 

A currency is a unit of exchange, facilitating the transfer of goods and services. A medium of exchange, a store of value, and a standard of value. A currency is the dominant medium of exchange.

 

To facilitate trade between currency zones, there are exchange rates, which are the prices at which currencies (and the goods and services of individual currency zones) can be exchanged against each other. Currencies can be classified as either floating currencies or fixed currencies based on their exchange rate regime. 

 

Other Currency pages from KookyPlan:

 

• predicting trends in foreign exchange rates  (for speculating)
• foreign currency trading  (for practical tips, and current exchange rates)
• currency hedging  (for protecting yourself / your company against currency markets)

 

 

 

Table of Contents: 

What is "Foreign Exchange Currency"? Risk Management Exchange rate currency issues Different types of exchange rates A system of fixed exchange rates flexible or floating Managed exchange rates Today’s Hybrid System Depreciation / Appreciation Fixed Exchange vs. Floating (example) Question #1. Why cant they use monetary policy to stimulate their economies? Question #2. Why would fiscal expansion be effective (if they could tolerate higher budget deficits)? Question #3. Why would a depreciation of the exchange rate produce both higher output and lower government deficit? A Brief History of currency Markets: History of US monetary & FX policy (in Brief) Links from KookyPlan...see also: External Links: Forex Education: External Links for finding FX info External Links about Currency Trading Lessons about Global Finance:  Annenberg foundation videos 1. Trade—An Introduction 2. Protectionism vs. Free Trade 3. Trade Policy 4. Trade Liberalization and Regional Trade Blocs 5. Labor and Capital Mobility 6. Multinational Corporations 7. Fixed vs. Floating Exchange Rates 8. Managing Currencies and Policy Coordination 9. Exchange Rates, Capital Flight, and Hyperinflation 10. Developing Countries 11. Economies in Transition 12. Environment 13. The Evolving World Economy Books about FX trading from Amazon.com

 

 

Risk Management

 

There are three types of risks associated with currencies

1. Accounting risk - the risk that foreign operations will look less profitable on paper due to currency movements
2. Operational risk - risk that currency depreciation in some part of world will cause disruption to your business
3. Competitive risk - risk that a foreign company will suddenly be more competitive because their currency devalued.

 

For a discussion about how to deal with these risks, you should study currency hedging

 

 

 

Exchange rate currency issues

 

Foreign trade involves the use of different national currencies.

The foreign exchange rate is the price of one Currency in terms of another currency.

 

The foreign exchange rate is determined in the market where different currencies are traded.

 

 

Different types of exchange rates

 

The central element of the international monetary system involves the arrangements by which exchange rates are set. In recent years, nations have used one of three major exchange rate systems:

 

A system of fixed exchange rates

fixed exchange rate occurs when a government fixes its exchange rate, and it must “intervene” in foreign exchange markets to maintain the rate.

 

Government exchange rate intervention occurs when the government buys or sells foreign exchange to affect exchange rates.

 

One approach is to intervene by buying the depreciating (peso) currency and selling the appreciating currency (dollars). This will increase the demand for pesos and maintain the official parity.

 

An alternative would be to use monetary policy. Induce private sector to increase its demand for peso by raising interest rates. This would lead investors to move funds into pesos and increase the private demand for pesos.

 

Problem, however, the need to use monetary policies to manage the exchange rate can collide with the need to use monetary policy to stabilize the domestic business cycle.

 

 

flexible or floating

A system of flexible or floating exchange rate, where exchange rates are determined by market forces

 

A country has flexible exchange rates when exchange rates move purely under the influence of supply and demand. The government neither announces an exchange rate nor takes steps to enforce one.

 

Flexible exchange rates are used by 3 major economic regions (USA, Euroland, Japan).  For these 3 regions, the movements of exchange rates are determined almost entirely by private supply and demand for goods, services and investment.

 

 

Managed exchange rates

- in which nations intervene to smooth exchange rate fluctuations or to move their currency toward a target zone.

 

Exchange rates are basically determined by market forces but governments buy or sell currencies or change their money supplies to affect their exchange rates.

Sometimes governments lean against the winds of private markets. At other times governments have “target zones” which guide their policy actions.

 

 

Today’s Hybrid System

 

Today’s exchange rate system fits into no tidy mold. The world has moved to a hybrid exchange rate system.

Features:

 

• A few countries allow their currencies to float freely – a country allows markets to determine its currency’s value and it rarely intervenes.

• Some major countries have managed but flexible exchange rates – a country will buy or sell its currency to reduce the day to day volatility of currency fluctuations. A country will sometimes engage in systematic intervention to move its currency toward what it believes to be a more appropriate level.

• Many countries, peg their currencies in a fixed exchange rate. Sometimes, the peg is allowed to glide smoothly upward or downward in a system known as a gliding or crawling peg.

• Almost all countries tend to intervene either when markets become “disorderly” or when exchange rates seem far out of line with the “fundamentals”, when they are inappropriate for existing price levels and trade flows.

 

When a country adopts a fixed exchange rate, it faces an inescapable fact: Real output and employment must adjust to ensure that its relative prices are aligned with those of its trading partners.

 

Depreciation / Appreciation

 

When a country’s currency falls in value relative to that of another country, we say that the domestic currency has undergone depreciation while the foreign currency has undergone an appreciation.

 

When a country’s official foreign exchange rate is lowered, we say that the currency has undergone devaluation. An increase in the official foreign exchange rate is called a revaluation.

 

 

 

Fixed Exchange vs. Floating (example)

 

Consider the example of small open economies like Belgium and the Netherlands that have highly mobile financial capital and fixed exchange rates but also have high government budget deficits. Suppose that these countries find themselves in a depressed economic condition, with low output and high unemployment. Explain why they cannot use monetary policy to stimulate their economies. Why would fiscal expansion (fiscal policy) be effective if they could tolerate higher budget deficits? Why would a depreciation of the exchange rate produce both higher output and a lower government deficit?

 

 

Features:

1. Highly mobile financial capital

- sensitive to interest rates & inflation.

- High interest rates will attract financial capital

- High inflation will drive financial capital away

 

2. fixed exchange rates

- likely pegged to dollar or Euro

- Gov’t needs to buy/ sell currency reserves to adjust for imbalance in supply / demand of currency

- PPP will have to fall to adjust, rather than FX

 

3. High government budget deficits

- High current account deficit will mean that there will need to be a high financial account surplus to keep the balance of payments.

 

4. depressed economic conditions (low output & high unemployment)

- Internal pressure from population for improvement

- Federal Reserve will want to stimulate the economy either by

(a) monetary policy – expansion of the money supply (lower

interest rates)

(b) fiscal policy – increase government spending to multiply

consumption and investment.

 

 

Question #1. Why cant they use monetary policy to stimulate their economies?

 

Because in a fixed exchange rate system, the country has given up control of their currency, and therefore they also have given up control of the interest rate.  With a fixed exchange rate, they must keep their interest rate exactly the same as the country to which they pegged their exchange rate. For example; if they pegged their FX rate to the US dollar, then they need to keep their interest rate exactly the same as the US interest rate (adjusted for overall country risk premium). If they allowed their interest rate to deviate, then investors could easily move their money to exploit the difference. See interest rate parity  and Mundell trilemma for more discussion.

 

In the absence of interest rate controls, a government can not use monetary policy to stimulate their economy.

 

note:  the monetary policy uses instruments to control the interest rates in order to control the level of investment (and consumption, net export).

 

 

Question #2. Why would fiscal expansion be effective (if they could tolerate higher budget deficits)?

 

In the absence of monetary policy, another way for a government to stimulate the economy is through the use of fiscal policy.

 

By embarking on a policy of fiscal expansion, a government can set of a chain of events to stimulate the economy. By spending money on road construction, for example, a government will pay the salaries of the workers, who in turn go out and spend some of that money on other products, and the sellers of those products go out and spend money on other products. This is what is called the “government expenditure multiplier”.

 

But, how does the government raise the money in order to embark on this spending binge? One way is to raise taxes, but if the goal is to stimulate the economy, than raising taxes will be counter productive. The other way for the government to raise this mony is to borrow from abroad. The drawback to borrowing from abroad is that it must be repaid (unlike taxes), and it results in higher budget deficits.

 

This course of action should only be taken if the government feels confident that it can tolerate the higher budget deficits.

 

 

Question #3. Why would a depreciation of the exchange rate produce both higher output and lower government deficit?

 

Lowering the value of their currency (depreciating) would have two very positive effects on the country:

 

 

1. Higher national output:

 

  Increased net exports:

• By lowering the value of their currency related to other currencies (in the world), they would therefore increase foreign demand for their products. Exports would increase, and imports would decrease. An increase in net exports would increase GDP.
  • Increased investment and consumption.
• By lowering the value of their currency, they would decrease foreigners desire to purchase financial assets in their country. This would result in a lower demand for money, resulting in a lower interest rate. The lowered interest rate would result in an increased level of investment by the countries businesses, and an increased level of automobile and house purchases by the consumers. All of these factors combined would result in an increased national output.

 

Note:  In a fixed (pegged) exchange rate system, the government could either float the currency (and allow it to depreciate), or they could devalue the currency (by setting a new, lower fixed value).  It is safe to assume that the currencies of these countries are “fixed” at a value that is above the equilibrium clearing exchange rate. In that case, the supply will be greater than demand for those currencies. In order to maintain the higher exchange rate level, the governments of these countries must step in and buy up the excess supply of their currencies. If they did not do this, then their exchange rates would fall until reaching the equilibrium level.

 

2. Lower government deficit:

 

By deciding to stop artificially propping up their currency, the government no longer is forced to purchase the extra supply of currency. Before the devaluation (in a fixed exchange rate system) or the depreciation (in a floating exchange rate system), the government needed to constantly soak up the extra supply. If the rate were to be brought back to an equilibrium situation, then the government would no longer need to constantly purchase this extra currency from the market. The devaluation of the currency, therefore, has a very powerful effect of reducing the government’s deficit.

 

 

A Brief History of currency Markets:

 

The gold standard was the way in which the international monetary system maintained parities until the 1930’s (with a notable interruption during WWI and the years that followed it). Later, at the end of WWII, more than 40 countries signed on to the Bretton Woods agreement, which established a fixed exchange rate system between most of the major world economies.

 

The accord stipulated that the undersigned fixed the value of their currencies in relation to the US Dollar (USD), and that the dollar would be convertible to gold at the fixed price of U$35/ozt. The Bretton Woods lasted until 1971, when President Richard Nixon suspended the USD convertibility to gold and unilaterally changed the USD parity with other international currencies. From 1973 to 1999, the USD, the Japanese Yen and the European currencies operated a “dirty float” exchange system, that is to say the currencies were allowed to move in accordance with market forces but the central bank of each country would intervene to move the exchange rate in one or another direction. In general, exchange rates between the European currencies stayed inside a tight band from 1973. For example the German Mark and the French Franc freely floated with respect to the USD, though they stayed within a tight band between each other most of the time by virtue of an agreement known as the European Monetary System.

 

In January 1999, eleven countries adopted the same currency, the Euro, issued and administered by the European Central Bank (ECB), which floats against the dollar in the same way as the various European currencies did up to 1999. Today, thirteen countries have adopted the Euro, with two more due to join in 2008. After Bretton Woods fell apart, the USD remained the focus of the international monetary system, and evidence to support that abounds. In 2000, more than 70% of international reserves were in USD. However, that proportion has fallen every year, reaching a bit under 65% in 2007. It is the Euro which has gained from the reduction of dollar holdings: Euro assets have gone from a little over 18% of world reserves to nearly 26% in 2007. The British Pound has also gained, to 4.7% of total reserves in 2007.

 

 

History of US monetary & FX policy (in Brief)

 

During the early part of the 1980s, the United States pursued a combination of loose fiscal policy and tight monetary policy, which caused the dollar to appreciate and produced trade and current account deficits that set new records. Rather than altering domestic macroeconomic policy, the first Ronald Reagan administration actively encouraged capital inflows to finance the fiscal and current account deficits. These policies flooded the United States with imports and put pressure on traded-goods producers that was unprecedented in the postwar period. When these producers complained to the Treasury, they were told that Treasury would not attempt to cap the value of the dollar for their benefit. These groups then complained to Congress, which responded by passing the 1988 Act. Proponents intended this legislation to improve congressional oversight and Treasury's accountability on exchange rate policy.

 

Exchange rates have again become a particularly important issue for Congress in recent years. The issue's return to political prominence has this time been driven largely by objections to China's exchange rate policy. Competition from China has put pressure on US producers, who have complained to Congress that the renminbi is substantially undervalued. Meanwhile, Treasury has refused to cite China in its reports to Congress as a country that "manipulates" its currency, despite unprecedented amounts of foreign exchange intervention by Chinese authorities to restrain the renminbi's appreciation.

 

Frustrated by what they perceive to be the modest results of these discussions, several members of Congress have proposed legislation that, if adopted, would reform the process by which Treasury identifies and responds to currency manipulation and could impose trade restrictions to compensate for the resulting undervaluation. The stakes are high because such provisions would also apply to countries beyond China whose economic strategies have also included substantial undervaluation of their currencies.

 

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Links from KookyPlan...see also:

 

• foreign currency trading

• The US Dollar

• Currency  

• Eurocurrency  

• currency hedging  

• ADR

• Futures market
• forward exchange rate
• foreign exchange Swaps
• foreign exchange Swaps
• Foreign exchange Options ...[spot exchange rate] ...
• fixed exchange rate ...Page name match: fixed exchange rate...
• floating exchange rate ...Page name match: floating exchange rate...
• spot exchange rate ...Page name match: spot exchange rate...
• international marketing ,  
• hedging,  
• Options ,
• Foreign exchange Options  , 
• forward exchange rate ,
• International Finance markets

 

 

 

External Links:

 

Forex Education:

• http://www.babypips.com/school/

 

External Links for finding FX info

 

My favorite:  OANDA.com

 

Others:

•  http://fx.sauder.ubc.ca/ 

• www.exchangerate.com

•  WWW.EXIM.GOV

•  WWW.SECURITIES.COM 

  WWW.IMF.ORG 

• www.forextrading.com
• www.cme.com    (Chicago Mercantile Exchange futures contract exchange rates)

•  www.phlx.com

    (Philadelphia Stock Exchange options contract exchange rates)
• http://www.ino.com/
• ^{http://quotes.ino.com/}

•  www.barchart.com

• www.forexgestion.com
• http://www.oanda.com/convert/fxhistory

  

 

External Links about Currency Trading

 

 

 

 

 

 

Lessons about Global Finance:  Annenberg foundation videos

 

Here is a series of videos from the Annenberg foundation discussing international trade & currency issues.  Each video is about 1 hour long, and gives an excellent background...

 

 

1. Trade—An Introduction

Why nations trade and what determines trade’s basis and direction. Case studies: IBM’s computer production in Japan; Australia’s mineral export boom and domestic car production.

 

2. Protectionism vs. Free Trade

Tariff and nontariff trade barriers and the beneficiaries of protectionism. Case studies: French agricultural subsidies and conflict in the Uruguay Round; voluntary export restraints on Japanese cars into the U.S.

 

3. Trade Policy

Subsidies, regulatory policies, import-competing, and export-promotion. Case studies: Airbus; the Chilean wine industry.

 

4. Trade Liberalization and Regional Trade Blocs

Multilateral trade liberalization and preferential trading arrangements. Case studies: the Canadian-U.S. Free Trade Agreement; the U.K.’s entry into the EC. Updated 2003.

 

5. Labor and Capital Mobility

The mobility of capital, labor, and technology, including what drives and inhibits labor migration. Case studies: guest workers in the Netherlands; Mexican immigration to the U.S. and maquiladoras.

 

6. Multinational Corporations

How capital moves, transfer technology, and the surrounding controversies. Case studies: investment by Ericsson in Hungary; a comparison of Smith-Corona and Brother.

 

7. Fixed vs. Floating Exchange Rates

The strengths and weaknesses of each type of rate, along with their role as shock absorbers. Case studies: Komatsu vs. Caterpillar; petrodollar recycling in the 1970s.

 

8. Managing Currencies and Policy Coordination

What motivates governments to manage currencies and coordinate policies. Case studies: the Plaza and Louvre Accords; the cost to the U.K. of joining the European Monetary System.

 

9. Exchange Rates, Capital Flight, and Hyperinflation

How international capital flows, inflation, and trade flows affect exchange rates. Case studies: Mexico and the money center banks; hyperinflation in Argentina. Updated 2003.

 

10. Developing Countries

How these nations have been helped or hurt by the rapid growth since WWII. Case studies: comparing South Korea and Sri Lanka; aid vs. trade in Tanzania.

 

11. Economies in Transition

Transforming former Communist countries into market economies. Case studies: state industries vs. private entrepreneurs in Russia; the success of Poland’s “shock therapy.”

 

12. Environment

Transnational pollution and international property rights. Case studies: the U.S.-Mexico agreement on dolphin-safe tuna fishing; trans-national pollution along the Rhine River.

 

13. The Evolving World Economy

The importance of human capital and the shift away from manufacturing to services and knowledge-intensive industries. Case studies: the rise of East Asia, especially China; Microsoft and U.S. dominance of the software market. Updated 2003.

 

 

 

Books about FX trading from Amazon.com