Global Monetary Economics

🪅Global Monetary Economics Unit 8 – Exchange Rates and Forex Markets

Exchange rates and forex markets are crucial components of the global financial system. They determine the value of currencies relative to one another, influencing international trade, investment flows, and economic policies. Understanding exchange rate systems, factors affecting currency values, and market dynamics is essential for navigating the complex world of global finance. This knowledge helps policymakers, businesses, and investors make informed decisions in an interconnected economy.

Key Concepts and Definitions

  • Exchange rate measures the value of one currency in terms of another currency
  • Nominal exchange rate unadjusted for inflation (spot rate)
  • Real exchange rate adjusted for inflation and purchasing power differences between countries
  • Appreciation occurs when a currency gains value relative to another currency
  • Depreciation happens when a currency loses value relative to another currency
  • Foreign exchange market (forex) global decentralized market for trading currencies
    • Largest financial market in the world with daily trading volume exceeding $6 trillion
  • Currency pair notation expresses the exchange rate between two currencies (EUR/USD)

Exchange Rate Systems

  • Fixed exchange rate system government or central bank maintains a fixed rate against another currency or basket of currencies
    • Requires intervention in the forex market to maintain the peg
    • Examples include the Bretton Woods system and the European Exchange Rate Mechanism (ERM)
  • Floating exchange rate system market forces of supply and demand determine the exchange rate without government intervention
    • Most major currencies today operate under a floating system (USD, EUR, JPY)
  • Managed float or dirty float central bank occasionally intervenes to influence the exchange rate
    • Aims to reduce excessive volatility or achieve specific economic objectives
  • Currency board arrangement strict form of a fixed exchange rate system
    • Domestic currency is fully backed by foreign reserves at a fixed rate
    • Examples include Hong Kong's peg to the USD and Bulgaria's peg to the EUR

Factors Influencing Exchange Rates

  • Interest rate differentials higher interest rates attract capital inflows, leading to currency appreciation
    • Covered interest rate parity (CIP) condition states that interest rate differentials should equal the forward premium or discount
  • Inflation differentials countries with higher inflation rates tend to experience currency depreciation
    • Purchasing power parity (PPP) theory suggests that exchange rates adjust to equalize the purchasing power of currencies
  • Economic growth and productivity stronger economic performance and productivity gains can lead to currency appreciation
  • Political stability and risk perceptions political instability, geopolitical tensions, or increased risk aversion can trigger capital outflows and currency depreciation
  • Current account balance and trade flows countries with trade surpluses tend to experience currency appreciation, while trade deficits can lead to depreciation
  • Central bank policies monetary policy actions (interest rate changes, quantitative easing) can significantly impact exchange rates
  • Speculative activity and market sentiment speculative trades and shifts in market sentiment can cause short-term exchange rate fluctuations

Forex Market Structure and Participants

  • Decentralized global market operates 24 hours a day, 5 days a week across multiple time zones
  • Spot market immediate exchange of currencies at the current market rate
  • Forward market agreement to buy or sell a currency at a predetermined rate on a future date
  • Futures market standardized contracts traded on exchanges for future delivery of currencies
  • Options market contracts granting the right, but not the obligation, to buy or sell a currency at a specific rate
  • Major participants include commercial banks, central banks, hedge funds, and multinational corporations
    • Interbank market accounts for the majority of forex transactions
  • Retail investors access the market through brokers or online trading platforms

Exchange Rate Theories

  • Purchasing power parity (PPP) theory exchange rates adjust to equalize the purchasing power of currencies
    • Absolute PPP states that the exchange rate between two currencies should equal the ratio of their price levels
    • Relative PPP focuses on the change in exchange rates and inflation rates over time
  • Interest rate parity (IRP) theory interest rate differentials between countries should be offset by expected changes in exchange rates
    • Covered interest rate parity (CIP) incorporates the use of forward contracts to hedge against exchange rate risk
    • Uncovered interest rate parity (UIP) assumes that the expected change in the spot rate compensates for the interest rate differential
  • Balance of payments (BOP) approach exchange rates adjust to ensure equilibrium in the balance of payments
    • Current account balance (trade in goods and services) and capital account balance (financial flows) impact exchange rates
  • Asset market approach views currencies as financial assets, with exchange rates determined by the demand and supply of these assets
    • Factors such as interest rates, inflation, and economic growth influence the attractiveness of a currency

Currency Trading Strategies

  • Technical analysis uses past price and volume data to identify patterns and predict future exchange rate movements
    • Chart patterns (head and shoulders, triangles) and technical indicators (moving averages, RSI) are commonly used
  • Fundamental analysis focuses on economic, financial, and political factors that can affect currency values
    • Traders monitor economic indicators, central bank policies, and geopolitical events to make trading decisions
  • Carry trade involves borrowing in a low-interest-rate currency and investing in a high-interest-rate currency
    • Profits from the interest rate differential, but exposed to exchange rate risk
  • Momentum trading aims to capitalize on strong trends in currency pairs
    • Traders enter positions in the direction of the prevailing trend and exit when the trend reverses
  • Range trading identifies currency pairs trading within a defined range and seeks to profit from buying at the bottom and selling at the top of the range
  • News-based trading involves trading around economic releases, central bank announcements, and other high-impact events
    • Requires quick reactions and effective risk management to navigate volatile market conditions

Economic Impacts of Exchange Rates

  • Trade competitiveness a weaker currency makes exports more competitive and imports more expensive, potentially improving the trade balance
    • Marshall-Lerner condition states that currency depreciation will improve the trade balance if the sum of export and import elasticities exceeds 1
  • Inflation pass-through exchange rate changes can affect domestic prices through the cost of imported goods and raw materials
    • Higher import prices due to currency depreciation can lead to inflationary pressures
  • Economic growth and employment exchange rates influence the competitiveness of a country's exports and the cost of imports, impacting aggregate demand and economic growth
    • Currency appreciation can dampen export-led growth, while depreciation can stimulate exports and domestic production
  • Capital flows and financial stability exchange rate volatility can impact cross-border capital flows and the stability of the financial system
    • Sudden capital outflows due to currency depreciation can lead to balance of payments crises and financial instability
  • Monetary policy transmission exchange rates play a role in the transmission of monetary policy to the real economy
    • Changes in interest rates and exchange rates affect borrowing costs, investment decisions, and overall economic activity
  • Rise of emerging market currencies increasing importance of currencies such as the Chinese Yuan (CNY) and Indian Rupee (INR) in global trade and finance
    • Gradual internationalization of the CNY and its inclusion in the IMF's Special Drawing Rights (SDR) basket
  • Impact of unconventional monetary policies quantitative easing (QE) and negative interest rates have significantly influenced exchange rates and capital flows
    • QE programs in the US, EU, and Japan led to currency depreciation and increased global liquidity
  • Trade tensions and currency manipulation accusations of currency manipulation and the use of exchange rates as a tool in trade disputes (US-China trade war)
    • Tariffs and trade barriers can impact currency values and global trade patterns
  • Brexit and its impact on the British Pound (GBP) uncertainty surrounding the UK's withdrawal from the European Union led to significant volatility in the GBP
    • Concerns over future trade arrangements and economic growth prospects affected the currency
  • Role of cryptocurrencies and stablecoins emergence of decentralized digital currencies and their potential impact on traditional currency systems
    • Stablecoins, such as Tether (USDT) and USD Coin (USDC), aim to provide stability by pegging their value to fiat currencies or other assets


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© 2024 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.