Exchange Rates and

International Macroeconomics
What Is an Exchange Rate?

An exchange rate is a rate at which one currency will be exchanged for another currency and affects trade
and the movement of money between countries.

Exchange rates are impacted by both the domestic currency value and the foreign currency value. In July
2022, the exchange rate from U.S. Dollars to the Euro was 1.02, meaning it takes $1.02 to buy €1.

Understanding Exchange Rates

The exchange rate between two currencies is commonly determined by the economic activity, market
interest rates, gross domestic product, and unemployment rate in each of the countries. Commonly called
market exchange rates, they are set in the global financial marketplace, where banks and other financial
institutions trade currencies around the clock based on these factors. Changes in rates can occur hourly or
daily with small changes or in large incremental shifts.

An exchange rate is commonly quoted using an acronym for the national currency it represents. For
example, the acronym USD represents the U.S. dollar, while EUR represents the euro. To quote the
currency pair for the dollar and the euro, it would be EUR/USD. In the case of the Japanese yen, it's
USD/JPY or dollar to yen. An exchange rate of 100 means that 1 dollar equals 100 yen.
How Exchange Rates Fluctuate

Exchange rates can be free-floating or fixed. A free-floating exchange rate rises

and falls due to changes in the foreign exchange market. A fixed exchange rate is
pegged to the value of another currency. The Hong Kong dollar is pegged to the
U.S. dollar in a range of 7.75 to 7.85.

This means the value of the Hong Kong dollar to the U.S. dollar will remain
within this range.

Exchange rates have what is called a spot rate, or cash value, which is the
current market value. Alternatively, an exchange rate may have a forward value,
which is based on expectations for the currency to rise or fall versus its spot
price.
Forward rate values may fluctuate due to changes in expectations for future interest rates in one country
versus another. If traders speculate that the eurozone will ease monetary policy versus the U.S., they may
buy the dollar versus the euro, resulting in a downward trend in the value of the euro.

Exchange Rate Example

A traveler to Germany from the U.S. wants 200 USD worth of EUR when arriving in Germany. The sell rate is
the rate at which a traveler sells foreign currency in exchange for local currency. The buy rate is the rate at
which one buys foreign currency back from travelers to exchange it for local currency.

If the current exchange rate is 1.05, $200 will net €190.48 in return.

In this case, the equation is: dollars ÷ exchange rate = euro

$200 ÷ 1.05 = €190.48

After the trip, suppose €66 is remaining. If the exchange rate has dropped to 1.02, the change from euros to
dollars will be $67.32.

€66 x 1.02 = $67.32

The Japanese yen is calculated differently. In this case, the dollar is placed in front of the yen, as in USD/JPY.
The equation for USD/JPY is: dollars x exchange rate = yen

If a traveler to Japan wants to convert $100 into yen and the exchange rate is 110, the traveler would get
¥11,000. To convert the yen back into dollars one needs to divide the amount of the currency by the exchange
rate.

$100 x 110 = ¥11,000.00

-or-

¥11,000.00/110= $100
How Do Exchange Rates Affect the Supply and Demand of Goods?

Changes in exchange rates affect businesses by changing the cost of supplies that are purchased from a different
country, and by changing the demand for their products from overseas customers.

What Is the FOREX?

The forex market, or foreign exchange market, allows banks, funds, and individuals to buy, sell or exchange currencies.
The market operates 24 hours, 5.5 days a week, and is responsible for trillions of dollars in daily trading activity as
traders look to profit by betting that a currency's value will either appreciate or depreciate against another currency.

What Is a Restricted Currency?

Exchange rates can differ within the same country. Some countries have restricted currencies, limiting their exchange to
within the countries' borders and often there is an onshore rate and an offshore rate. A more favorable exchange rate
can often be found within a country's borders versus outside its borders and a restricted currency has its value set by
the government. China is an example of a country that has this rate structure and a currency that is controlled by the
government. Every day, the Chinese government sets a midpoint value for the currency, allowing the yuan to trade in a
band of 2% from the midpoint.
The Role of Exchange Rates in International Trade

Exchange rates play a fundamental role in facilitating international trade by determining the value of one
currency relative to another. These rates serve as a crucial pricing mechanism, influencing the
competitiveness of exports and imports, as well as the overall balance of trade between countries.
Understanding the dynamics of exchange rates is essential for businesses, policymakers, and investors
involved in global commerce.

Determinants of Exchange Rates:

Several factors influence exchange rates, including economic fundamentals, monetary policy, market
sentiment, and geopolitical events. For instance, interest rate differentials between countries can attract
capital flows, affecting currency demand and exchange rates. Similarly, economic indicators such as GDP
growth, inflation rates, and trade balances can influence currency valuations. Central bank interventions,
through measures like open market operations or foreign exchange market interventions, also play a role
in shaping exchange rate movements.
Impact on Exporters and Importers:

Exchange rate fluctuations directly impact exporters and importers by affecting the prices of goods and services
traded internationally. A depreciation of a country's currency relative to its trading partners can make its exports
cheaper and more competitive in foreign markets, potentially boosting export volumes and revenues. Conversely,
an appreciation of the domestic currency may make imports cheaper but could reduce the competitiveness of
exports.

Trade Balances and Current Accounts:

Exchange rates influence a country's trade balance and current account by affecting the value of exports and
imports. A depreciation of the domestic currency tends to improve the trade balance by increasing export
competitiveness and reducing import demand. However, sustained trade imbalances can lead to long-term
adjustments in exchange rates as markets respond to changes in supply and demand for currencies.

Policy Implications:

Policymakers closely monitor exchange rates and may intervene in currency markets to achieve various economic
objectives, such as promoting export-led growth, maintaining price stability, or addressing external imbalances.
However, policymakers often face trade-offs between these objectives, as exchange rate interventions can have
unintended consequences and may not always be effective in achieving desired outcomes.
Exchange rate regimes
Exchange rate regimes refer to the framework or system used by countries to determine the value of their
currencies relative to other currencies or a standard unit of value, such as gold or another currency. These
regimes vary in flexibility and are chosen based on a country's economic goals, institutional capacity, and
external economic environment. Understanding exchange rate regimes is essential for analyzing monetary
policy, international trade dynamics, and financial market behavior.

Types of Exchange Rate Regimes:

• Fixed Exchange Rate Regime: Under a fixed exchange rate regime, the value of a country's currency is
pegged to another currency, a basket of currencies, or a commodity like gold. Central banks intervene in
currency markets to maintain the pegged exchange rate by buying or selling foreign currency reserves.
Examples of fixed exchange rate systems include currency boards and dollarization.

• Floating Exchange Rate Regime: In a floating exchange rate regime, the value of a country's currency is
determined by market forces of supply and demand in the foreign exchange market. Central banks may
intervene occasionally to smooth excessive volatility or address disorderly market conditions, but they
generally do not target specific exchange rate levels. Most major currencies, such as the US dollar, euro, and
Japanese yen, operate under floating exchange rate regimes.
• Managed or Flexible Exchange Rate Regime: A managed or flexible exchange rate regime combines
elements of both fixed and floating exchange rate systems. Countries with managed exchange rates
allow their currencies to fluctuate within a specified band or target range, but central banks may
intervene to influence exchange rate movements or prevent extreme fluctuations. This regime offers
policymakers some flexibility in responding to economic shocks while providing a degree of stability to
exchange rates.

• Crawling Peg or Adjustable Peg Regime: In a crawling peg or adjustable peg regime, the exchange rate is
initially fixed but periodically adjusted in response to changes in economic fundamentals or external
conditions. Central banks set a predetermined rate of change or "crawling" for the pegged exchange
rate, allowing for gradual adjustments over time. This regime provides a balance between stability and
flexibility, allowing for gradual adjustments to changing economic conditions.

• Currency Union: A currency union involves multiple countries adopting a common currency and a
unified monetary policy. Examples include the Eurozone, where member countries share the euro
currency and are subject to the monetary policies of the European Central Bank (ECB). Currency unions
offer the benefits of price stability, reduced transaction costs, and enhanced economic integration but
require coordination of fiscal policies and surrendering control over monetary policy to a central
authority.
Basics of the fixed exchange rate regime

In a fixed exchange rate regime, also known as a pegged exchange rate regime, a country's central bank maintains an
official exchange rate with a key foreign currency. There is a maintained parity rate, and the central bank stands ready to
buy or sell foreign currency at this rate at all times.

A prominent example of a fixed rate system is the Bretton Woods Agreement, which was in place from 1944 to 1971.
Countries worldwide pegged their currencies to the US dollar, which in turn was tied to gold. However, this system
collapsed when the United States suspended the convertibility of the dollar into gold, ushering in an era of predominantly
floating rates.

Pros and cons of a fixed exchange rate regime

As with any economic structure, the fixed exchange rate regime has its advantages and disadvantages.

The primary advantage of a fixed exchange rate is that it reduces the risk of speculative currency trading. Because the price
of the currency is fixed, traders cannot speculate on its future movements. Furthermore, with the exchange rate securely
fixed, international trade and investment can become more predictable.

On the downside, fixed exchange rates can limit a country's economic flexibility. Since it requires the national central bank
to maintain the set rate, the country might need to adjust its monetary policy (like
interest rates) and potentially maintain high foreign reserves, which could be disadvantageous during economic
downturns. Moreover, a fixed exchange rate can lead to balance of payment deficits or surpluses.
Factors Influencing Exchange Rate Regime Choice:

The choice of exchange rate regime depends on various factors, including:

• Economic goals and priorities, such as price stability, external competitiveness, and economic
growth.

• Institutional capacity and credibility of monetary authorities to maintain exchange rate stability.

• Trade openness and exposure to external shocks, such as fluctuations in commodity prices or capital
flows.

• Historical and political considerations, including currency preferences, regional integration efforts,
and geopolitical factors.
Balance of payments and trade deficits

Balance of Payments Overview:

The balance of payments is a comprehensive accounting framework that records all economic transactions
between residents of a country and the rest of the world over a specific period, typically one year.
It consists of three main components:

• The current account, which includes trade in goods and services, income from investments, and unilateral
transfers.
• The capital account, which records capital transfers and the acquisition or disposal of non-financial assets.
• The financial account, which captures transactions involving financial assets and liabilities, such as foreign
direct investment, portfolio investment, and changes in reserve assets.

Trade Deficits Defined:

A trade deficit occurs when a country's imports of goods and services exceed its exports over a given period. It
represents an imbalance in trade flows, where a country is purchasing more goods and services from abroad
than it is selling to foreign markets.
Causes of Trade Deficits:

Several factors can contribute to trade deficits:

• Differences in comparative advantage: Countries may specialize in producing and exporting

goods and services in which they have a comparative advantage, leading to trade imbalances.

• Exchange rate movements: A country with a relatively strong currency may experience
reduced export competitiveness, leading to an increase in imports and a widening trade
deficit.

• Domestic consumption and investment: Strong domestic demand for imported goods and
services, fueled by consumer spending or investment, can contribute to trade deficits.

• Structural factors: Structural factors such as demographic trends, technological changes, and
trade policies may also influence trade balances over the long term.
Consequences of Trade Deficits:

Trade deficits can have both short-term and long-term consequences:

• Short-term impacts may include currency depreciation, loss of domestic

jobs in industries facing import competition, and inflationary pressures due
to increased demand for imported goods.

• Long-term consequences may include a decline in domestic manufacturing

capacity, a deterioration of the trade balance, and increased reliance on
foreign borrowing to finance the deficit.
Policy Implications:

Governments have several policy options to address trade deficits:

• Exchange rate policies: Central banks may intervene in currency markets

to influence exchange rates and improve export competitiveness.

• Trade policies: Governments may implement trade policies such as tariffs,

quotas, or subsidies to protect domestic industries and reduce reliance on
imports.

• Structural reforms: Policymakers can pursue structural reforms to enhance

productivity, competitiveness, and export diversification, thereby
addressing underlying causes of trade deficits.
Understanding Trade Deficits

A trade deficit occurs when there is a negative net amount or negative balance in an international
transaction account. The balance of payments (international transaction accounts) records all economic
transactions between residents and non-residents where a change in ownership occurs.

A trade deficit or net amount can be calculated on different categories within an international transaction
account. These include goods, services, goods and services, current account, and the sum of balances on
the current and capital accounts. The sum of the balances on the current and capital accounts equals net
lending/borrowing.

This also equals the balance on the financial account plus a statistical discrepancy. The financial account
measures financial assets and liabilities, in contrast to purchases and payments in the current and capital
accounts.
Advantages of Trade Deficits
The most obvious benefit of a trade deficit is that it allows a country to consume more than it produces.
In the short run, trade deficits can help nations to avoid shortages of goods and other economic
problems.

In some countries, trade deficits correct themselves over time. A trade deficit creates downward
pressure on a country's currency under a floating exchange rate regime. With a cheaper domestic
currency, imports become more expensive in the country with the trade deficit. Consumers react by
reducing their consumption of imports and shifting toward domestically produced alternatives. Domestic
currency depreciation also makes the country's exports less expensive and more competitive in foreign
markets.

Trade deficits can also occur because a country is a highly desirable destination for foreign investment.
For example, the U.S. dollar's status as the world's reserve currency creates a strong demand for U.S.
dollars. Foreigners must sell goods to Americans to obtain dollars. The stability of developed countries
generally attracts capital, while less developed countries must worry about capital flight.
Disadvantages of Trade Deficits

Trade deficits can create substantial problems in the long run. The worst and most obvious problem is that
trade deficits can facilitate a sort of economic colonization. If a country continually runs trade deficits,
citizens of other countries acquire funds to buy up capital in that nation.

That can mean making new investments that increase productivity and create jobs. However, it may also
involve merely buying up existing businesses, natural resources, and other assets. If this buying continues,
foreign investors will eventually own nearly everything in the country.

Trade deficits are generally much more dangerous with fixed exchange rates. Under a fixed exchange rate
regime, devaluation of the currency is impossible, trade deficits are more likely to continue, and
unemployment may increase significantly.

According to the twin deficits hypothesis, there is also a link between trade deficits and budget deficits.
Some economists believe that the European debt crisis was caused in part by some EU members running
persistent trade deficits with Germany. Exchange rates can no longer adjust between countries in the
Eurozone, making trade deficits a more serious problem.
Trade Deficit and Politics

Trade deficits are frequently politicized, serving as ammunition for politicians to advance
their agendas. For instance, the trade deficit between the U.S. and China has been a focal
point in political discourse and specific reporting.

This political narrative surrounding trade imbalances shapes public perception,

influences policy decisions, and often underscores broader concerns about globalization
and job loss. In summary, trade deficit may dictate how some people vote.

Moreover, trade deficits can strain diplomatic relations between countries.

Disproportionate trade imbalances may lead to tensions and disputes, prompting
retaliatory measures like tariffs or trade barriers. For instance, consider how sanctions
and export control on Russia would have been met by retaliation measures by Russia as
part of the Ukraine conflict.

In this situation, having a trade deficit may be unfavorable as it may be an indicator of

nobody willing to export to them.
How Does a Trade Deficit Impact Employment?

A trade deficit can have both positive and negative effects on employment. On the
negative side, increased imports can lead to job losses in industries that face stiff
competition from foreign producers. However, on the positive side, a trade deficit
can also be associated with strong domestic demand, which can stimulate job
creation in other sectors of the economy.

Can Trade Deficits Be Beneficial for an Economy?

While trade deficits are often viewed negatively, they can also have potential
benefits for an economy. For example, a trade deficit may reflect strong domestic
demand and economic growth, as well as access to a wider range of goods and
services for consumers. Additionally, a trade deficit can be financed by foreign
investment inflows, which can stimulate domestic investment and economic activity.
 Prepare for a quiz next
meeting
Case study Case Study: Trade Dynamics in Selected Asian Countries