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Cap Mark Lecture Exchange Rate

Capital markets subject unit 2

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Elena Denisa Cioinac
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27 views3 pages

Cap Mark Lecture Exchange Rate

Capital markets subject unit 2

Uploaded by

Elena Denisa Cioinac
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CAP MARKETS: EXCHANGE RATE LECTURE

1. Definition:
Exchange rate (nominal exchange rate): number of units of foreign currency needed to buy a single
unit of the local currency (the currency whose value we are trying to understand). E.g.: 1.47 dollars
per pound if we are focusing on the UK economy.
o An increase is an “appreciation” of the local currency (it is more valuable)
o A decrease is a “depreciation” of the local currency (it is less valuable).

2. Effects of supply and demand (free market – currency to float)


The exchange rate is affected by supply and demand. The EQ exchange rate is the price at which
demanders and suppliers agree to settle.
o as the price of the currency falls, more people will be willing to buy (demand) it
o as the price increases, there are more people willing to sell (supply) the currency in the market.

There are also “shifts” of the whole curves, helping to understand exchange rate fluctuations:
⁃ an increase in demand shifts the demand curve to the right (increasing the equilibrium exchange
rate)
⁃ decrease in demand shifts the demand curve to the left (decreasing the equilibrium exchange rate).

Two main forces that affect the supply and demand for the local currency:
A. Capital flows affect exchange rates because investors need change currencies when they
move their money from one country to another.
Capital Flows
⁃ Capital outflows increase the supply in the market for local currency, depreciating it.
⁃ Capital inflows increase the demand for the local currency, appreciating it.

B. Trade flows affect exchange rates because importers and exporters have to change currencies
to buy or sell in foreign markets.
Trade Flows
⁃ Imports increase the supply of the local currency. The more imports there are, the more supply
there will be in the market for the local currency, depreciating it.
⁃ Exports increase the demand for the local currency.
3. Government intervention
i. through policies that impact capital flows or trade decisions, or
contractionary monetary policy –> reduction in money supply –> increase in interest rate –>
making it more attractive for capital to flow –> capital inflow –> increase demand for local
currency (appreciation)

ii. through directly via Central Bank interventions in the currency market (by selling
and buying pounds)
to depreciate the local currency –> sell them –> to buy foreign currency –> increases amount
of foreign currency “reserves”
to appreciate local currency –> buy pounds –> sell foreign reserves –> increase demand for
pounds

4. Exchange Rate Regimes:


⁃ "managed floating”: ad-hoc government interventions
⁃ System of “bands” for intervention around a given exchange rate
⁃ fixed-exchange regime (“peg”): government promises that the exchange rate will remain constant
at a given value (“parity”)
⁃ currency boards (peg + 100% backing of the local currency with foreign reserves)
⁃ full dollarisation: where the country no longer uses its own currency

They require that the government intervene in the market to ensure that the price of the local currency
remains within the specified limits. Each regime type involves trade-offs, meaning there is no longer
monetary policy independence.

The imposition of capital controls (no one is allowed to participate in the market) often leads to the
creation of a parallel “black market,” where the exchange rate differs significantly from the one in
the official market.
5. The Trilemma (Impossible Trinity):
The trilemma suggests that it is impossible for a country to simultaneously achieve at most two out
of the three desirable outcomes: stable exchange rates (reduce uncertainty and facilitates investments
to trade – a managed or pegged exchange rate), free capital flows (needed to attract foreign capital –
full financial integration), and independent monetary policy (allow government to adjust to economic
shocks). A country can only achieve two of the three, their choice is a choice of what to pursue and
what to give up–that of the opposite point of the pyramid. Marginal compromise is possible.

Examples are provided to illustrate how different countries prioritise these outcomes:
⁃ The UK, post-Brexit, opted for independent monetary policy and free capital flows, resulting in
volatile exchange rates.
⁃ Argentina in 2018 prioritized free capital flows and stable exchange rates, sacrificing monetary
policy independence.
⁃ China prefers stable exchange rates and independent monetary policy, hence imposing strict
capital controls.

Choices:
⁃ Fixed exchange rate and independent monetary policy: Capital mobility must be restricted to
prevent market forces from causing capital inflows or outflows that would affect the fixed rate.
⁃ Fixed exchange rate and free capital mobility: The country must align its monetary policy with
its target fixed exchange rate, essentially forgoing a domestic monetary policy that responds to
the state of the domestic economy.
⁃ Independent monetary policy and free capital mobility: The exchange rate cannot be fixed and
must float because the capital flows will affect exchange rates if monetary policy adjusts
interest rates.

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