Week 6

Exchange Rates and the Global

Financial System
Exchange Rate Regimes
• Exchange rate regimes refer to the systems and
policies that countries adopt to determine the value of
their currency in relation to other currencies. There are
several different exchange rate regimes, including:
• Floating Exchange Rate
• Fixed Exchange Rate
• Managed Floating Exchange Rate/ Dirty float
• Crawling Peg
• Dollarization
• Currency Union
1. Floating Exchange Rate
• A floating exchange rate regime is one where the
value of a currency is determined by market forces,
specifically supply and demand in the foreign
exchange market.
• In this system, the exchange rate is allowed to
fluctuate freely based on factors such as inflation,
interest rates, economic performance, geopolitical
events, and market speculation.
• Example: USD, GBP, JPY
2. Fixed Exchange Rate
• A fixed exchange rate regime is one where the value of a country's
currency is pegged, or fixed, to the value of another currency or a basket
of currencies.
• Under this system, the central bank of the country intervenes in the
foreign exchange market to maintain the exchange rate at the
predetermined level by buying or selling its own currency.
• Example: HKD pegged to USD
• Benefit: stability and predictability in international trade and investment,
as businesses can rely on stable exchange rates for planning and
decision-making.
• Downside: maintaining a fixed exchange rate requires a strong
commitment from the central bank and can be challenging, especially in
the face of external economic shocks or speculative attacks on the
currency.
3. Managed Floating
Exchange Rate
• A managed floating exchange rate regime is a hybrid system that combines
elements of both fixed and floating exchange rate systems.
• Under this regime, the exchange rate is allowed to fluctuate freely in
response to market forces like supply and demand, but central banks
intervene occasionally to influence the direction or pace of these
fluctuations.
• Example: INR
• In India, the RBI typically intervenes in the foreign exchange market to
smooth out excessive volatility in the exchange rate or to achieve specific
policy objectives. For example, if the rupee is depreciating rapidly and the
RBI believes that the depreciation is excessive or driven by speculative
forces, it may intervene by selling foreign currency reserves and buying
rupees to support the value of the rupee.
• A managed floating exchange rate regime seeks to strike a balance
between the flexibility of a floating exchange rate and the stability of a
fixed exchange rate
4. Crawling Peg
• A crawling peg exchange rate system is a type of fixed exchange rate
regime where a country's currency is pegged to another currency or a
basket of currencies, but with periodic adjustments to the pegged
rate based on a combination of factors such as inflation differentials,
balance of payments considerations, and competitiveness concerns.
• Example: BRL against the USD
• For instance, let's say Brazil initially pegged the real at 2 BRL to 1
USD. However, if Brazil's inflation rate started to rise faster than that
of the United States, leading to a loss of competitiveness for Brazilian
exports, the central bank might adjust the peg slightly by devaluing
the real. So, it might change the exchange rate to 2.1 BRL to 1 USD.
This adjustment would make Brazilian goods relatively cheaper in
international markets, boosting exports and helping to address the
competitiveness issue.
5. Dollarization
• Dollarization occurs when a country adopts a foreign currency
(usually the US dollar) as its official currency alongside or
instead of its domestic currency.
• Example: Ecuador's adoption of the US dollar as its official
currency in the year 2000.
• Prior to dollarization, Ecuador experienced severe economic
instability, including hyperinflation and multiple currency
devaluations. In an effort to restore stability and regain
investor confidence, the government decided to abandon its
domestic currency, the sucre, and officially adopted the US
dollar.
• Benefits and drawbacks? [Read up in detail]
6. Currency Union
• A currency union is a form of monetary arrangement where
multiple countries adopt a single currency and share a
common central bank or monetary authority responsible for
issuing and managing that currency.
• Example: Eurozone (19 EU member countries)
• Under the Eurozone arrangement, participating countries
surrender their national currencies and adopt the euro as the
sole legal tender.
• The European Central Bank (ECB) serves as the central bank
for the Eurozone and is responsible for formulating monetary
policy, issuing euro banknotes, and regulating the eurozone
financial system.
Currency Exchanges
• Different countries have different currencies, each of which
can be exchanged for goods and services wherever the
currency typically circulates. A $10 bill will get you a taxi ride
in Manhattan; a Tokyo taxi driver will not accept American
currency. Conversely, a thousand yen will get you a
comparable taxi ride in Tokyo while getting you nothing but
scorn and contempt from a New York taxi driver.
• Pieces of paper that have enormous value in one place have
no immediate use somewhere else.
• In the aggregate, the exchange rate between two currencies—
the price at which one currency can be exchanged for another
—will reflect supply and demand.
How it works
• A country’s economic conditions change from day to day, which is why
exchange rates also fluctuate continuously.
• Buyers base their trading decisions primarily on the performance of a
country’s economy. They examine realtime data such as interest rates,
and political and commercial events that will affect economic
performance—such as elections, the crash of a financial institution, or
news of increased investment in manufacturing facilities.
• Four key economic factors—gross domestic production (GDP), inflation,
employment, and interest rates—indicate how well a country’s economy
is performing, and determine its exchange rates.
• Political stability is also crucial. If investors fear that a government is not
capable of managing its country’s economy, they will lose confidence,
sell their investments in that country, and exchange the local currency
for other currencies. This in effect pushes down the value of the local
currency by increasing the supply of it and reducing the demand for it.
Hawkish vs Dovish
Is a fixed or floating exchange
rate better?
• In both floating and fixed exchange regimes, central banks seek to
maintain the currency value that best promotes international
trade and a robust economy. Fixed exchange rates are typically
used in developing countries to help establish regular trade
relationships and grow local economies. Meanwhile, floating
exchanges are found in nations whose currency values can be
safely maintained by their already established economies.

• Some countries have used a fixed exchange rate in periods of

severe economic instability while working to establish an economy
that can thrive under a floating exchange. However, most
countries adopted a floating exchange rate after the fall of the
gold standard and the Bretton Woods system.
Depreciation vs Devaluation
• Devaluation is reduction in value of domestic currency
by the government under fixed exchange rate system.
It is a deliberate effort.
• On the other hand, Depreciation is decrease in value
of domestic currency due to market forces of demand
and supply under flexible exchange rate system.
Appreciation & Depreciation of
Currencies
• If a huge number of Americans (holding dollars) suddenly want more
Mexican pesos, the demand for pesos relative to dollars will go up,
meaning that the “price” of pesos in dollars will climb. An economist
would say that the peso has appreciated relative to the dollar.
• That brings us back to the New York and Tokyo taxi drivers. One of the
core principles related to exchange rates is that swapping one currency
for another ought to enable you to buy more or less the same stuff,
albeit in a different country. If $10 will get you a short taxi ride in New
York, it’s likely that converting $10 into yen at the market rate will get
you roughly enough yen —somewhere in the ballpark—to take a short
taxi ride in Tokyo.
• But it is extremely unlikely that you could take $10 to the currency
exchange at the Tokyo airport and get enough yen to buy a big screen
television or a Honda Civic.
PPP
• If $100 buys a certain basket of goods in the United States, we ought to be
willing to swap $100 for whatever quantity of yen, euros, or pesos will
purchase a comparable basket of goods in Japan, France, or Mexico.
Obviously not every item in the basket will conform to the theory of
purchasing power parity.
• Anyone who has traveled abroad will recognize that some things seem cheap
in other countries (haircuts in India, for instance) while others seem
expensive (hotel rooms in Tokyo). But the broad theory should be intuitive.
• If the exchange rate becomes wildly out of line with what PPP predicts,
rational individuals could exploit the gap.
• But haircuts and hotel rooms are nontradable goods. TVs, on the other hand,
are tradable goods.
• If there is a significant price disparity for televisions between India and the
United States, an entrepreneur could make easy money by buying hundreds,
thousands, or even millions of televisions with rupees in Mumbai and then
importing them for sale in dollars in America (subject to transportation costs,
trade restrictions, and such).
Balassa-Samuelson Effect
• The Balassa-Samuelson effect is a theory that says countries with
higher productivity in making things that can be traded
internationally (like cars or electronics) will have higher wages and
prices in that sector compared to countries with lower productivity.
• According the law of one price, the prices of tradable goods should
be equal across countries, but not for non-tradable goods.
• Higher productivity in tradable goods will mean higher real wages
for workers in that sector, which will lead to higher relative price
(and wages) in local non-tradable goods that those workers
purchase.
• It helps explain why some countries have higher living costs than
others, despite similar levels of economic development
Balassa-Samuelson Effect
• Video: When in India, get a haircut!
Over- or Under-Valued
Currencies
• Official exchange rates often deviate from what
purchasing power parity would suggest for many
reasons, including the importance of the nontradable
sector.
• Still, PPP is an extremely useful benchmark for
evaluating the relative value of currencies.
• Currencies that are worth more than PPP would
suggest are typically described as overvalued.
 The Big Mac
Index
• Video:
What is the Big Mac Ind
ex?
Who Rules the
• Ever since the concept of an international
reserve currency was introduced in the 1800s,
primarily for ease and uniformity of
transactions across borders, emerging
economies have suffered, especially when said
currency is appreciated. First, it was gold, then
it was the pound-sterling and ever since WWII,
it has been the US dollar.
• In the aftermath of COVID-19 and the Russian
invasion of Ukraine, developing countries have
been clobbered by high import payments and
rising costs of debt servicing putting pressure
on their foreign reserves.
The Problem with the Dollar
• A strong dollar can make debt-servicing and import payments more
expensive for developing countries and can often render the domestic
monetary and fiscal policies within these countries ineffective.
• But it's not only the developing countries. The dollar's position as the
global reserve currency means that investors want to hold on to dollars,
raising its demand, especially during periods of crisis. This means that no
matter what happens it is unlikely for the US dollar to suffer from a shock.
• This sense of security has allowed the US to undertake reckless
geopolitical stances, often at the cost of its allies, let alone developing
countries. For example, the US sanctions on Russia not only have failed to
prevent Russian progression, but have depreciated other major
currencies, including those of its allies like euro and the pound, by at
least 11% since the start of 2022, a World Bank report from August 2023
suggests.
• The US dollar has
reached a 20-year
high, reaching parity
with the euro, making
imports cheaper in the
United States. On the
other hand, its
European allies are
facing higher import
costs.
Can Yuan replace the
dollar as the reserve
currency?
Can the Renminbi replace the
greenback?
• It would be naive to assume that any currency is going
to replace the dollar as the predominant reserve
currency anytime soon.
• Rather, the focus should be on diversifying the foreign
reserves with more and more currencies such as the
renminbi (or yuan) and the euro. For instance, India's
largest concrete maker UltraTech Cement has decided
to pay for 1,57,000 tonnes of Russian coal in renminbi.
• The issue with currencies like the renminbi or the
Ruble is the sheer lack of transparency regarding the
economic policy and the policymakers which drive the
valuation of these currencies.
But what about Euro?
• In the case of the euro, since its inception, the pan-
European currency had to grapple with multiple
disasters in Greece and most recently, Brexit.
• Europe's heterogeneity in terms of economic power,
rising unemployment and trade deficit in most
countries within the eurozone and the European
Central Bank's failure to harmonise its monetary policy
for each country within the region, have left the euro
arguably in a weaker position than the Ruble, let alone
the Chinese yuan or the US dollar.
Multipolar Reserve Regime
• Regardless, it appears that many countries are indeed warming
up to the idea of a multipolar reserve regime with the Chinese
yuan as the primary alternative to the dollar.
• In July 2022, Indonesia, Malaysia, Singapore, Chile and Hong
Kong pledged to each contribute 15 billion yuan to the Renminbi
Liquidity Arrangement (RMBLA).
• The establishment of RMBLA is part of China's broader strategy
to internationalize the renminbi and increase its usage in global
trade and finance.
• Meanwhile, the Chinese yuan has already become a de facto
reserve currency in Moscow and is the most demanded currency
in its stock exchange, due to the US sanctions on Russia.
Can developing countries replace
their reserve dollar?
• Larger economies such as Russia, China and India can
diversify their foreign reserves thanks to their large
volumes of trade. But least developed countries like
Bangladesh or Pakistan still have a long way to go to
achieve this feat.
Readings
• Here's why it'll be hard for the yuan to replace the doll
ar even in the next 20 years, according Stanford histor
ian Niall Ferguson.
• Russia Turns to China’s Yuan in Effort to Ditch the Dolla
r
Nominal vs Real Exchange
Rates
• Most people are familiar with the nominal exchange
rate, the price of one currency in terms of
another.
• It's usually expressed as the domestic price of the
foreign currency. So if it costs a U.S. dollar holder
$1.36 to buy one euro, from a euro holder's
perspective the nominal rate is 0.735. But the nominal
exchange rate isn't the whole story. The person, or
firm, who buys another currency is interested in what
can be bought with it. Are they better off with dollars
or euros? That's where the RER comes in.
Nominal vs Real Exchange
Rates
• One can measure the real exchange rate between two countries
in terms of a single representative good—say, the Big Mac, the
McDonald's sandwich of which a virtually identical version is
sold in many countries. If the real exchange rate is 1, the burger
would cost the same in the United States as in, say, Germany,
when the price is expressed in a common currency.
• That would be the case if the Big Mac costs $1.36 in the United
States and 1 euro in Germany. In this one-product world (in
which the prices equal the exchange rates), the purchasing
power parity (PPP) of the dollar and the euro is the same and
the RER is 1. In this case, economists say that absolute PPP
holds.
RER Calculations
• But suppose the burger sells for 1.2 euros in Germany. That would mean it
costs 20 percent more in the euro area, suggesting that the euro is 20
percent overvalued relative to the dollar.
• It would make economic sense to buy dollars, use them to buy Big Macs in
the United States at the equivalent of 1 euro, and sell them in Germany for
1.2 euros. Taking advantage of such price differentials is called arbitrage.
• As arbitrageurs buy dollars to purchase Big Macs in US and to sell in
Germany, demand for dollars will rise, as will its nominal exchange rate,
until the price in Germany and the United States is the same—the RER
returns to 1.
• In the real world, there are many costs that get in the way of a straight
price comparison—such as transportation costs and trade barriers. But the
fundamental notion is that when RERs diverge, the currencies face pressure
to change.
• For overvalued currencies, the pressure is to depreciate; for undervalued
currencies, to appreciate.
RER Calculations - Example
• The RER between two currencies is the product of the nominal
exchange rate (the dollar cost of a euro, for example) and the
ratio of prices between the two countries. The core equation is
RER=eP*/P, where, in our example, e is the nominal dollar-euro
exchange rate, P* is the average price of a good in the euro
area, and P is the average price of the good in the United
States.

• In the Big Mac example, e = 1.36. If the German price is 2.5

euros and the U.S. price is $3.40, then (1.36) x (2.5) ÷ 3.40
yields an RER of 1. But if the German price were 3 euros and the
U.S. price $3.40, then the RER would be 1.36 x 3 ÷ 3.40 = 1.2.
Difference Between NEER &
REER
NEER and REER
• Economists and policymakers are more interested in the
real effective exchange rate (REER) when measuring a
currency's overall alignment. The REER is an average of
the bilateral RERs between the country and each of its
trading partners, weighted by the respective trade shares
of each partner.
• The “bilateral exchange rate” is the price of the Rupee
against another currency. For instance, the bilateral
exchange rate against the US dollar is around 290.
• This means that 1 US dollar is worth 290 Rupees. Similarly,
the bilateral exchange rate against the Euro is 310
Rupees, against the pound is 355 Rupees, against the UAE
dirham is 80 Rupees, and so on.
NEER
• The “nominal effective exchange rate” (NEER) summarizes the bilateral
exchange rates against each currency into a single number.
• NEER is all the bilateral exchange rates of the Rupee weighted by how
much trade we do with that country. For instance, if we only traded with
the US and UAE, and 70 percent of our trade was with the US and 30
percent with UAE, the NEER at these rates would be = 290*.7 + 80*.3 =
227.
• The NEER is converted into an index that equals 100 at a given point in
time. 100 has no special significance other than it being the value of the
index at that time.
• For instance, we could set the index to 100 today. And if tomorrow, the PKR
depreciates to 300 against the USD but appreciates to 70 against the UAE
dirham, then the NEER would have depreciated to 300*.7 + 70*.3 = 231.
• Since 227 was indexed to 100, the index value of 231 would be
(231/227)*100=101.76. So we would say that the nominal effective
exchange rate has depreciated by 1.76%
REER
• The “real effective exchange rate” (REER) is the best representation of how
competitive the Rupee is in international markets. It reflects the cost of our
exports abroad by adjusting for any change in their prices in Pakistan.
• REER is the NEER adjusted for the difference between inflation in Pak and that in
other countries. For instance, if Pak only traded with the US and our exchange
rate depreciated from 260 this year to 300 next year, it would represent a
nominal depreciation of 15%=(300-260)/260*100.
• However, that would not mean that Pakistan’s goods are now 15% cheaper in
the US. Say, US inflation remained at 2% this year and next but our inflation
increased from 5% to 10%, then in “real” terms, our goods would only have
become 10% cheaper in the US = 15-(10-5).
• This illustrates a very important concept: if your exchange does not depreciate
against another currency by as much as your inflation rises relative to that
country, you will lose competitiveness, i.e. your goods will become more
expensive there.
• At a minimum, therefore, you should expect the Rupee to depreciate every year
by how much inflation in Pakistan has gone up relative to other countries.
NEER and REER
• Again, the REER (like NEER) is expressed as an index that equals
100 at a given point in time. Again, 100 has no special significance
other than it being the value of the index at that time.
• The REER on its own tells you nothing about where the Rupee
should be. A currency’s value is determined in the short run by
demand & supply, and in the long run by inflation, productivity,
demographics, interest rates, the current account & financial
inflows.
• So, if we want a strong Rupee, we should (1) lower our inflation, (2)
become more productive, (3) slow down population growth and
increase domestic savings (including by running a tighter fiscal
policy), (4) maintain appropriately high interest rates (5) control
our current account deficit (increase our exports), and (6) generate
more foreign currency inflows into Pakistan in the form of FDI and
foreign inflows into our equity markets.
“ A common mistake
people (including our
former finance minister)
make is to assume that
a REER value of 100
”
represents the fair value
of the Rupee. That is
totally wrong!
What does a rise or fall in REER
mean?
• A rise in REER suggests that exports of the country
become more costly and the imports get cheaper;
hence, an increase signals a decline in trade
competitiveness.

• A decline in REER suggests that exports of the country

become attractive and the imports get expensive;
hence, it signals a rise in trade competitiveness.
Strong vs Weak Currencies
• Exchange rates have profound economic and political
consequences.
• Governments and central banks have the capacity to manipulate
their exchange rates, which in turn creates economic winners and
losers—both within countries and across the global economy.
• The political tension related to currency values stems from a single
economic truism: all other things being equal, a weak currency is
good for exports and bad for imports. A strong currency does the
opposite: exports become more expensive and imports cheaper.
• This concept is so crucial to international economics, and therefore
to global politics, that it deserves a simple numerical example.
Example 1: Strong vs Weak
Currencies
• Consider a company like Ford that builds cars in the United States for
export to Canada. For the purposes of simplicity, we’ll assume that
Ford’s key inputs—labor and parts— are priced in American dollars; the
cars and trucks are sold in Canada for Canadian dollars. Suppose the
exchange rate between the Canadian dollar (called the loonie for the
loon on the back of the dollar coins) and the U.S. dollar is parity: one
Canadian dollar can be exchanged on currency markets for one U.S.
dollar. Further suppose that Ford can manufacture a car for $18,000 (in
U.S. dollars) and sell it in Canada for $20,000 (Canadian dollars). That’s
a comfortable $2,000 profit margin after the loonies are converted back
into U.S. dollars.
• But now suppose that for reasons that have nothing to do with
automobiles, the U.S. dollar appreciates by 15 percent relative to the
Canadian dollar. Every U.S. dollar now buys $1.15 Canadian; conversely,
each loonie buys only $.87 U.S.
Example 1: Strong vs Weak
Currencies
• Back in Michigan, Ford cares a lot. The cost of making cars in America has not
changed—same parts, same union agreements, same number of U.S. dollars
on all the contracts. Nor has the price at which Ford can sell cars in Canada.
The typical Canadian car buyer thinks about prices in terms of loonies—
because they are paid in loonies and they buy their goods in loonies.
• If the competitive price for an entry-level Ford pickup was $20,000 Canadian
dollars before the loonie began losing value, the competitive price for the
same truck after the currency loses value will be unchanged. In fact, nothing
changes about selling American cars and trucks in Canada—until Ford
converts that revenue back into U.S. dollars. Now $20,000 Canadian is worth
only $17,400 U.S., which is less than the cost of producing that truck in
America.
• This is why exchange rates have such a profound effect on international
firms. Nothing has changed about how Ford makes or sells cars—not the
production costs, the sale price, or the relative attractiveness of Ford’s
vehicles. Yet Ford has gone from making money on each sale to losing money
—all because of a swing in the currency market.
Example 2: Strong vs Weak
Currencies
• As a point of comparison, let’s suppose Honda Motors operates a plant in
Toronto, where it builds cars and trucks for the Canadian market using
exclusively Canadian inputs. Neither Honda’s production costs nor its sale
price are affected by the change in the exchange rate with the United
States.
• Honda is entirely insulated from swings in the exchange rate (which is one
reason firms like Honda have built plants in America and in other countries
with large markets).
• If Honda exports cars to the United States from its Toronto factory, things
get even better. Assume that prior to the Canadian currency depreciation
Honda could build pickups in Canada for $18,000 Canadian and sell them
south of the border for $20,000 U.S. When the two currencies were at
parity, this was a nice $2,000 profit per vehicle. After the Canadian dollar
depreciates, those exports get sweeter still. The cost structure in Canada is
unchanged—each car still costs $18,000 Canadian to produce. But now the
$20,000 earned from every U.S. sale is worth 15 percent more when
repatriated into Canadian dollars— $23,000, to be exact.
So, which is better?
Strong or a Weak Currency?
• The right exchange rate is as much about politics as it
is about economics.
• Within countries, different parties often advocate for a
cheaper or dearer currency.
• What’s best for the country overall? Bob McTeer,
former president of the Federal Reserve Bank of
Dallas, has written, “A strong dollar usually serves us
well, but occasionally and temporarily, a weaker dollar
serves us better.” In other words, that depends, too.
“ A strong
currency does
not necessarily ”
reflect a strong
economy.
A stronger local currency
• When the economy is running at capacity, a strong dollar is a
nice thing. Prosperous Americans can buy goods cheaply from
the rest of the world.
• I remember a professor once making a statement that is
obvious only after the fact: exports are the price we pay for
imports. All else being equal, we would like to give up less to
get more.
• When factories are running at capacity and everyone has a
good job, what’s not to like about cheaper French perfumes
and Japanese cars?
• A strong dollar is like getting a discount coupon for the rest of
the world’s goods while selling your own stuff at full price.
A weaker local currency
• When an economy is weak, however, things get more
complicated. A cheaper currency stimulates exports,
and exports put people back to work. A weak currency
means that a nation gets less in return for what it
produces.
• A cheaper currency is like putting your whole country
on sale for the rest of the world.
Post GFC
• In the years after 2008, just about every economy in the world had unsold
merchandise hanging on the racks. Central banks were lowering interest
rates to stimulate their domestic economies and depreciate their currencies.
• Other things being equal, lower interest rates make a country a less
attractive place to invest. When investors sell the local currency to take
advantage of more attractive investments elsewhere in the world, the
exchange rate weakens. Which brings us to 2010, when the Wall Street
Journal reported, “At least half a dozen countries are actively trying to push
down the value of their currencies, the most high profile of which is Japan,
which is attempting to halt the rise of the yen after a 14 percent rise since
May.”
• The strength of a currency is relative. If one currency gets weaker, another
currency has to get stronger.
• It’s mathematically impossible for all currencies to get weaker at the same
time. It’s like standing up at a football game to get a better view—a great
strategy until everyone else does same thing.
“ Devaluing a currency is like
peeing in bed. It feels good at
first, but pretty soon it becomes
a real mess.
”
—Anonymous Federal Reserve official