This tutorial covers two central aspects of foreign exchange (FX) markets. First, we discuss exchange rate regimes and the potential pros and cons (and dangers) of adopting each regime. Special attention is given to the difficulties in pegging a country's currency. Second, we discuss various exchange rate theories, here giving particular attention to the role that prices, money supply, and inflation have in exchange rate expectations. The case of China's currency predicament is presented, where the country has recently experienced massive monetary growth, and hence domestic inflation, but also a strengthening currency, largely due to pressure from the U.S. government. We conclude with a look into a likely future scenario that sees a gradual depreciation of the Yuan.
2. IBUS2301:
Int’l Business Mgmt
Grade update
Mid-semester exam (not T04)
• Average = 19.5
• High = T01 (20.3), Low = T03 (18.1)
• Students with perfect attendance = 20.3
• Students with 2+ absences = 17.2
Case analysis
• Average = 7
• Range = 6–8
5. 4/29/2014
IBUS2301:
Int’l Business Mgmt
Floating exchange rate
• Determined by FX market
Managed (dirty) float
• Hold value within range of
ref. currency
Exchange Rate
Regimes
Pegged exchange rate
• Fixed relative to ref.
currency
Fixed exchange rate
• Set of currencies fixed
against each other
What are the different types of exchange rate regimes?
12. IBUS2301:
Int’l Business Mgmt
Prices
How are prices related to exchange rate
movements?
• Law of one price: In competitive markets free of
transportation costs and barriers to trade, identical products
sold in different countries must sell for the same price when
their price is expressed in terms of the same currency.
• PPP theory: By comparing the prices of identical products in
different currencies, it is possible to determine the “real” or
PPP (purchasing power parity) exchange rate.
13. 2010 price of Coke:
1 AUD
2010 price of Coke:
.85 USD
2010 inflation rate:
8%
2010 inflation rate:
2%
Q1: What should be the PPP exchange rate in 2010?
Australia USA
Q2: What should be the price of Coke in 2011 in Australia?
USA?
Q3: What should be the PPP exchange rate in 2011?
Q4: Does the AUD appreciate or depreciate? By how much?
1 AUD = .85 USD
1 USD = 1.17 AUD
1.08 AUD
.87 USD
1 AUD = .806 USD
1 USD = 1.24 AUD
(.806-.85)/.85 = -0.0517
Depreciates by 5%
15. IBUS2301:
Int’l Business Mgmt
Money Supply
and Inflation
How is money supply linked to inflation, and
exchange rates?
• When the growth in a country’s money supply
is faster than the growth in its output, price
inflation is fueled
depreciation of its currency
20. IBUS2301:
Int’l Business Mgmt
Interest Rates
How are interest rates related to exchange rate
movements?
• They reflect expectations about likely future inflation
rates
• Fisher effect: a country’s nominal interest rate (i) is
the sum of the required real rate of interest (r) and
the expected rate of inflation over the period (I)
i = r + I
Easier for banks to borrow money easier for people to borrow money increased demand Should lead to price inflation and thus currency depreciation