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

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

Current Trends and Case Studies

• 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