Exchange Rates and International Financial

System
Introduction
Economies are interlink with each other through
international trade.
International trade in goods and services allows
nations to raise their standards of living by
specializing in areas of comparative advantage,
exporting products in which they are relatively
efficient while importing ones in which they are
relatively inefficient.
In a modern economy, trade takes place using
different currencies.
TRENDS IN FOREIGN TRADE
An economy that engages in international trade is
called an open economy. A useful measure of
openness is the ratio of a country’s exports or imports
to its GDP.
 Figure 27-1 shows the trend in the shares of imports
and exports for Pakistan.
Growing Exports and Imports
THE BALANCE OF
INTERNATIONAL PAYMENTS
In the area of international economics, the key
accounts are a nation’s balance of international
payments.
These accounts provide a systematic statement of all
economic transactions between that country and the
rest of the world.
Its major components are the current account and the
financial account.
TABLE 27-1. Basic Elements of the Balance
of Payments
Basic Elements of the Balance of
Payments
The balance of payments has two fundamental parts.
The current account represents the spending and
receipts on goods and services along with transfers.

The financial account includes purchases and sales of

financial assets and liabilities. An important principle
is that the two must always sum to zero :
Current account financial account = I + II = 0
Debits and Credits
Like other accounts, the balance of payments records
each transaction as either a plus or a minus. The
general rule in balance-of-payments accounting is the
following:
i. If a transaction earns foreign currency for the
nation, it is called a credit and is recorded as a
plus item.
ii. If a transaction involves spending foreign
currency, it is a debit and is recorded as a negative
item. In general, exports are credits and imports
are debits.
Exports earn foreign currency, so they are credits.
Imports require spending foreign currency, so
they are debits .
Details of the Balance of Payments
Details of the Balance of Payments
I. Balance on Current Account.
The totality of items IN the balance on current
account includes all items of income and outlay—
imports and exports of goods and services, investment
income, and transfer payments.
First thing is the trade balance, which consists of
merchandise imports and exports. It consists mainly of
primary commodities (like food and fuels) and
manufactured goods.
Current Account.
Trade balance could be trade surplus (an excess of
exports over imports), calling this a “favorable balance
of trade.” or an “unfavorable trade balance,” by which
they meant a trade deficit (an excess of imports over
exports).
Services consist of such items as shipping, financial
services, and foreign travel.
A third item in the current account is investment
income, which includes the earnings on foreign
investments (such as earnings on Pak. assets abroad).
II. Financial Account.
Financial-account transactions are asset transactions
between Pakistani and foreigners. They occur,
for example, when a Japanese pension fund buys
Pakistani government securities or when a Pakistani
buys stock in a German firm .
The general rule, which is drawn from double-entry
business accounting, is this: Increases in a country’s
assets and decreases in its liabilities are entered as
debits, ; conversely, decreases in a country’s assets and
increases in its liabilities are entered as credits.
A debit entry is represented by a negative (-) sign and
a credit entry by a positive (+) sign.
THE DETERMINATION OF FOREIGN EXCHANGE
RATES
Foreign trade involves the use of different national
currencies. The foreign exchange rate is the
price of one currency in terms of another currency.
The foreign exchange rate is determined in the
foreign exchange market, which is the market where
different currencies are traded.
FOREIGN EXCHANGE RATES
When we want to exchange one nation’s money
for that of another, we do so at the relevant foreign
exchange rate.
For example, if you traveled to Mexico, you would have
received about 19.75 Mexican pesos for 1 U.S. dollar.
There is a foreign exchange rate between U.S. dollars
and the currency of every other country
Currently the foreign exchange rate per U.S. dollar is
285.17 for Pakistan.
FOREIGN EXCHANGE RATES
With foreign exchange, it is possible for me to
buy a US bicycle .
Suppose its quoted price is 200 $, and the rate is Rs
160/$, , I could go to the bank to convert my Rs 32000
into 200$.
You should be able to show what Japanese importers
of American trucks have to do if they want to buy, say,
a $36,000 truck from an American exporter. Here yen
must be converted into dollars. You will see that, when
the foreign exchange rate is 100 yen per dollar, the
truck costs them ¥3,600,000.
FOREIGN EXCHANGE RATES
The foreign exchange rate is the price of one currency
in terms of another currency.
We measure the foreign exchange rate (e) as the
amount of foreign currency that can be bought with 1
unit of domestic currency:
e = foreign currency $ Euros
_________________ = ___ = _______ = ……
domestic currency Rs Rs
THE FOREIGN EXCHANGE MARKET
The foreign exchange market is the market in which
currencies of different countries are traded and foreign
exchange rates are determined. Foreign currencies are
traded at the retail level in many banks and firms
specializing in that business.
There may be variety of exchange rate systems (types)
in the foreign exchange market. Its two broad types or
systems are Fixed Exchange Rate and Flexible
Exchange Rate as explained below.
Fixed Exchange Rate
Fixed exchange rate is the rate which is officially fixed
by the government or monetary authority and not
determined by market forces.
In this system, foreign central banks stand ready to
buy and sell their currencies at a fixed price.
A typical kind of this system was used under Gold
Standard System in which each country committed
itself to convert freely its currency into gold at a fixed
price.
Flexible (Floating) Exchange Rate
The system of exchange rate in which rate of exchange
is determined by forces of demand and supply of
foreign exchange market is called Flexible Exchange
Rate System.
There is no official intervention in foreign exchange
market. Under this system, the central bank, without
intervention, allows the exchange rate to adjust so as to
equate the supply and demand for foreign currency In
India, Pakistan , it is flexible exchange rate which is
being determined.
Exchange Rate Determination
We can use our familiar supply and demand curves to
illustrate how markets determine the price of foreign
currencies. Figure 27-3 shows the supply
and demand for US dollar that arise in dealings
with rupees.
Exchange-Rate Determination
Exchange-Rate Determination
The supply of US dollar comes from people in the
America who need rupees to purchase Pakistani
goods, services, or financial assets.
The demand for dollar comes from people in Pakistan
who buy US goods, services, or investments and who,
accordingly, need rupees to pay for these items.
The price of foreign exchange—the foreign exchange
rate—settles at that price where supply and demand
are in balance at point E.
Exchange-Rate Determination
In supply side, American supply dollars when they
purchase foreign goods, services, and assets.
In Figure , the vertical axis is the foreign
exchange rate (e), measured in units of foreign
currency per unit of domestic currency—that is, in
dollar per rupees.
The horizontal axis shows the quantity of dollars
bought and sold in the foreign exchange market.
Exchange-Rate Determination
The supply of U.S. dollars is represented by the
upward-sloping SS curve.
The upward slope indicates that as the foreign
exchange rate rises, the number of rupees that can be
bought per dollar increases.
This means, with other things held constant, that
the prices of Pakistani goods fall relative to those of
American goods. Hence, Americans will tend to buy
more Pakistani goods, and the supply of U.S. dollars
therefore increases
Exchange-Rate Determination
Foreigners demand U.S. dollars when they buy
American goods, services, and assets.
The demand curve in Figure 27-3 slopes downward to
indicate that as the dollar’s value falls , foreigners
purchasers will therefore tend to buy more American
computers, and the quantity demanded of U.S. foreign
exchange will increase
Exchange-Rate Determination
Market forces move the foreign exchange rate
up or down to balance the supply and demand. The
price will settle at the equilibrium foreign exchange
rate, which is the rate at which the dollars willingly
bought just equal the dollars willingly sold
Exercise
We have discussed the foreign exchange market
in terms of the supply and demand for dollars. But
in this market, there are two currencies involved,
so we could just as easily analyze the supply and
demand for Rupees.
If Rs 160/$ is the equilibrium looking from the point of
view of the dollar, then $0.0062/Rs is the reciprocal
exchange rate .
Terminology for Exchange-Rate Changes
When a country’s currency falls in value relative to
that of another country, we say that the domestic
currency has undergone a depreciation
while the foreign currency has undergone an
appreciation.
When a country’s official foreign exchange rate is
lowered, we say that the currency has undergone a
devaluation.
An increase in the official foreign exchange rate is
called a revaluation
Effects of Changes in Trade
What would happen if there were changes in foreign
exchange demand? For example, if Japan has
a recession, its demand for imports declines. As a
result, the demand for American dollars would
decrease.
The decline in purchases of American goods, services,
and investments decreases the demand for dollars
in the market. This change is represented by a leftward
shift in the demand curve.
A Decrease in Demand for Dollars Leads
to Dollar Depreciation
Effects of Changes in Trade
The result will be a lower foreign exchange rate—that
is, the dollar will depreciate and the yen will
appreciate.
At the lower exchange rate, the quantity of dollars
supplied by Americans to the market will decrease
because Japanese goods are now more expensive.
How much will exchange rates change? Just enough so
that the supply and demand are again in balance. In
the example shown in Figure, the dollar has
depreciated from ¥100/$ to ¥75/$.
Exchange Rates and the Balance
of Payments
What is the connection between exchange rates
and adjustments in the balance of payments?
Monetary policy can affect the exchange rate through
the financial account.
If the Federal Reserve raises dollar interest rates, this
induces investors into dollar securities and raises the
demand for dollar foreign exchange.
The result is an appreciation of the dollar.
Exchange Rates and the Balance
of Payments
Exchange Rates and the Balance
of Payments
Exchange-rate movements serve as a balance
wheel to remove disequilibria in the balance of
payments. Such a change in the foreign exchange rate
has an important effect on trade flows.
As the one country’s currency appreciated, for
example German Mark, German goods became more
expensive in foreign markets and foreign goods
became less expensive in Germany. This led to a
decrease in German exports and an increase in
German imports. As a result, the trade balance moved
toward deficit.
Purchasing Power Parity and Exchange
Rates
In the short run, market-determined exchange rates are highly
volatile in response to monetary policy, political events, and
changes in expectations.
But over the longer run, exchange rates are determined primarily
by the relative prices of goods in different countries. An important
implication is the purchasing power-parity (PPP) theory of
exchange rates.
Under this theory, a nation’s exchange rate will tend to equalize
the cost of buying traded goods at home with the cost of buying
those goods abroad
PPP ……
The PPP theory can be illustrated with a simple example.
Suppose the price of a market basket of goods (automobiles,
jewelry, oil, food, and so forth) costs $1000 in the United
States and 10,000 pesos in Mexico.
 At an exchange rate of 100 pesos to a dollar, this bundle
would cost $100 in Mexico. Given these relative prices and
the free trade between the two countries, we would expect to
see American firms and consumers streaming across the
border to take advantage of the lower Mexican prices.
The result would be higher imports from Mexico and
an increased demand for Mexican pesos.
That would cause the Mexican peso to appreciate
relative to the U.S. dollar, so you would need more
dollars to buy the same number of pesos.
As a result, the prices of the Mexican goods in dollar
terms would rise even though the prices in pesos have
not changed
THE INTERNATIONAL MONETARY SYSTEM
What is the international monetary system? This
term denotes the institutions under which payments
are made for transactions that cross national
boundaries.
In particular, the international monetary system
determines how foreign exchange rates are set
and how governments can affect exchange rates.
In recent years, nations have used one of three major
exchange-rate systems:
Exchange Rate System
A system of fixed exchange rates
A system of flexible or floating exchange rates,
where exchange rates are determined by market
forces
Managed exchange rates, in which nations intervene
to smooth exchange-rate fluctuations or to move their
currency toward a target zone
FIXED EXCHANGE RATES: THE
CLASSICAL GOLD STANDARD
At one extreme is a system of fixed exchange rates,
where governments specify the exact rate at which
dollars will be converted into pesos, yen, and other
currencies, which was used off and on from 1717 until
1936 .
The Bretton Woods System
After World War II, governments were determined
to replace the gold standard with a more flexible
system. They set up the Bretton Woods system,
which was a system with fixed exchange rates.
The Bretton Woods System
The innovation here was that exchange rates were
fixed but adjustable. When one currency got too far out
of line with its appropriate or “fundamental” value, the
parity could be adjusted.
The Bretton Woods system functioned effectively
for the quarter-century after World War II.
The system eventually broke down when the dollar
became overvalued. The United States abandoned the
Bretton Woods system in 1973, and the world moved
into the modern era .
FLEXIBLE EXCHANGE RATES
The international monetary system for major
countries today relies primarily on flexible exchange
rates. (Another term often used is floating exchange
rates, which means the same thing.) Under this
system, exchange rates are determined by supply and
demand.
Managed but flexible exchange rates.
Some major countries have managed but flexible
exchange rates. Today, this group includes
Canada, Japan, and many developing countries.
Under this system, a country will buy or sell its
currency to reduce the day-to-day volatility of
currency fluctuations.
 Question

??????????????