Foreign Exchange Market

Learning Objectives
• Discuss the determinants of foreign exchange rates in the long-
run
• Identify the determinants of foreign exchange rates in the
short-run
• Discuss government intervention in the foreign exchange
market
• Explain foreign exchange rate regimes and systems

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 Foreign Exchange Market
• The foreign exchange market allows currencies to be
exchanged in order to facilitate international trade or
financial transactions.
• Nominal exchange rate – the rate at which one can
exchange the currency of one country for the currency of
another country.
• Real exchange rate – the rate at which one can exchange the
goods and services from one country for goods and services
from another country.
– Real exchange rate = cedi price of domestic goods
cedi price of foreign goods
 Foreign Exchange Rates in the
Long-Run
• The Law of One Price is based on the concept of
arbitrage
– cedi price of domestic goods = cedi price of foreign goods

• The Law of One Price fails almost all the time due to:
– Transportation cost
– High tariffs
– Differences in technical specifications
– Differences in tastes
 Determinants of Foreign Exchange Rates in the
Long-Run
• Comparative Price levels.

• The Level of Productive Efficiency.

• Trade Barriers.

• Changes in Tastes and Preferences.

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 Foreign Exchange Rates in the
Short-Run
• To explain the short-run changes in nominal
exchange rates, we turn to an analysis of the
supply of and demand for currencies.

• Equilibrium in the Market for Dollars.

• Shifts in the supply of and demand for dollars

 Determinants of
Foreign Exchange Rates in the Short Run
• Effect of Inflation.
• Effect of Interest Rates.
• Current Account Deficits.
• Political Environment.
• Government Policy.
• Speculation.
• Market sentiment.

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 Government Policy and Foreign
Exchange Intervention (1)
• Govt. officials can intervene in the foreign
exchange market in several ways:
– Adopt fixed exchange rate – maintain fixed
exchange rate at all times.
– Foreign exchange intervention – buy and sell
currency in an attempt to offset demand and
supply.
 Government Policy and Foreign Exchange
Intervention (2)
• Drawing down international reserves
• Reduction in net open positions of banks
• Revision of application of statutory reserve requirement
• Increasing the monetary policy rate
• Provision of cedi cover for Vostro balances
• Open market operations

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 Fixed Exchange-Rate Regimes
• The system for establishing exchange rates has
evolved over time.
– From 1876 to 1913, each currency was convertible
into gold at a specified rate, as dictated by the gold
standard.
– This was followed by a period of instability, as World
War I began and the Great Depression followed.
 Exchange-Rate Pegs and the Bretton
Woods System (1)
– In 1944, a group of 44 countries agreed to form the
Bretton Woods System
– The 1944 Bretton Woods Agreement called for fixed
currency exchange rates.
– Each country pegged it’s exchange rate to the US
dollar.
– By 1971, the U.S. dollar appeared to be overvalued.
• The Smithsonian Agreement devalued the U.S. dollar and
widened the boundaries for exchange rate fluctuations from
±1% to ±2%.
 Exchange-Rate Pegs and the Bretton
Woods System (2)
– Even then, governments still had difficulties
maintaining exchange rates within the stated
boundaries.

– In 1973, the official boundaries for the more widely

traded currencies were eliminated and the floating
exchange rate system came into effect.
 Review
1) Discuss the determinants of foreign exchange rates in the long-run
2) Identify the determinants of foreign exchange rates in the short-run
3) Discuss government intervention in the foreign exchange market
4) Explain foreign exchange rate regimes and systems
5) How can we address the persistent depreciation of the cedi?

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