Analysis of the

International
Macroeconomic policy
EXCHANGE RATE POLICY IN INTERNATIONAL
TRADE
 DETERMINATION OF EXCHANGE RATE

 An exchange rate is the price of one currency

in terms of another, such as the Tanzania
shilling, stated in terms of another currency
unit, such as the U.S. dollar, the British
pound, the Japanese yen and so forth.
 There are two distinctions made on exchange

rate, these are

 direct and
 indirect quotation.
 Exchange rate Quotation
 An exchange rate quoted in:
 direct quotation is expressed in terms of the

numbers of units of the local currency

exchangeable for one unit of a foreign
currency eg a direct quote between Tanzania
shilling (TZS) and Kenya shilling (KES) would
be for example TZS 10 for KES 1.
 Exchange rate Quotation
 An indirect quote involves expressing number
of units of a foreign currency exchangeable
for one unit of the local currency eg. KSH
0.10 for TZS 1.
 TYPES OF EXCHANGE RATE

 There two types of exchange rate prevailing

in the foreign exchange market
 Spot exchange rates
 Forward exchange rates
 Spot rate of exchange
 Spot rate of exchange refers to the price of
foreign exchange in terms of domestic money
payable for the immediate delivery of a
particular foreign currency.
 It is the exchange rate at which one currency

can be exchanged for another currency at the

present time as opposed to future date
 Forward rate of exchange
 Forward rate of exchange, on the other hand,
refers to the price at which a transaction will
be accomplished at some specified time in
the future.
 A forward exchange market functions side by

side with a spot exchange market.

 The transactions of forward exchange market

are known as forward exchange transactions.

 Exchange rate arbitrage
 Exchange rate arbitrage:
 Arbitrage is the act of simultaneously buying

a currency in the market and selling it in

another to make a profit by taking advantage
of price or exchange rate difference in the
two markets
 EQUILIBRIUM RATE OF EXCHANGE

 In flexible exchange rate system the rate of

exchange being a price of a national currency
in terms of another, is determined in the
foreign exchange market in accordance with
the general principle of the theory of value,
that is, by the interaction of the forces of
demand and supply.
EQUILIBRIUM RATE OF EXCHANGE
 Although a few countries officially fix the
exchange value of their currency to a key
currency or baskets of currencies, the market
forces of supply and demand primarily
determine the exchange rate between most
curries.
The illustration of the equilibrium rate of exchange under the market
force

Supply of TZS
Price

Demand for TZS

Quantity of TZS
 DETRMINANTS OF EXCHANGE RATE

 Long term trends in exchange rates: The

theory underlying long term movements in
the equilibrium exchange rate focuses on
o the differences in the relative inflation rates,
o relative interest rates,
o the position of balance of payments,
o relative productivity of one country versus
another,
o government policy regarding exchange rates
to mention a few.
 Long Term Determinants
 Relative inflation is explained by the
purchasing power parity (PPP) theory. It is
relative purchasing power of the two
currencies which determine the exchange
rate.
 For instance, if a basket or goods costs U.S

dollar 1 in USA and TZS 1200 in Tanzania,

then the equilibrium exchange rate would be
U.S dollar 1=TZS 1200.
 Long Term Determinants
 Relative interest rates: High interest rates
attract capital funds from overseas and also
add to investor confidence; as such capital
inflows from abroad create an increased
demand for the domestic currency, thus
pushing its exchange rates higher, all other
things being equal.
 Long Term Determinants
 Balance of payment position: A deficit balance
of payments of a country implies that
demand for foreign exchange exceeds its
supply.
 As result, the price of foreign currency in

terms of domestic currency must rise, that is

the exchange rate of domestic currency must
fall and vice versa is true
 Short Term Determinants
 Short term movements in exchange rates:
 I n the short run,

 nominal exchange rates depends primarily on

financial market variables and expectations;

 and if the price of goods and services are

slow to change, nominal exchange rate

movements will be reflected immediately in
real exchange rate changes.
 EXCHANGE RATE REGIMES

 There are two basic exchange rate regimes

that can operate under many economic
systems.
 These are fixed and flexible exchange rates.
 FIXED EXCHANGE RATE

 A fixed exchange rate system is one where

the authorities attempt to hold the exchange
rate of their currency at a fixed rate against
other currencies.
 In a fixed exchange rate system foreign

central banks stand ready to buy and sell

their currencies at a fixed price in terms of
dollars.
 FIXED EXCHANGE RATE
 The major countries had fixed exchange rates
against one another from the end of World
War II until 1973.
 Today, some countries fix their exchange

rates but others not.

 FLEXIBLE EXCHANGE RATE

 Under the fixed exchange rate, the central

banks have to provide whatever amounts of
foreign currency are needed to finance
payments imbalances.

 FLEXIBLE EXCHANGE RATE
 In a flexible (floating) exchange rate system,
 the central banks allow the exchange rate to

adjust to equate the supply and demand for

foreign currency.
 The terms flexible and floating rates are used

interchangeably.
 There are forms of floating exchange rate
 Clean floating exchange rate
 Dirty floating exchange rate
CLEAN FLOATING EXCHANGE RATE
 In a system of clean floating, central banks
stand aside completely and allow exchange
rates to be freely determined in the foreign
exchange markets.
 Since the central banks do not intervene in the
foreign exchange markets in such system,
official reserve transactions are zero.
 That means the balance of payments is zero in
a system of clean floating. The exchange rate
adjusts to make the current and capital
accounts sum zero.
DIRTY FLOATING EXCHANGE RATE
 In a system of dirty/managed floating
exchange rate, government through central
banks some time intervene to control the
exchange rate and thereafter leave the
market forces to determine the exchange
rates (freely determined in the foreign
exchange markets)
 INTERVENTION

 Foreign central banks hold reserves –

inventories of dollar, other currencies and
gold that they can sell for dollars –to sell
when they want to or have to intervene in the
foreign exchange market.
 Intervention is the buying or selling of
foreign exchange by the central bank.
 INTERVENTION

 The main determinant of intervention is the

balance of payment needed from the central
bank.
 However, if a country persistently runs
deficits in the balance of payments, the
central bank eventually will run out of
reserves of foreign exchange and will be
unable to continue its intervention.
 CAPITAL MOBILITY

 One of striking facts about the international

economy is the high degree of integration, or
linkage, among financial, or capital, markets-
the markets in which bonds and stocks are
traded.
 CAPITAL MOBILITY
 In most industrial countries today there are
no restrictions on holding assets abroad.
 They therefore search around the world for

the highest return, thereby linking together

yields in capital markets in different
countries.
 CAPITAL MOBILITY
 For example, if interest rates in New York
rose relative to those in Canada, investors
would turn to lending in New York, while
borrowers would turn to Toronto.
 With lending up in New York and borrowing

up in Toronto, yields would quickly fall into

line.
 CAPITAL MOBILITY
 In practice, the flexible rate system, in effect
since 1973, has not been one of clean
floating.
 Instead, the system has been one of managed

or dirty floating.
 CAPITAL MOBILITY
 Under managed floating, central banks
intervene to buy and sell foreign currencies in
attempts to influence exchange rates.
 Official reserve transactions are, accordingly,

not equal to zero under managed floating.

 CAPITAL MOBILITY
 Our working assumption from now on
involves perfect capital mobility.
 Capital is perfectly mobile internationally

when investors can purchase assets in any

country they choose, quickly, with low
transaction costs, and in unlimited amounts.
 CAPITAL MOBILITY
 When capital is perfectly mobile, asset
holders are willing and able to move large
amounts of funds across borders in search of
the highest return or lowest borrowing cost.
 CAPITAL MOBILITY
 The high degree of capital market integration
implies that any one country’s interest rates
cannot get too far out of line without
bringing about capital flows that tend to
restore yields to the world level.
PERFECT CAPITAL MOBILITY UNDER
FIXED EXCHANGE RATES
 A small interest differential moves enough
money in or out of the country to completely
swamp available central bank reserves.
 The only way to keep the exchange rate from

falling is for the monetary authority to back

off from the interest rate differential.
PERFECT CAPITAL MOBILITY UNDER
FIXED EXCHANGE RATES
 The conclusion is this: under fixed exchange
rates and perfect capital mobility, a country
cannot pursue an independent monetary
policy.
 Interest rates cannot move out of line with

those prevailing in the world market.

PERFECT CAPITAL MOBILITY UNDER
FIXED EXCHANGE RATES
 Any attempt at independent monetary policy
leads to capital flows and a need to intervene
until interest rates are back in line with those
in the world market.
 PERFECT CAPITAL MOBILITY AND FLEXIBLE EXCHANGE
RATES

 Under fully flexible exchange rates the central

bank does not intervene in the market for
foreign exchange.
 The exchange rate must adjust to clear the

market so that the demand for and supply of

foreign exchange balance.
 Without central bank intervention, therefore,

the balance of payments must be equals to

zero.