Chapter 19 The International Financial System Exchange rates among the major currencies fluctuate Floating currency the outcome of a country allowing its currency s exchange rate to be determined by demand and supply Exchange rate system an agreement among countries about how exchange rates should be determines Many countries allow their currencies to float most of the time but they occasionally intervene to buy and sell their currency or other currencies to affect exchange rates Managed float exchange rate system the current exchange rate system under which the value of most currencies is determined by demand and supply with occasional government intervention Fixed exchange rate system a system under which countries agree to keep the exchange rates among their currencies fixed for long periods Gold standard Bretton Woods system Current Exchange Rate System US allows the dollar to float against other major currencies 17 countries in Europe have adopted a single currency the euro Some developing countries have attempted to keep their currencies exchange rates fixed against the dollar or another major currency The Floating Dollar The value of the US dollar has fluctuated widely against other major The dollar increases in value when it takes more units of foreign currency to The dollar falls in value when it takes fewer units of foreign currency to buy currencies buy 1 1 Determination of Exchange Rates in the Long Run Causes of exchange rate movements in Short Run o Changes in interest rates Cause investors change their views of which countries financial investments will yield the highest returns Changes in investors expectations about the future values of Causes of exchange rate movements in Long Run currencies o Purchasing power parity the theory that in the long run exchange rates move to equalize the purchasing powers of different countries Purchasing power of every country s currency should be the same If exchange rates are not at the values indicated by purchasing power parity it appears that there are opportunities to make profits Once the exchange rate reflected the purchasing power of the two currencies there would be no further opportunities for profit Exchange rates will be at the levels determined by purchasing power parity o 3 complications that keep purchasing power parity from being a complete explanation of exchange rates Not all products can be traded internationally When goods are not traded internationally their prices will not be the same in every country Products and consumer preferences are different across countries We expect the same product to sell for the same price around the world but if a product is similar but not identical to another product their prices might be different Prices of the same product may differ across countries if consumer preferences differ Countries impose barriers to trade Tariff a tax imposed by a government on imports Quota a numerical limit that government imposes on the quantity of a good that can be imported into the country 4 determinants of exchange rates in the long run 1 Relative price levels a If prices of goods and services rise faster in one country than another the value of that countries dollar ahs to decline to maintain demand for their products 2 Relative rates of productivity growth a When the productivity of a firm increases the firm is able to produce more goods and services using fewer works machines or other inputs b The firm s costs of production fall and usually so do the prices of its c products If average productivity of a firm increases faster than another firm that firm s products will have relatively lower prices than the other country which increases the quantity demanded of their products relative to the other countries i The value of country s dollar should rise against the other 3 Preferences for domestic and foreign goods country s dollar a If consumers in one country increase their preferences for another country s products the demand for that country s currency will increase relative to the demand for the other country s dollar i The country whose dollar will increase will increase in value relative to the other country s dollar 4 Tariffs and quotas a The quota increases the demand for dollars relative to foreign currencies i Lead to higher exchange rate Factors change over time the value of one country s currency can increase or decrease by substantial amounts in the long run Create problems for firms A decline in the value of a country s currency o Lowers the foreign currency prices of the country s exports o Increases the price of imports Pegging against the dollar Some developing countries have attempted to keep their exchange rates fixed against the dollar or another major currency o When exchange rate is fixed business planning becomes easier Possible for firms in certain countries to borrow dollars directly from foreign investors or indirectly from foreign banks Fear the inflationary consequences of a floating exchange rate o When the value of a currency falls the prices of imports rise o If imports are significant fraction of the goods consumers buy a fall in the value of the currency may increase the inflation rate significantly Pegging the decision by a country to keep the exchange rate fixed between its currency and another country s currency Currency pegged at a value above the market equilibrium exchange rate is overvalued undervalued Currency pegged at a value below the market equilibrium exchange rate is Destabilizing speculation actions by investors can make it difficult to maintain a fixed exchanged rate Speculative attacks selling of countries currencies that would causes a large reduction in the demand for that country s currency o Cause that country s central bank to quickly run through its dollar reserves o Dollar reserves holdings of dollars in the central International Capital Markets Exchange rates fluctuate because investors seek out the best investments they can find anywhere in the world Shares of stock and long term debt are bought and sold on capital markets 3 most important international financial centers o NY o London o Tokyo Flow of foreign funds into US stocks and bonds are called portfolio investments Flight to safety is when countries sell other investments to buy US government bonds Globalization of financial markets has helped increase growth and efficiency in the world economy Possible for firms in almost every country to tap the savings of foreign households