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International Business

Chapter Ten
The Determination of
Exchange Rates
Chapter Objectives
• To describe the International Monetary Fund and its
role in the determination of exchange rates
• To discuss the major exchange rate arrangements
that countries use
• To explain how the European Monetary System
works and how the euro came into being as the
currency of the euro zone
• To identify the major determinants of exchange
• To show how managers try to forecast exchange
rate movements
• To explain how exchange rate movements influence
business decisions

The International Monetary
International Monetary Fund (IMF): a multi-
national institution established in 1945 as
part of the Bretton Woods Agreement to
maintain order in the international
monetary system
• Initially the Bretton Woods Agreement estab-
lished a system of fixed exchange rates under
which each IMF member country set a par
value [benchmark] for its currency quoted in
terms of gold and the U.S. dollar.

Objectives of the IMF
• To promote exchange rate stability
• To facilitate the international flow of currencies and
hence the balanced growth of international trade
• To promote international monetary cooperation
• To establish a multilateral system of payments
• To make resources available to member nations
experiencing balance-of-payments difficulties*
*IMF loan criteria are designed to help stabilize a
country’s economy. However, they are often unpopular with
affected constituencies.

The IMF Quota
IMF Quota: the sum of the total assessments levied
on member countries to form the pool of money
from which the IMF draws to make loans to
member nations
• National quotas are based upon countries’ national
incomes, monetary reserves, trade balances, and
other economic indicators.
• Quotas form the basis for the voting power of
each member nation—the higher the quota, the
greater the number of votes.

Special Drawing Rights
Special Drawing Rights (SDRs): an artificial
international reserve asset created in 1969
to supplement IMF members’ existing reserves
of gold and foreign exchange
• The SDR is used as the IMF’s unit of account for
purposes of financial record-keeping, but it has not
assumed the role of gold as a primary reserve asset.
• The value of the SDR is based upon the weighted
average of a basket of four currencies.
Weights as of Dec. 31, 2004
U.S. dollar39%
Euro 36%
Japanese yen 13%
British pound 12%

The Evolution to Floating
Exchange Rates
• The Smithsonian Agreement of 1971:
a restructuring of the international monetary
system that widened exchange rate flexibility
from 1 percent to 2.25 percent from par value
• The Jamaica Agreement of 1976:
an amendment to the original IMF rules that
eliminated the concept of fixed exchange rates
and par values in order to accommodate greater
exchange rate flexibility via a spectrum of
exchange rate regimes

Exchange Rate Arrangements:
Broad Categories
• Peg the exchange rate to another currency or basket
of currencies with little or no flexibility
[Ecuador, El Salvador, Finland, Niger]
• Peg the exchange rate to another currency or basket
of currencies with trading occurring within a band
[Denmark, Cyprus, Hungary]
• Allow the currency to float in value against other
currencies, either managed or not managed
[Britain, Brazil, India, Norway, Turkey, So. Africa, USA]
IMF member countries are permitted to select and maintain their
exchange rate regimes, but they must be open and act responsibly with
respect to their exchange rate policies.

Exchange Rate Regimes:
2004 NO. OF
Arrangements with no separate legal tender 41
Currency board arrangements 7
Other conventional fixed peg arrangements 41
Pegged exchange rates within horizontal bands 4
Crawling pegs 5
Exchange rates within crawling bands 5
Managed float with no pronounced path 49
Independently floating 35
Total 187
Source: International Monetary Fund, IMF Annual Report, 2004, pp. 118-120.

The Role of Central Banks
• Each country has a central bank responsible for the
policies affecting the value of its currency.
[The NY Fed, one of 12 of a system of regional Federal Reserve
Banks, intervenes in foreign exchange markets on behalf of both
the Federal Reserve and the U.S. Treasury.]
• Central banks intervene in currency markets by
buying or selling a particular currency in order to
affect its price; central banks are primarily
concerned with liquidity. SDRs [Selling a
currency puts downward pressure on its value; buying a
currency puts upward pressure on its value.]
• Central banks keep their reserve assets in three
major forms: gold, foreign exchange, and IMF-
related assets (SDRs).

• Depending on market conditions, a central bank may:
– coordinate its actions with other central banks or go it
– aggressively enter the market to change attitudes about
its views and policies
– call for reassuring action to calm markets
– intervene to reverse, resist, or support a market trend
– be very visible or be very discrete
– operate openly or operate indirectly through brokers
The Bank for International Settlements (BIS) in Basel,
Switzerland, acts as the central bankers’ central
bank and also serves as a place to gather to discuss
monetary cooperation.

Map 10.2: Exchange Rate
Arrangements, 2004

The Euro
• European Monetary System (EMS): established
by the EU (then the EC) in 1979 as a means of
creating exchange rate stability within the bloc
• European Central Bank: established by the EU
on July 1, 1998, to set monetary policy and to
admin-ister the euro
• Euro: the common European currency
established on Jan. 1, 1999 as part of the EU’s
move toward monetary union as called for by the
Treaty of Maastricht of 1992
• European Monetary Union (EMU): a formal
arrangement linking many but not all of the
currencies of the EU

• The Exchange Rate Mechanism (ERM), i.e., the
Stability and Growth Pact that defines the criteria
that EU member nations must meet to qualify for
adoption of the euro, requires:
– an annual government deficit not to exceed 3% of GDP
– total outstanding government debt not to exceed 60% of
– rates of inflation within 1.5% of the three best performing
EU countries
– average nominal interest rates within 2% of the average
rate in the three countries with the lowest inflation rates
– exchange rate stability, i.e., for at least two years, ex-
change rate fluctuations within the “normal” margins of the
The UK, Sweden, and Denmark are the only members of the
initial group of 15 that opted not to adopt the euro.

Exchange Rate Determination:
Fixed to Floating Regimes
Floating rate regimes: currencies float freely, i.e.,
free from government intervention, in response
to demand and supply conditions
Managed fixed rate regimes: a nation’s central
bank intervenes in the foreign exchange market
in order to influence its currency’s relative price
• Demand for a country’s currency is a function of the
demand for that country’s goods, services, and
financial assets.
Equilibrium exchange rates are achieved when
supply equals demand.

Fig. 10.1: The Equilibrium
Exchange Rate

• The prices of tradable products, when expressed
in a common currency, will tend to equalize across
countries as a result of exchange rate changes.
• If economic policies and intervention are
ineffective, governments may be forced to revalue
or devalue their currencies.
• A currency that is pegged is usually changed on a
formal basis.
• The G8 group of finance ministers meets often to
discuss global economic issues, including exchange
rate values and policies.
Black markets closely approximate prices based on supply and
demand for currencies, rather than government-controlled prices.

Purchasing Power Parity:
The Concept
Purchasing power parity: the number of units of
a country’s currency required to buy the same
amount of goods and services in the domestic
market that one unit of income would buy in
another country

Purchasing power parity [PPP] is estimated by calculating

the value of a universal “basket of goods” that can be
purchased with one unit of a country’s currency.

Purchasing Power Parity:
The Theory
• Purchasing power parity predicts that the ex-change
rate will change if relative prices change.
• A change in the comparative rates of inflation in two countries
necessarily causes a change in their relative exchange rates in
order to keep prices fairly similar.
– An example: If the domestic inflation rate is lower than the rate in the
foreign country, the domestic currency should be stronger than the
currency of the foreign country.
– The alternative example: If the domestic inflation rate is higher than the
rate in the foreign country, the domestic currency should be weaker than
the currency of the foreign country.
Inflation represents a monetary phenomenon in which a nation’s
money supply increases faster than its stock of goods and
services, thus causing prices to rise.

• Purchasing power parity seeks to define the
relationships between currencies.
• While PPP may be a reasonably good long- term
indicator of exchange rate movements, it is less
accurate in the short run because:
– the theory falsely assumes that no barriers to trade exist
and that transportation costs are zero
– it is difficult to determine an appropriate basket of
commodities for comparative purposes
– profit margins vary according to the strength of
– different tax rates have different effects upon prices

The Big Mac Index: Under/Over
Valuation Against the U.S.
Price in Implied Exchange Under[-]/
Local Price in PPP of Rate: Over[+]
Currency Dollars the US$ 20/05/04 Valuation
United States 2.90 2.90 - - -
Brazil 5.39 1.70 1.86 3.1350 - 41
Britain 4.47 3.37 1.54 1.7825 +16
Canada 3.19 2.33 1.10 1.3770 - 20
China 10.41 1.26 3.59 8.2869 - 57
Denmark 27.75 4.46 9.57 6.1959 +54
Egypt 10.01 1.62 3.45 6.2294 - 44
Euro Area 3.07 3.28 1.06 1.2010 +13
Japan 261.87 2.33 90.30 113.00 - 20
Russia 42.05 1.45 14.50 28.995 - 50
South Africa 12.41 1.86 4.28 6.7707 - 36
Source: “The Big Mac Index: Food for Thought,” The Economist, 2004, pp. 71-72.

The Role of Interest Rates
Fisher Effect Theory: [links interest rates and inflation]
r: the nominal interest rate, i.e.,
the actual rate of interest earned on an investment
R: the real interest rate, i.e.,
the nominal interest rate less inflation
A country’s nominal interest rate r is determined by the real
interest rate R and the inflation rate i as follows:
(1 + r) = (1 + R)(1 + i).
International Fisher Effect Theory (IFE):
[links interest rates and exchange rates]
The currency of the country with the lower interest rate will
strengthen in the future because the interest rate
differential is an unbiased predictor of future changes in
the spot exchange rate.

• Like PPP, the International Fisher Effect is not a
particularly good predictor of short-run changes
in spot exchange rates.
• An example of the Fisher Effect: Because the
interest rate should be the same in every
country, the country with the higher interest rate
should have higher inflation.
Thus, if R = 5%, the U.S. inflation rate is 2.9%,
and the Japanese inflation rate is 1.5%,
the nominal interest rates are:
rus = (1.05)(1.029) – 1 = .08045 or 8.045%
rj = (1.05)(1.015) – 1 = .06575 or 6.575%
On the other hand, if inflation rates were the same,
investors would place their money in countries with
higher interest rates in order to get higher real

Forecasting Exchange Rates:
Fundamental vs. Technical
Fundamental forecasting: trend analyses and
econometric models that use economic variables
to predict future exchange rates
Technical forecasting: analyses that use past
trends in exchange rate movements to predict
future exchange rates
• Forecasters need to provide ranges or point estimates
within subjective probabilities based on available date
and subjective interpretations.

Forecasting Exchange Rates:
Factors to Monitor
• The institutional setting—the extent and
nature of government intervention
• Fundamental factors—PPP rates, balance-
of-payments levels, macroeconomic data,
levels of foreign exchange reserves, fiscal
and monetary policies, etc.
• Confidence factors
• Critical events, e.g., 9/11
• Technical factors—expectations and
market trends
Operational Implications of
Exchange Rate Fluctuations
Exchange rate changes can affect:
• marketing decisions, i.e., demand for a
firm’s products, both at home and abroad
• production decisions, i.e., production site
locations, insourcing vs. outsourcing
• financial decisions, i.e., sourcing of funds
(debt and equity), the timing and level of
the remit-tance of funds, and the reporting
of financial results

• Central banks are the key institutions in

countries that opt to intervene in
foreign exchange markets to influence
currency values.
• Exchange rates affect business
operations in three primary areas:
marketing, production, and finance.

• A country may change the exchange rate
re-gime that it uses, so managers must
monitor country policies carefully.
• A country that strictly controls and
regulates the convertibility of its currency
is likely to have a black market that
maintains a cur-rency exchange rate which
is much more indicative of supply and
demand than is the official rate.