The economics of exchange rates.

Countries have multiple choices when it comes to exchange rate policy. At one end are the floating exchange rate regimes where the price of the local currency is determined only by market forces. If travelers, importers, exporters, and international investors demand more (or less) of a certain currency, its price goes up (down).

At the other end are the fixed exchange rate regimes where the government does not allow the value of the currency to change. If the demand for the local currency increases, then the government starts selling local money to stop the appreciation. If the demand for the local currency decreases, the government starts to buy local money (using its reserves of foreign currencies) to stop the depreciation. These sales and purchases are called foreign exchange market intervention.

Note that the exchange rate of the Argentine peso was fixed during the 1990’s and was flexible thereafter. In other words, countries could have different exchange rate regimes over time.

Fear of floating

There are very few countries that have a purely floating exchange rate. Only the very large economies such as the U.S., the eurozone, and Japan have policies that come close to that type of a currency policy. However, even these countries occasionally interfere in currency markets. Fixed exchange rates are more widespread but most countries have the so-called managed exchange rate regimes, also known as “dirty float.” Under that policy, currency values are allowed to adjust to market conditions. However, if exchange rate changes become too large, the government or the central bank of the country intervenes to keep currency values within certain bounds.

Why so few countries have a floating exchange rate? The reason is that large changes in currency values create uncertainty and instability. If the local currency appreciates fast and by much, domestically produced goods and services become expensive on international markets and exports decline. If the currency depreciates fast and by much, the prices of imported goods would increase sharply and will cause high inflation.

Even if currency values don’t change much, the mere possibility that they might change drastically in the future creates problems. Would you buy investment assets in a country with an unstable currency? Probably not. Hence, we have the “fear of floating” phenomenon, a term coined by Guillermo Calvo and Carmen Reinhart, two well-known international economists.

Other exchange rate regimes

The fixed, flexible, and managed float regimes are part of the range of options available to countries. Other alternatives include dollarization when the local money is replaced with the dollar or the euro, currency boards when the government fixes the exchange rate and keeps very large foreign exchange reserves, and currency unions where several countries use the same currency. Another regime that is no longer in existence but was prevalent in the past is the gold standard.

What factors determine the exchange rates?

The exchange rate is the price of one currency expressed in units of another currency. For example, at the beginning of 2012, 1 U.S. dollar exchanged for about 13 Mexican Peso, 1 euro exchanged for 4.3 Polish Zloty, and one Brazilian Real exchanged for 0.57 Canadian Dollars. We say that a currency is appreciating/depreciating relative to another currency if it takes more/less units of the other currency to purchase it.

The exchange rate appreciates when the demand for the currency increases, i.e. when more people want to buy it and depreciates when the supply increases, i.e. when more people want to sell it. Look at it from the U.S. perspective. Foreigners want to buy dollars when they:

  1. Invest in the U.S.
  2. Buy goods and services from the U.S.

At the same time U.S. citizens sell dollars when then they:

  1. Invest overseas.
  2. Buy foreign goods and services.

Holding all else constant, if foreign investment in the U.S. increases, this will create more demand for dollars, and the dollar will appreciate. Similarly, when U.S. citizens increase their international travel, that creates additional supply of dollars and the dollar will depreciate.

Several examples

U.S. interest rates increase. That leads to greater foreign investment into the U.S., greater demand for dollars, and dollar appreciation.

New tariffs on U.S. exports to Europe. Now foreigners buy fewer U.S. goods, the demand for dollars declines, and the dollar depreciates.

The U.S. economy is growing rapidly. On one hand, that attracts foreign investment and causes dollar appreciation. On the other hand, U.S. imports increase since Americans can buy more international goods and services and cause dollar depreciation. We are not sure which effect would be stronger but usually a growing economy is associated with an appreciating currency.

Expected appreciation of the dollar. If for some reason investors believe that the dollar will appreciate in one year, they will want to buy it now. This creates additional demand for dollars and leads to appreciation now.

If you wonder what the effect of some macroeconomic variable on the exchange rate is, ask yourself how, holding everything else constant, that variable affects the demand or the supply of the currency. Based on that, you can determine if the change is likely to lead to appreciation or depreciation.

Forecasting currency values: short, medium, and long run

Of course, in reality there are multiple macroeconomic changes occurring at the same time. Interest rates may be changing in various countries, GDP growth rates differ, trade flows shift, etc. The combination of all these factors makes it virtually impossible to predict the exchange rate at short horizons (days, weeks). Too many fundamentals are moving in different directions at the same time. Therefore, economists say that the exchange rate follows a “random walk”, i.e. the best forecast of tomorrow’s exchange rate is today’s exchange rate. The likelihood of appreciation and depreciation are the same.

At medium-term time horizons (months, a few years) the effect of particular macroeconomic fundamentals on the exchange rate becomes more visible. For example, if the economy is growing rapidly its currency is likely to appreciate as the country attracts international capital that creates demand for the local money.

In contrast, in the long-run (many years, decades) macroeconomic fundamentals cease to have a role. Over such long periods of time, the economic growth rates, interest rates, as well as international trade and investment flows have stabilized at some “average” levels. Then, the only determinant of the exchange rate is the rate of money supply growth. Countries that print money more rapidly than the rest of the world will experience currency depreciation. In fact, the size of the depreciation would be equal to the increase of the money supply. Recall that the exchange rate is the price of a currency. If you create too much of it the price will come down.

The unholy trinity of international finance

The unholy trinity states that a country cannot have all of the following at the same time: free capital mobility, a fixed exchange rate, and independent monetary policy. It can have any two of these three but not all three. Let’s first explain what these three policies are:

Free capital mobility means that the country imposes no restrictions on international investment. Capital can flow in or out of the country with no restrictions. The country may want free capital mobility in order to attract capital for investment and development.

With a fixed exchange rate, the country maintains a fixed price of its currency to the dollar or another international currency. The country may want a fixed exchange rate to keep its inflation low. If the local currency starts to depreciate, then the government buys local money and sells dollars. This creates additional demand for the local currency and stops the depreciation. In the process, however, the government is losing foreign exchange reserves (dollars) that are limited.

Independent monetary policy means that, if it wants, the country can lower its interest rates to stimulate the economy. A lower interest rate allows people to get cheaper credit and to buy houses, cars, and other goods. This leads to faster economic growth.

Now why can’t a country have all these three? An actual example will make this clear. Think of the UK in the early 1990’s. It had a (pretty much) fixed exchange rate to the German mark and free capital mobility. However, its economy was in a recession. The government wanted to lower interest rates and to make it easier for people to take credit and buy goods and services.

However, when it lowered interest rates, international investment started to leave the country since the return on investment (interest rates) was now lower. Foreign investors were selling British pounds to leave the country and were putting pressure on the pound to depreciate. The government tried to stop the depreciation by buying pounds and selling foreign exchange reserves. However, their reserves were limited and at some point they would be depleted and the pound would depreciate.

So, the government had a dilemma: should they lower interest rates and stimulate their economy but risk devaluation of the pound. Or should they keep interest rates the same to avoid the capital outflows but at the same time leave the economy in a recession. Or restrict capital flows so investors cannot leave the country?

Stimulate the economy, keep the fixed exchange rate, and let capital flow: can’t have them all. By the way, the British government chose devaluation and lowered interest rates as the chart shows. They economy recovered very fast but the pound depreciated sharply.