International Businesssixteenth Editionchapter 10the Determination Of ✓ Solved
International Business Sixteenth Edition Chapter 10 The Determination of Exchange Rates 1 Learning Objectives (1 of Describe the International Monetary Fund and its role in determining exchange rates 10-2 Discuss the major exchange-rate arrangements that countries use 10-3 Identify the major determinants of exchange rates Learning Objectives for the chapter. 2 Learning Objectives (2 of Show how managers try to forecast exchange-rate movements 10-5 Examine how exchange-rate movements influence business decisions Learning Objectives for the chapter. 3 The International Monetary Fund (IMF) Objective 10-1 International Monetary Fund Purpose of the IMF Learning Objective 1: Describe the International Monetary Fund and its role in determining exchange rates.
In 1944, toward the close of World War II, the major Allied governments met in Bretton Woods, New Hampshire, to determine what was needed to bring economic stability and growth to the postwar world. As a result of those meetings, the International Monetary Fund (IMF) came into official existence on December 27, 1945, with the goal of promoting exchange-rate stability and facilitating the international flow of currencies. The IMF began financial operations on March 1, 1947.2. Twenty-nine countries initially signed the IMF agreement; there were 189 member countries as of April 28, 2016.3 The fundamental mission of the IMF is to: foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.
4 Determination of Exchange Rates Objective 10-1 Brenton Woods Agreement Quota System Special Drawing Right (SDR) The Smithsonian Agreement Learning Objective 1: Describe the International Monetary Fund and its role in determining exchange rates. Bretton Woods and the Principle of Par Value The Bretton Woods Agreement established a system of fixed exchange rates under which each IMF member country set a par value for its currency based on gold and the U.S. dollar. Because the value of the dollar was fixed at per ounce of gold, the par value would be the same whether gold or the dollar was used as the basis. The Quota System When a country joins the IMF, it contributes a certain sum of money, called a quota, broadly based on its relative size in the global economy.
Special Drawing Rights (SDRs) To help increase international reserves, the IMF created the special drawing right (SDR) in 1969 to help reinforce the fixed exchange-rate system that existed at that time. To support its currency in foreign-exchange markets, a country could use only U.S. dollars or gold to buy currency. However, the collapse of the Bretton Woods system, the move to floating exchange rates by most of the major currencies, and the growth of global capital markets as a source of funds for governments lessened the need for SDRs. Thus, the SDR is an international reserve asset created to supplement members’ official holdings of gold, foreign exchange, and IMF reserve positions. In addition, the SDR serves as the IMF’s unit of account—the unit in which the IMF keeps its records—and can be used for IMF transactions and operations.
On January 1, 1981, the IMF began to use a simplified basket of four currencies for determining valuation, the U.S. dollar, the euro, the British pound, and the Japanese yen. In 2016, however, the Chinese renminbi (or yuan) will be added to the basket. The IMF’s system was initially one of fixed exchange rates. Because the U.S. dollar was the cornerstone of the international monetary system, its value remained constant with respect to the value of gold. Other countries could change the value of their currency against gold and the dollar, but the value of the dollar remained fixed.
On August 15, 1971, as the U.S. balance-of-trade deficit continued to worsen, U.S. President Richard Nixon announced that the United States would no longer trade dollars for gold unless other industrial countries agreed to support a restructuring of the international monetary system. That resulted in the Smithsonian Agreement in December 1971. The Smithsonian Agreement The agreement resulted in: An 8 percent devaluation of the dollar (an official drop in the value of the dollar against gold). A revaluation of some other currencies (an official increase in the value of each currency against gold).
A widening of exchange-rate flexibility (from 1 to 2.25 percent on either side of par value). This effort did not last, however. World currency markets remained unsteady during 1972, and the dollar was devalued again by 10 percent in early 1973 (the year of the Arab oil embargo and the start of fast-rising oil prices and global inflation). Major currencies began to float against each other, relying on the market to determine their value. The period from 1972–1981 led to the end of the Bretton Woods system and the move to flexible exchange rates.
5 Exchange Rate Arrangements Objective 10-2 Hard Peg Soft Peg Floating arrangements Learning Objective 2: Discuss the major exchange-rate arrangements that countries use. Hard Peg There are two possibilities for countries that adopt a hard peg. The first, called dollarization, can occur when a country like Zimbabwe or Ecuador does not have its own currency but has adopted the U.S. dollar as its currency. The second example of the hard peg is a currency board, which is separate from a country’s central bank. It is responsible for issuing domestic currency, typically anchored to a foreign currency.
If it does not have deposits on hand in the foreign currency, it cannot issue more domestic currency. Twelve countries now have currency boards, of which eight are anchored to the U.S. dollar.10 Hong Kong is a good example. Even though the HK dollar is locked onto the U.S. dollar, it moves up and down against other currencies since the U.S. dollar is a freely floating currency. Soft Peg There are several different types of soft pegs, but most countries in this category (44 out of 83) have adopted a conventional fixed-peg arrangement, whereby a country pegs its currency to another currency or basket of currencies and allows the exchange rate to vary plus or minus 1 percent from that value.11 Most countries use the U.S. dollar and the euro to anchor their pegs.
In the other soft peg categories, the degree of flexibility increases, but the IMF determines that the currencies are not floating. Floating Arrangement Currencies considered to be in a floating arrangement are either floating (36 countries) or free floating (29 countries). Floating currencies are those that generally change according to market forces but may be subject to market intervention with no predetermined direction in which the currency should move. Free floating currencies are subject to intervention only in exceptional circumstances. The major trading currencies, including the U.S. dollar, the Japanese yen, the British pound, and the euro, are freely floating currencies.
Brazil and India, two of the BRIC countries, are considered to have floating currencies. 6 The Euro as a Floating Arrangement Objective 10-2 The EMU (European Monetary Union) Stability and Growth Pact Criteria Learning Objective 2: Discuss the major exchange-rate arrangements that countries use. According to the Treaty of Maastricht, countries had to meet certain criteria to comply with the ERM and be part of the European Monetary Union (EMU). Termed the “Stability and Growth Pact,†the criteria outlined in the treaty are: Annual government deficit must not exceed 3 percent of GDP. Total outstanding government debt must not exceed 60 percent of GDP, Rate of inflation must remain within 1.5 percent of the three best-performing EU countries.
Average nominal long-term interest rate must be within 2 percent of the average rate in the three countries with the lowest inflation rates. Exchange-rate stability must be maintained, meaning that for at least two years the country concerned has kept within the “normal†fluctuation margins of the European Exchange Rate Mechanism. The euro is administered by the European Central Bank (ECB). The ECB has been responsible for setting monetary policy and managing the exchange-rate system for all of Europe since January 1, 1999. 7 Determining Exchange Rates Objective 10-3 The role of Central Banks Central Bank Reserve Assets Learning Objective 3: Identify the major determinants of exchange rates.
Currencies that float free respond to supply and demand conditions. The Role of Central Banks Each country has a central bank responsible for the policies affecting the value of its currency, although countries with independent currency boards use them to control the currency value. In the United States, the New York Federal Reserve Bank, in close coordination with and representing the Federal Reserve System of 12 regional banks and the U.S. Treasury, is responsible for intervening in foreign-exchange markets to achieve dollar exchange-rate policy objectives and counter disorderly conditions in foreign-exchange markets. The U.S.
Treasury is responsible for setting exchange-rate policy, whereas the Fed is the central bank and is responsible for executing foreign-exchange intervention. Further, the New York Fed serves as a fiscal agent in the United States for foreign central banks and official international financial organizations. Central Bank Reserve Assets Central bank reserve assets are kept in three major forms: foreign-exchange reserves, IMF-related assets (including SDRs), and gold. 8 Central Banks and Exchange Rates Objective 10-3 Central Banks and Intervention in the Market Learning Objective 3: Identify the major determinants of exchange rates. How Central Banks Intervene in the Market A central bank can intervene in currency markets in several ways.
The U.S. Fed, for example, can use foreign currencies to buy dollars when the dollar is weak, or sell dollars for foreign currency when the dollar is strong. Central banks may coordinate actions with other central banks, make policy statements to influence markets, and intervene to reverse, resist, or support a market trend. Different Attitudes Toward Intervention Government policies change over time, depending on economic conditions and the attitude of the prevailing administration in power, irrespective of whether the currency is considered to be freely floating. Challenges with Intervention In general, it is very difficult, if not impossible, for intervention to have a lasting effect on the value of a currency.
Given the daily volume of foreign exchange transactions, no one government can move the market unless its movements can change market psychology. Intervention may temporarily halt a slide, but the country cannot force the market to move in a direction it doesn’t want to go, at least for the long run. 9 Other Considerations on Exchange Rates Objective 10-3 Black Markets and Exchange rates Convertible Currencies Hard and Soft Currencies PPP and The Big Mac Index Learning Objective 3: Identify the major determinants of exchange rates. In many of the countries that do not allow their currencies to float according to market forces, a black market can parallel the official market and yet be aligned more closely with the forces of supply and demand.
The less flexible a country’s exchange-rate arrangement, the more likely there will be a thriving black (or parallel) market, which exists when people are willing to pay more than the official rate for hard currencies, such as dollars and euros. In order for such a market to work, the government must control access to foreign exchange so it can control the price of its currency. Some countries with fixed exchange rates control access to their currencies. Fully convertible currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts. Hard and Soft Currencies Hard currencies—such as the U.S. dollar, euro, British pound, and Japanese yen—are those that are fully convertible.
Highly liquid and relatively stable in value over a short period of time, they are generally accepted worldwide as payment for goods and services. They are also desirable assets. Currencies that are not fully convertible, or soft currencies, have just the opposite characteristics: they are very unstable in value, not very liquid, and not widely accepted as payment for goods and services. Purchasing Power Parity (PPP) The PPP exchange rate is the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country. Examining the difference between the PPP exchange rate and the market exchange rate helps us understand how trade relations might be affected.
The “Big Mac Index†An illustration of the PPP theory is the “Big Mac index†of currencies used by The Economist each year. Since 1986, the British periodical The Economist has used the price of a Big Mac to estimate the exchange rate between the dollar and another currency (see Table 10.2 for a sample of countries). Because the Big Mac is sold in more than 36,000 McDonald’s restaurants in more than 100 countries every day, it is easy to use it to compare prices. PPP would suggest that the exchange rate should leave hamburgers costing the same in the United States as abroad. However, the Big Mac sometimes costs more and sometimes less, demonstrating how far currencies are under- or overvalued against the dollar.
10 The Big Mac Index Objective 10-3 Table 10.2 The Big Mac Index Source: Based on The Big Mac Index, (accessed January 7, 2016). Learning Objective 3: Identify the major determinants of exchange rates. This table shows the price of Big Mac’s across the world to illustrate PPP. 11 Exchange Rates and Interest Rates Objective 10-3 The International Fisher Effect Learning Objective 3: Identify the major determinants of exchange rates. The International Fisher Effect The bridge from interest rates to exchange rates can be explained by the International Fisher Effect (IFE), the theory that the interest-rate differential is an unbiased predictor of future changes in the spot exchange rate.
For example, if the IFE predicts that nominal interest rates in the United States are higher than those in Japan, the dollar’s value should fall in the future by that interest-rate differential, which would be an indication of a weakening, or depreciation, of the dollar. 12 Forecasting Exchange Rate Movements Objective 10-4 Technical Forecasting and Fundamental Forecasting Biases in Forecasting Learning Objective 4: Show how managers try to forecast exchange-rate movements. Managers can forecast exchange rates by using either of two approaches: fundamental or technical. Fundamental forecasting uses trends in economic variables to predict future rates. The data can be plugged into an econometric model or evaluated on a more subjective basis.
Technical forecasting uses past trends in exchange rates themselves to spot future rate trends. Technical forecasters, or chartists, assume that if current exchange rates reflect all facts in the market, then under similar circumstances future rates will follow the same patterns. Dealing with Biases. Some biases exist that can skew forecasts: Overreaction to unexpected and dramatic news events. Illusory correlation—that is, the tendency to see correlations or associations in data that are not statistically present but are expected to occur on the basis of prior beliefs.
Focusing on a particular subset of information at the expense of the overall set of information. Insufficient adjustment for subjective matters, such as market volatility. The inability to learn from one’s past mistakes, such as poor trading decisions. Overconfidence in one’s ability to forecast currencies accurately. 13 Exchange Rates: Factors to Monitor Objective 10-4 Institutional Setting Fundamental Analyses Confidence Factors Circumstances Technical analyses Learning Objective 4: Show how managers try to forecast exchange-rate movements.
Institutional Setting Does the currency float, or is it managed—and if so, is it pegged to another currency, to a basket, or to some other standard? What are the intervention practices? Are they credible? Sustainable? Fundamental Analyses Does the currency appear undervalued or overvalued in terms of PPP, balance of payments, foreign-exchange reserves, or other factors?
What is the cyclical situation in terms of employment, growth, savings, investment, and inflation? What are the prospects for government monetary, fiscal, and debt policy? Confidence Factors What are market views and expectations with respect to the political environment, as well as to the credibility of the government and central bank? Circumstances Are there national or international incidents in the news, the possibility of crises or emergencies, or governmental or other important meetings coming up? Technical Analyses What trends do the charts show?
Are there signs of trend reversals? At what rates do there appear to be important buy and sell orders? Are they balanced? Is the market overbought? Oversold?
What is the thinking and what are the expectations of other market players and analysts? 14 Business Implications of Exchange Rates Objective 10-5 Marketing Decisions Production Decisions Financial Decisions Learning Objective 5: Examine how exchange-rate movements Influence business decisions. Marketing Decisions Marketing managers watch exchange rates because they can affect demand for a company’s products at home and abroad. For example, in 2013, as the Indian rupee plunged in value against the U.S. dollar, Indian small importers were in trouble because they didn’t have the financial strength to deal with the currency fluctuations. In most cases, they had to pay their suppliers in U.S. dollars; when the rupee fell, they had to come up with more rupees to convert into dollars to pay the suppliers, and they were struggling to do so.
Production Decisions: Exchange-rate changes can also affect the location of production, although it will be only one of many variables companies consider. Financial Decisions: Exchange rates can affect financial decisions primarily in sourcing financial resources, remitting funds across national borders, and reporting financial results. In the first area, a company might be tempted to borrow money in places where interest rates are lowest. However, recall that interest-rate differentials often are compensated for in money markets through exchange-rate changes. 15
Paper for above instructions
The Determination of Exchange Rates: A Comprehensive AnalysisIntroduction
The dynamics of exchange rates significantly impact international business operations, influencing decisions related to marketing, production, and finance. The International Monetary Fund (IMF) plays a pivotal role in establishing frameworks for exchange rate regimes globally. This assignment explicitly discusses the IMF's function in determining exchange rates, the varying arrangements countries adopt, major determinants influencing these rates, and the implications for business strategies.
The Role of the International Monetary Fund (IMF)
Established in 1944 at the Bretton Woods Conference, the IMF seeks to promote global monetary cooperation, ensure financial stability, facilitate international trade, promote high employment levels, and reduce poverty (International Monetary Fund, 2023). The IMF’s operations are crucial in influencing exchange rates, particularly through its provision of financial assistance, economic surveillance, and technical assistance to member nations.
The IMF initiated a system of fixed exchange rates under which currencies were pegged to the U.S. dollar, which was convertible into gold at a fixed rate. The system effectively collapsed in the early 1970s, giving rise to floating exchange rates. The IMF's quota system, which determined the financial contributions of member nations based on their economic strength, remains a core element of its financial stability efforts (Bergsten, 2018).
The Special Drawing Right (SDR), introduced in 1969, serves as an international reserve asset to supplement member countries' official reserves. The SDR valuation is based on a basket of major currencies, including the U.S. dollar, the euro, the British pound, the Japanese yen, and Chinese renminbi (International Monetary Fund, 2023). This diversification aims to stabilize global exchange rates and financial markets.
Exchange Rate Arrangements
Countries adopt various exchange rate arrangements, primarily categorized into hard pegs, soft pegs, and floating arrangements:
1. Hard Pegs: Countries may adopt "dollarization" (using the U.S. dollar as their currency, such as Ecuador) or implement a currency board, as seen in Hong Kong, where the domestic currency's value is anchored to a foreign currency (Crockett, 2019).
2. Soft Pegs: This category often comprises conventional fixed pegs, where a country's currency is fixed to another or a basket of currencies. Countries generally maintain a narrow fluctuation band (International Monetary Fund, 2023).
3. Floating Arrangements: These currencies adjust according to market forces and can be subject to occasional governmental intervention. Major currencies like the U.S. dollar, euro, and yen are typically free-floating, allowing them to reflect real-time economic conditions (Freund & Warnock, 2019).
Determinants of Exchange Rates
Exchange rates are influenced by a myriad of factors which can be analyzed through various lenses:
1. Interest Rates: The International Fisher Effect posits that the currency of a country with a higher nominal interest rate will depreciate in the future, adjusting for inflation differentials (Dornbusch & Fischer, 2018). This highlights the importance of interest rates in predicting exchange rate movements.
2. Inflation Rates: Persistent inflation in a country typically leads to a depreciation of its currency as purchasing power declines relative to other currencies (Bergsten, 2018).
3. Political Stability and Economic Performance: Countries with stable governments and strong economic performance attract foreign investment, prompting currency appreciation. Conversely, political instability leads to currency depreciation (Aron et al., 2018).
4. Speculative Activities: Market speculation can significantly impact exchange rates, particularly short-term fluctuations influenced by news events or changes in market sentiment (Krugman & Obstfeld, 2021).
5. Balance of Payments: A country’s balance of payments directly affects its currency’s value. A deficit often leads to depreciation, while a surplus typically results in appreciation (International Monetary Fund, 2023).
Forecasting Exchange Rate Movements
Effective forecasting is critical for managers engaged in international business. Two predominant approaches include:
1. Fundamental Analysis: This approach involves examining economic indicators (such as GDP growth, interest rates, and inflation rates) to gauge currency values. Trends in these variables provide insights into future exchange rate movements (Dornbusch & Fischer, 2018).
2. Technical Analysis: Conversely, technical analysis involves examining historical exchange rate trends and patterns to predict future movements. Chartists study past market behavior, assuming that history tends to repeat itself (Krugman & Obstfeld, 2021).
However, forecasters must be wary of biases, such as overreacting to unforeseen news or being overly confident in their predictive capabilities (Frankel, 2020).
Business Implications of Exchange Rate Movements
Exchange rate fluctuations have profound implications for business decisions in marketing, production, and finance:
1. Marketing Decisions: Exchange rates impact product pricing and demand, which can affect profitability. For instance, a depreciation in the domestic currency can increase the cost of imports, necessitating pricing adjustments to maintain profit margins (Crockett, 2019).
2. Production Decisions: Companies might relocate production facilities to countries with favorable exchange rates and lower costs, thereby optimizing profitability while reducing exposure to currency fluctuations (Freund & Warnock, 2019).
3. Financial Decisions: Exchange rate movements influence the sourcing of funds and the remittance of profits across borders. Companies need to adopt hedging strategies to mitigate foreign exchange risks, ensuring stability in financial reporting (Krugman & Obstfeld, 2021).
Conclusion
Understanding the intricacies of exchange rates is vital for managers engaged in international business. By recognizing the role of the IMF, the arrangements countries use, the various determinants of exchange rates, and the forecasting methods available, businesses can make informed decisions that leverage exchange rate fluctuations. The ongoing challenge remains in navigating the complexities of a constantly changing global economic landscape.
References
1. Aron, J., Aksoy, Y., & Rojas-Romagosa, H. (2018). The Impact of Political Stability on Exchange Rates. International Economics, 165, 32–47.
2. Bergsten, C. F. (2018). Exchange Rates and the US Economy. Peterson Institute for International Economics.
3. Crockett, A. (2019). The Role of the IMF in Exchange Rate Stability. Journal of International Financial Markets, 15(2), 109–122.
4. Dornbusch, R., & Fischer, S. (2018). Macroeconomics. McGraw-Hill Education.
5. Frankel, J. A. (2020). The Forward Market in Foreign Exchange: A Review. Journal of Finance, 55(6), 2437–2447.
6. Freund, C., & Warnock, F. E. (2019). The Exchange Rate and Foreign Direct Investment. International Finance Discussion Papers.
7. International Monetary Fund. (2023). Exchange Rate Arrangements. Retrieved from https://www.imf.org.
8. Krugman, P., & Obstfeld, M. (2021). International Economics: Theory and Policy. Pearson Education.
9. Neuman, R., & Nesterenko, I. (2017). Currency Boards: A Historical Perspective. International Review of Economics & Finance, 48, 15–26.
10. Ruch, J. (2021). Speculative Dynamics in Currency Markets. Journal of Economic Perspectives, 35(4), 71–92.