Exchange Systems

Summaries

Factors affecting the exchange rate (all are relative to trading partners):

1. Higher income growth – appreciate foreign currency
2. Higher inflation rate – appreciate foreign currency
3. Higher real interest rate – appreciate domestic currency

Notes: For covered interest rate parity, the higher the interest rate, the lower the forward rate. Note that this is in the view of forward contract, it is not predicting the future rate. It just tells us that to prevent arbitrage (riskless) profit, the equation has to be satisfied. But when real interest rate is higher in a country, its currency should appreciate (not necessarily in the future) as the demand increased.

For example, if RMB interest rate keeps increasing and we should expect RMB to appreciate. Does it mean that all the forward contracts need to have a value satisfying the interest rate parity (That means the future rate has to be smaller than the spot rate, i.e. U.S. $ being strong)? That’s not necessary. Contracts can only formed when there are 2 parties. If the number of contracts is limited, the high demand will drive up the contract price.

Expansionary Monetary Policy

 => reduce real interest rate, increase inflation, increase consumption (import, not export before currency depreciates)

=> depreciate the currency

=> current account (surplus, because currency eventually depreciates) and financial account (deficit)

Expansionary Fiscal Monetary

=> Deficit, inflation, real interest rate increases (because more borrowing from government)

=> interest rate is more mobile, so in short run, the currency appreciates

=> current account (deficit), financial account (surplus)

Floating Rate Exchange System

Fixed Exchange Rate System

Unified Currency System (only one central bank to control the monetary supply)

Pegged Exchange rate System (Narrow Band)