The Federal Reserve and Exchange Rates

Personal Finance

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Gold Standard

1876 – 1913 Values of currency set against precious

metals Each country set own conversion rate Must maintain adequate reserves (Fort Knox) for

redemption

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Gold Standard

Gold standard implied fixed XR Limited growth of money supply for any

country Need enough gold

WWI limited free movement of gold

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1920s and 1930s

Some countries reverted to gold standard Some abandoned Some pegged to dollar or pound Period of instability

International trade declined

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Bretton Woods Agreement

International agreement in 1944 Fixed exchange rates

All currencies pegged to dollar Dollar set at $35/ounce of gold Intervention to prevent fluctuation of > 1%

Lasted until 1973

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Floating Exchange Rates

By 1971, dollar had depreciated Concerns about U.S. ability to convert dollars

to gold March 1973

U.S. allows dollar to float Other major currencies float as well

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Countries with Floating XRs

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Countries with Pegged XRs

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Floating Exchange Rates

Determined by supply and demand Factors affecting demand

Demand for nation’s product Demand for nation’s stocks and bonds Inflation expectations Government stability

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Floating Exchange Rates

Supply is determined by monetary policy of central bank

U.S. central bank is the Federal Reserve Too much supply – inflation Not enough supply - recession

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Federal Reserve

U.S. Central Bank Established in 1913 12 federal reserve banks

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Federal Reserve

Board of Governors• Seven members

Appointed by President and confirmed by congress 14-year term Chairman’s term is four years

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Federal Reserve

FOMC Chief policymaking committee

All 7 governors President of NY fed bank Four other fed presidents

– All fed presidents attend meetings All votes are equal

Chairman has much influence

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Federal Reserve

FOMC determines monetary policy Supply of money

Purchase or sell fixed income assets Influences short-term rates Impacts XR

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Federal Reserve

Mission Maximum employment Stable prices Moderate long-term interest rates

Goals may conflict XR is not explicit goal

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Foreign Exchange Market

Spans the globe Operates 24 hours/day Major exchanges

Singapore, Hong Kong, Tokyo, Bahrain, London, New York, San Francisco, Sydney

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Foreign Exchange Market

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Tokyoopens

Asiaclosing

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LunchIn Tokyo

Exchange Rates

Spot Rate – the price of a currency in terms of another currency for trade today

Forward Rate – The price of a currency in terms of another currency for a trade agreed upon today but to be executed at a specified date in the future (usually 30, 60,90, 180 or 360 days from today)

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Exchange Rates

Direct Quote – the number of dollars needed to buy one unit of the foreign currency. Dollar is in the numerator

Indirect Quote – the number of units of a foreign currency needed to buy one dollar. Dollar is in the denominator

Direct and Indirect Quotes are reciprocals of each other

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Exchange Rates

Which is a better deal – bananas being sold at 50 cents per pound, or two pounds of a dollar?

1.23 $/€ is the same as .813 €/$ Price of a dollar: €.813 Price of a euro: $1.23 Currency in the denominator is being priced

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Exchange Rates

Suppose you have $5.00 and want to convert to euros.

You are both selling dollars and buying euros

If XR is quoted at 1.23 $/€, do you multiply or divide?

Suppose you have €30 and want dollars?

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Exchange Rates

There are always two exchange rates The ask and the bid

Ask > Bid The spread is the dealer’s profit The dealer buys at the bid and sells at the ask You are not the dealer, so you sell at the bid and buy at

the ask

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Exchange Rates

Suppose you observe direct quotes of: Ask: .0091 $/¥ Bid: .0090 $/¥

You have $150 you want to convert to yen. How many yen will you receive? Which currency’s price is being quoted? Are you buying or selling that currency? Do you buy or sell at the bid, or the ask?

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Exchange Rates – Cross Rates

  Dollar Euro Pound SFranc Peso Yen CdnDlrCanada 1.2134 1.3591 1.8655 1.3097 0.08 0.01 ...

Japan 119.87 134.276 184.299 129.397 7.904 ... 98.795

Mexico 15.166 16.988 23.3167 16.3707 ... 0.127 12.499

Switzerland 0.9264 1.0377 1.4243 ... 0.061 0.008 0.7635

U.K. 0.6504 0.7286 ... 0.7021 0.043 0.005 0.5361

Euro 0.8927 ... 1.3725 0.9637 0.059 0.007 0.7358

U.S. ... 1.1202 1.5375 1.0794 0.066 0.008 0.8242

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Is the Dollar Rising or Falling?

The dollar can only rise or fall in relation to another currency

If the dollar increases in value (vs that currency), that other currency must be decreasing in value (vs the dollar)

It is certainly possible for the dollar to rise in value vs one currency but fall in value vs a different currency

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Is the Dollar Rising or Falling?

Example: Yesterday, one euro was worth $1.12

Today, one euro is worth $1.10 Since a euro will buy fewer dollars, the euro

dropped in value Since it takes fewer dollars to buy a euro, the

dollar increased in value

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Is the Dollar Rising or Falling?

A strong dollar is good for importers because they can buy more foreign-made product with a dollar

A weak dollar is good for exporters because their customers can buy more U.S.-made goods with their foreign currency

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Is the Dollar Rising or Falling?

A strong dollar is good for you if you plan to travel overseas because your dollar will buy more

A weak dollar is good for U.S. businesses who cater to foreign travelers who come to the U.S. because their customers can purchase more

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