Chapter One

Exchange Rates
and the Foreign
Exchange Market
[Link] Foreign Exchange Market
The foreign exchange market is refers to the
organizational setting within which individuals,
business, governments and banks buy and sell
foreign currencies and other debt instruments.
The market in which international currency trades
take place is called the foreign exchange market.
The price of foreign currency is decided by the free
interface of households, firms and financial
institutions.
1.2. Characteristics and
participants of the foreign
exchange market :
The major participants in the foreign exchange
market are commercial banks, corporations that
engage in international trade, nonbank financial
institutions such as asset-management firms and
insurance companies, and central banks.
Individuals may also participate in the foreign
exchange market
 for example, the tourist who buys foreign currency
at a hotel's front desk
 The Characteristics of foreign exchange market are:
 Volume is enormous: over a trillion dollars a day.
Banks dealing in e-market tend to be concentrated in
certain key financial cities
 Highly integrated globally: when one major
market is closed usually another is open, so people
can trade around the clock, moving from one center
to another.
 Integration means exchange rate quotes in different
centers must be the same.
 It is guaranteed by arbitrage, which is defined as
making a riskless profit on a financial trade.
1.3. Functions of the foreign
exchange market
 Transfer of Purchasing Power: It is necessary
because international transactions normally involve
parties in countries with different national
currencies.
 Provision of Credit: Because the movement of
goods between countries takes time, inventory in
transit must be financed.
 Minimizing Foreign Exchange Risk: The foreign
exchange market provides "hedging" facilities for
transferring foreign exchange risk to someone else.
1.4. Demand for and Supply of
Foreign Exchange
A) Demand for foreign exchange:
The exchange rate R is a measure of the price of the
foreign currency (US$) in terms of domestic currency
(Ethiopia Birr).
An increase in R implies a decline in the value of
Birr and an increase in the value of US$.
In other words, a movement up on the vertical axis
represents an increase in the price of foreign currency
(which is equivalent to a fall in the price of Birr).
Cont…
The demand for a foreign currency bank deposit is
influenced by the same considerations that influence
the demand for any other asset.
A foreign currency deposit's future value depends in
turn on two factors:
 the interest rate it offers and
 the expected change in the currency's exchange rate
against other currencies.
B) Supply curve for foreign exchange
 The supply curve of foreign currency slopes up
because foreign firms and consumers are willing to
buy a greater quantity of domestic goods as the
domestic currency becomes cheaper.
 The supply of US$ will increase if US and/or
foreign citizens are willing to buy a greater quantity
of Ethiopia’s goods as the Ethiopian currency
becomes cheaper (i.e. as the foreigners receive
more birr per USD).

8
There are three major reasons why people hold
foreign currency rather than their own.
 For reasons related to trade and direct investment
( like business cycle, inflation and expectation of
future economic growth)
 To take advantage of interest rate changes
 To speculate
Changes in one or more of these three motives for
holding foreign currencies can lead to a shift in the
demand and supply curves of foreign currency
indicating in change in demand and change in
supply of foreign currency.
[Link] Foreign Exchange Rate
Exchange rate is the price of one currency in terms
of another.
Exchange rate allow us to denominate the cost or
price of a good or service in a common currency.
Exchange rate plays a central role in international
trade
 Because they allow us to compare the prices of goods
and services produced in different countries
 Euro/Birr = 22 you need to spend 22 Birr to obtain 1
Euro. Birr/Euro=0.045 you need to spend 0.045 Euro to
buy 1 Birr
 Types of Exchange rates
Spot Rates and Forward Rates :
Two parties agree to an exchange of bank deposits
and execute the deal immediately.
Spot exchange rates are exchange rates for
currency exchanges “on the spot”, or when trading
is executed in the present.
 Participants in the spot market:
1. Commercial banks 2. Brokers 3. Customers of
commercial and central banks
Cont…
Forward exchange rates are exchange rates for
currency exchanges that will occur at a future
(“forward”) date.
forward dates are typically 30, 90, 180 or 360
days in the future.
rates are negotiated between individual
institutions in the present, but the exchange
occurs in the future.
Participants in the Forward Market
1. Arbitrageurs 2. Traders 3. Hedgers 4. Speculators
Cont…
Foreign Exchange Swaps: this is a spot sell of a
currency and a forward repurchase of that same
currency later. This reduces transaction cost in
terms of brokerage fees
Future and options: some other financial
instruments give better flexibility as to timing and
exchange terms.
 Futures contract is a promise that a specified
amount of foreign currency is given on specific date
in the future.
Cont…
 An option entitles owners to buy/sell a specified foreign
currency at specified price any time up to expiration date.
 It gives the right but not an obligation to buy/sell the
underlined asset
 The right to buy is call option
 The right to sell is put option
Nominal, Real and Effective Exchange Rates
A. Nominal Exchange rate (e):It is the relative
price of the currency of two countries. i.e. the
“exchange rate” between two countries,
 For example, if the exchange rate between the
Ethiopia birr and U.S. dollar is 20 birr per 1 dollar,
then you can exchange 20 birr for 1 dollar in the
world markets for foreign currency.
 An American who wants to obtain birr would pay
0.05 dollar for each birr he bought; and an Ethiopian
who wants to obtain dollar would get 0.05 dollar for
each birr he paid.
B. Real exchange rate (e)
The real exchange rate is the relative price of the
goods of two countries.
That is, the real exchange rate tells us the rate at
which we can trade the goods of one country for the
goods of another.
To see the difference between the real and nominal
exchange rates, consider a single good produced in
many countries: i.e. cars.
Suppose an Ethiopian car costs birr 1,200,000 and a
similar American car costs $120,000.
Cont…
To compare the prices of the two cars, we must
convert them into a common currency.
If a dollar is worth 20 birr, then the Ethiopian car
costs 60,000 dollar.
Comparing the price of the Ethiopian car (60,000
dollar) and the price of the American car (120,000
dollar), we conclude that the Ethiopian car costs
one-half of what the American car costs.
In other words, at current prices, we can exchange 2
Ethiopian cars for 1 American car.
Cont…
 Real Exchange Rate =
(0.05 dollar/birr)  (1,200,000 birrs/Ethiopian car)
(120,000 dollar/American Car)
= 0.5 American Car
Ethiopian Car
At these prices, and this exchange rate, we obtain
one-half of an Ethiopian car per American car.
Real Exchange Rate =
Nominal Exchange Rate  Price of Domestic Good
Price of Foreign Good
C. Effective Exchange Rate
The effective exchange rate is a measure of whether
or not the currency is appreciating or depreciating
against a weighted basket of foreign currencies.
In order to illustrate how an effective exchange rate
is compiled consider the hypothetical case of the
UK conducting 30 per cent of its foreign trade with
the US and 70 per cent of its trade with Germany.
This means that a weight of 0.3 will be attached to
the bilateral exchange-rate index with the dollar, and
0.7 with the deutschmark.
The Determinants of Exchange Rates
There are numerous determinants of a nation's
exchange rate.
However, these are the four primary determinants;
 interest rates
 economic growth
 a nation's current account and
 inflation rates.
1.6. Exchange Rate Systems/Regimes
Exchange rate systems are the rules that nations
attach to the movement of their exchange rates.
There are a number of different categories of sets or
rules that nations may adopt, but they all are
modifications of two fundamental categories. These
are:
 Fixed exchange rate system
 Floating exchange rate system
The gold standard and fixed exchange rates
Gold standards are a form of fixed exchange rates.
Under a pure gold standard, nations keep gold as
their international reserve.
 Gold is used to settle most international obligations,
and nations must be prepared to trade it for their
own currency whenever foreigners attempt to
"redeem" the home currency they earned when they
sold goods and services.
In this sense, the nation's money is backed by gold
Cont…
There are essentially three rules that countries need
to follow in order to maintain a gold exchange
standard.
 Rule 1: Nations must fix the value of their currency
unit in terms of gold.
 Rule 2: Nations keep the supply of their domestic
money fixed in some constant proportion to their
supply of gold.
 Rule 3: Nations must be willing to redeem their own
currency with payments in gold, and they must freely
allow gold to be imported and exported
Alternative exchange rate systems
 Under a floating exchange rate system, the value of
a nation's currency "floats" up and down in response
to changes in its supply and demand.
 When demand for domestic currency exceeds its
supply, the domestic currency appreciates in value
(Rn, the nominal exchange rate falls), and when
supply is greater than demand, the domestic
currency depreciates (Rn rises).
Cont…
Between fixed and floating exchange rates, there are
a number of other types of exchange rate systems.
The simplest way to categorize these systems is on a
scale that measures the amount of flexibility each
allows.
 Freely floating rates: At one end are freely floating
rates, which are the most flexible and determined
purely by the forces of demand and supply of the
foreign exchange market.
Cont…
 Managed floating rate: One step down the spectrum
of flexibility is a managed floating rate.
The difference between a managed floating rate and
a purely floating exchange rate is that the national
government occasionally intervenes in international
currency markets in an attempt to "manage" the
direction of change.
Intervention takes the form of buying the home
currency in order to increase its demand and prop up
its value, or selling the home currency in order to
encourage depreciation.
[Link] Interaction of Hedgers,
Arbitrageurs, and Speculators
Arbitrage: refers to the purchase of a currency in
the monetary center where it is cheaper for
immediate resell in the monetary center where it is
more expensive for profit.
Hedging: Hedgers are agents (usually firms) that
enter the forward exchange market to protect
themselves against exchange-rate fluctuations which
entail exchange-rate risk.
Speculation: speculators are agents that hope to
make a profit by accepting exchange-rate risk.
1.8. Appreciation / Revaluation and
Depreciation / Devaluation of Currencies
Devaluation and revaluation are equivalent to
depreciation and appreciation, except that the first
group refers to changes in a currency's value under a
fixed exchange rate system.
Devaluation is a decline in the value of a currency
under a fixed exchange rate system, while
depreciation is a decline under a flexible system.
Revaluation is an increase in the value of currency
under a fixed exchange rate system, while an
appreciation is an increase in the value of currency
under a flexible exchange rate
Cont…
All else equal
 A depreciation of a country's currency against
foreign currencies (a rise in the home currency
prices of foreign currencies) makes its exports
cheaper and its imports more expensive.
 An appreciation of its currency (a fall in the home
currency prices of foreign currencies) makes its
exports more expensive and its imports cheaper.
Chapter Two

Theories of Exchange
Rate Determination
[Link] Purchasing – Power Parity (PPP)
Approach
The theory of purchasing power parity states that
the exchange rate between two countries' currencies
equals the ratio of the countries' price levels.
The PPP theory predicts that a fall in a currency's
domestic purchasing power will be associated with a
proportional currency depreciation in the foreign
exchange market.
Symmetrically, PPP predicts that an increase in the
currency's domestic purchasing power will be
associated with a proportional currency
appreciation.
Cont…
Determining the long – run equilibrium value of an
exchange rate (the value toward which the actual
rate tends to move, given current economic
conditions and policies) is important for successful
exchange rate management.
National authorities try to forecast the long–run
equilibrium exchange rate and initiate exchange rate
adjustments to keep the actual rate in line with the
forecast rate.
Cont…
The PPP, therefore, can be used to make predictions
about exchange rates.
 It is worth noting to see the two important concepts
of the PPP approach.
A. Absolute PPP (Law of One Price)
This is the simplest concept of the model of PPP.
For analysis, it assumes the following:
 It is costless to transport commodities between
nations; and
 There are no barriers to trade (such as tariffs).
Cont…
Given the assumptions, the law of one price asserts
that identical goods should be sold at a similar price
or cost in all nations.
This ‘Law of one price ‘is simply called the absolute
version of the PPP approach. According to this
version, the exchange rate between any two
currencies is simply the ratio of the two countries’
general price levels.
Cont…
B. Relative PPP
According to the relative purchasing power–parity
theory of exchange rate determination, changes in
relative national (general) price levels determine
changes in exchange rates over the long-run.
The theory predicts that the foreign exchange value
of a currency tends to appreciate or depreciate at a
rate equal to the difference between foreign and
domestic inflation.
Cont …
A currency would be expected to depreciate by an
amount equal to the excess of domestic inflation
over foreign inflation.
It would appreciate by an amount equal to the
excess of foreign inflation over domestic inflation.
The Absolute PPP is statement that exchange rate
equals relative countries’ price levels.
[Link], Interest Rates, and the
Exchange Rates
Brief review of the money market
 The interest rate and future exchange rate affect the
Foreign Exchange Market (FEM).
 The exchange rate depends on interest rates earned
on deposits of currencies and expected future
exchange rate.
 Let’s now see how interest rates are determined and
how expectations about future exchange rates are
formed.
Cont…
The first step in doing so will be explaining the
effects of money supply and demand on interest and
exchange rate.
Factors that affect the money supply and demand
are the most vital factors determining levels of
exchange rates.
Monetary development affect exchange rate by
affecting interest rates and future expectations about
exchange rate.
The exchange rate in turn depends on the trend in
prices of goods which in turn lies on money demand
and supply.
The Definition and Functions of
Money
To an economist, money is an asset that is widely
used and accepted as a means of payment.
Money Serves as a medium of exchange.
Money is the most liquid of all asset – it can be
transformed into goods and services rapidly
without high transaction costs.
Money as a unit of account – a widely
recognized measure of value.
Prices of good and services are typically
expressed in terms of money.
Cont …
Exchange rates allow us to translate different
countries’ money prices into comparable term.
Money as a store of value:
value money can be used to
transfer purchasing power from the present into
the future.
The Supply of and the Demand for
Money
Money supply Ms : It is the total amount of currency
and checking deposits held by households and firms.
The large deposits traded by participants in the
foreign exchange market are not considered part of
the money supply.
These deposits are less liquid than money and are
not used to finance routine transactions.
Cont…
An economy's money supply is controlled by its
central bank ( NBE in our case).
The central bank directly regulates the amount of
currency in existence and also has indirect control
over the amount of checking deposits issued by
private banks.
The procedures through which the central bank
controls the money supply are complex, and we
assume for now that the central bank simply sets the
size of the money supply at the level it desires.
Money demand Md
Money demand is the amount of assets that people
are willing to hold as money.
The demand for money reflects the quantity of
currency and checkable deposits the public wants to
hold to make payments.
Individuals base their demand for an asset on three
characteristics:
 The expected return the asset offers compared with
the returns offered by other assets.
 The riskiness of the asset's expected return,
 The asset's liquidity.
Cont…
While liquidity plays no important role in
determining the relative demands for assets traded
in the foreign exchange market, households and
firms hold money only because of its liquidity.
Aggregate money demand is just the sum of all the
economy's individual money demands.
There are three main factors that determine
aggregate money demand:
 The interest rate: A rise in the interest rate causes
each individual in the economy to reduce her
demand for money.
Cont…
 The price level. If the price level rises, individual
households and firms must spend more money than
before to purchase their usual weekly baskets of
goods and services. To maintain the same level of
liquidity as before the price level increase, they will
therefore have to hold more money.
 Real national income. When real national income
(GNP) rises, more goods and services are being sold
in the economy. This increase in the real value of
transactions raises the demand for money, given the
price level.
Equilibrium in the Money Market (M s =
Md)
The money market is in equilibrium when the real
money supply equals aggregate real money demand.
With the price level and real output given, a rise in
the money supply lowers the interest rate and a fall
in the money supply raises the interest rate.
 A rise in real output raises the interest rate, given
the price level, while a fall in real output has the
opposite effect.
The Demand for Foreign Currency Assets
The demand for foreign currency is affected by the
same set of factors that influence the demand for
other assets.
The future return of a foreign currency deposit
depends on interest rate and future exchange rate
against others.
What Influences Individual Demand for Money?
1. Expected returns/interest rate on money relative
to the expected returns on other assets.
 Other things equal, a rise in the interest rate
causes the demand for money to fall.
 Because an increase in the interest rate is a rise in
the rate of return on less liquid assets relative to
the rate of return on money.
2. Risk: the risk of holding money principally comes
from unexpected inflation, thereby unexpectedly
reducing the purchasing power of money.
– but many other assets have this risk too, so this
risk is not very important in money demand
Cont…
3. Liquidity: the main benefit of holding money
comes from its liquidity.
 A need for greater liquidity occurs when either
the price of transactions increases or the quantity
of goods bought in transactions increases.
 A rise in the average value of transactions
carried out by a household or firm causes its
demand for money to rise.
Linking Money, the Interest Rate, and
the Exchange Rate

 Reading Assignment