UNIVERSITY OF LJUBLJANA

FACULTY OF ECONOMICS

International

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

1. Definitions of the Exchange Rates and Their

Usage in Economic Analyses
Nominal Bilateral Exchange Rate
price of a currency in terms of another currency:
direct quotation: value of a unit of foreign currency in terms of the
units of domestic currency

indirect quotation: value of a unit of domestic currency in terms of

the units of foreign currency

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Real Bilateral Exchange Rate

nominal exchange rate between the currencies of the two countries that
takes into account the prices in the two countries

sp *
St
p

Points in
Time

Nominal
Bilateral
Exchange
Rate

Nominal
Bilateral
Exchange
Rate Index

Price
Index in
Slovenia
(1=100)

Price Index
in Germany
(1=100)

Real Bilateral
Exchange Rate
Index (1=100)

100

100

100

100

100

100

100

100

100

83

120

120

120

120

120

90

90

130

117

81

75

75

150

125

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Nominal Effective Exchange Rate

index, that tells us the movement of a particular currency relative to
the weighted average of the currencies of other countries, included
in the composite of currencies
Points in
Time

Nominal Bilateral
Exchange Rate Index
SIT/DEM (1=100) (1)

Nominal Bilateral
Exchange Rate Index
SIT/ITL (1=100) (2)

Nominal Effective
Exchange Rate Index SIT
(1=100) (3)

100

100

100

100

90

97

120

90

111

90

80

87

75

85

78

(3)=(1)* 0,7 + (2) * 0,3

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Real Effective Exchange Rate

index that tells us the movement of a particular currency
relative to the weighted average of the currencies of other
countries, included in the composite of currencies, taking
into account the prices in the home country and in all other
countries, whose currencies are included in the composite

Rp *
Rt
p

it reflects the competitiveness of the country

the relationship between the domestic prices for exchange
goods and services and domestic prices for non-exchange
goods and services
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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

2. Market Exchange Rate: Pure Flexible

Exchange Rate System
Foreign Currency Supply and Demand Curves
exchange rate determined only on the basis of market forces

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Factors that Influence Exchange Rate Changes

Exchange rate changes as a result of changes in the
Balance-of-Payments Accounts:
systematic analysis of the influences on the exchange rate
determination and changes, caused by changes in particular types
of economic transactions in the balance-of payments
current account, capital and financial account of the balance-ofpayments and international monetary reserves:
ex. relative increase in domestic prices domestic goods less
competitive increased imports & increased demand for foreign
currencies

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Factors that Influence Exchange Rate Changes

Exchange rate changes as a result of changes in particular
macroeconomic indicators:
Differences in the rates of inflation:
increase in the domestic rate of the level of prices depreciation of the
domestic currency
assumption
exchange rate reflects the relative purchasing power

ceteris paribus

Differences in the interest rates:

higher domestic interest rates appreciation of the domestic currency

Differences in the level of income:

higher domestic income depreciation of the domestic currency

Expectations
Other factors (political and psychological factors)

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relative
changes!
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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Factors that Influence Exchange Rate Changes

schematic representation of the influence of various factors
on the market exchange rate:

balance in the balance-of-payments is achieved by the

exchange rate (IMR=0)
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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

3. Exchange Rate under State Intervention: Pure

Fixed Exchange Rate System and Hybrid
Exchange Rate System
Basic Logic of the Pure Fixed Exchange Rate
System and the Hybrid Exchange Rate System
Pure Fixed Exchange Rate System:
the government determines the value of the domestic currency it
determines official exchange rate
the government must intervene on the foreign currency market to
keep the exchange rate within the allowed interval

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Basic Logic of the Pure Fixed Exchange Rate

System and the Hybrid Exchange Rate System
Hybrid exchange rate system:
the government establishes neither the official exchange rate nor
the interval within which the exchange rate can be
its intervantion on this market is completely discretionary:
it will intervene on the foreign exchange market when it estimates
that the exchange rate is not changing in accordance with its
expectations/wishes

deficit/suficit of the overall balance is reflected in:

pure fixed exchange rate system: IMR
pure flexible exchange rate system: depreciation/apreciation of the
currency
hybrid exchange rate system: combination of both

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Reasons for Governmental Intervention on the

Foreign Currency Market
reduction of oscillations in the exchange rate movement
determining implicit borders of the exchange rate
movement
reaction in exceptional circumstances:
for the neutralisation of the potential exchange rate
changes because of speculations

interventions usually do not have a long-term effect on the

exchange rate changes
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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Forms of Governmental Intervention on the Foreign

Exchange Market
direct interventions:
additional supply/demand of foreign currencies:
unsterilized interventions:
CB does not react to the changes in the quantity of money in obtoku, which is a
result of its intervention on the foreign currencies market

sterilized interventions:
CB intervenes on the foreign exchange market in such a way that the
intervention in combination with economic policy measures does not cause (it
sterilizes) changes in the quantity of money in obtoku
the size of the intervention to prevent the depreciation of the domestic currency
is bounded by the foreign reserves availability
the size of the intervention to prevent the apreciation of the domestci currency
is bounded by the size of the stock obsegom izdaje vrednostnih papirjev, ki ne
povzroi znatnega povianja obrestnih mer

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Forms of Governmental Intervention on the Foreign

Exchange Market
Indirect interventions:
Monetary policy:
open market operations (increasing/decreasing the interest rate)
directly related to the change in the quantity of money in v obtoku, and,
consequently, to the change in prices in the country

fiscal policy:
changes in the level of government spending and the taxation of the residents,
as well as the size of the government suficit/deficit
restrictive fiscal policy causes depreciation of the domestic currency
expansive fiscal policy causes apreciation of the domestic currency

other forms of intervention:

various forms of public communication between the CB representatives and
the government
credibility?

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

4. Arguments For and Against a Particular

Pure Exchange Rate System
Purely Flexible Exchange Rate System
balance-of-payments balance achieved automatically
stabilizing speculations
higher economic stability
monetary autonomy
insurance against external shocks

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Purely Flexible Exchange Rate System

higher stability in international relations:
lower uncertainty for exporters and importers
more direct investments and other long-term investments

better discipline in macroeconomic policy implementation:

it forces the countries into inflation rate lowering (the sidro
argument)

destabilizing speculations less likely:

too high risk aversion
bandwagon effect
wrong model of the exchange rate determination
neglecting the dynamic component of the economic development
rational bubbles

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

5. Arguments For and Against a Hybrid

Exchange Rate System
the possibility of having the advantages of both pure
systems and effectively reducing their disadvantages at the
same time
What kind of interventions?
Should they be only temporary?
How should the obligation of the
government to intervene on the
foreign exchange market be
defined?

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

establishment of the true exchange rate:

a country usually has better and more complete information about
its economy, and, hence, about all the crucial macroeconomic and
other indicators that are important for the exchange rate
establishment
the authorities are the only ones that are (should be) fully
acquainted with the economic policy measures they will
implement and that will have an effect on the exchange rate

reducing the economic adjustment costs:

economic adjustment process dynamics reduces the costs more
than if the adjustment were to be achieved by market forces
exclusively

reducing the costs in case of over-shooting

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

6. Criteria for Choosing an

Exchange Rate Regime
even after the government intervention is proven to be
necessary, its form, size and duration need to be exactly
specified
pegged arrangements:
geographically smaller countries
open economies
countries with a lower rate of production and export diversification
countries with geographically concentrated international trade
countries whose rate of inflation is similar to the world rate of
inflation
high rate of flexibility of the production factor markets, low
credibility of the economic policy makers, etc.

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

6. Criteria for Choosing an

Exchange Rate Regime

analysis of the effects of different shocks and changes on
the economy:
optimal regime causes the least oscillation in GDP
pegged arrangements appropriate when the shocks in the economy
are caused mainly by domestic nominal categories
floating arrangements appropriate when the shocks are external or
caused by domestic real categories

the role of credibility and political factors

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

7. Current Exchange Rate Regimes

Systematic Overview of the Regimes of the
Exchange Rate
most regimes come from the hybrid exchange rate
system
pegged arrangements:
country establishes the par value of the domestic currency
country determines the limits within which the exchange rate can
change or within which it will keep the exchange rate by
intervening in the foreign exchange market
difference: how long is the exchange rate pegged at the same level
and how wide are the limits within which it can change

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Systematic Overview of the Regimes of the

Exchange Rate
country promises to exchange the domestic currency for a foreign
currency at a fixed exchange rate, and that domestic money
emission will occur only if it is fully covered by foreign currency
possibly successful in countries in which a high rate of fiscal
discipline can be achieved, with relatively stable banking system
and possibility of flexibility of price and wage movements in both
directions

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Sistematini pregled uporabljanih reimov

deviznega teaja
par value irrevocably fixed or unchanged in the long run
R($/)

2,02
Par
value

2,00

Band

1,98

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Month

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

built-in possibility of occasional par value changes the currency

is devalued/revalued it contributes to the elimination of the
balance-of-payments imbalance deficit/surplus
R($/)

2,12

Band

peg against a single

currency
2,02
peg against a composite 2,00
1,98
of currencies

Devaluation

Revaluation

limits of the exchange

rate movements

1,88

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Month

UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

par value changes in regular intervals, for example every month or

every two months, that are known in advance, and each time the
change in par value is relatively small

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

floating arrangements:
CB intervenes discretionary which gives it more flexibility in
leading the monetary policy

the monetary authorities determine the appropriate exchange rate

for the country on the basis of their own analyses and estimates

CB interventions on the foreign exchange market are in principle

short and not intended to establish the exchange rate; rather, they
are mostly intended to prepreitvi its unnecessarily big oscillations
that occasionally happen because of speculating forces on the
currency

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Evolution of the Exchange Rate

Regimes After 1973

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

reasons for prehajanje from pegged to floating

arrangements
the nineties:

the eighties
large oscillations in the movement
of the exchange rates of the
currencies of the economically
most important countries in the
world
large increase in the rates of
inflation in most developing
countries
decline in the economic growth of
industrialized countries in the first
half of the decade, deterioration in
terms of trade for developing
countries and the effects of the
debt crisis

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huge increase in the number of

countries whose currencies became
convertible in transactions on the
current account of the balance-ofpayments
increasing tensions between two
crucial macroeconomic goals low
rate of inflation and high
international competitiveness of
the country
capital flows liberalization, the
effect of which is highly increased
rate of capital mobility

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

8. Other Classifications of the Exchange Rates

Spot and Forward Exchange Rates
spot foreign exchange transactions:
payment executed in two days after the transaction
spot exchange rate

forward foreign exchange transactions:

seller and buyer agree on the price of the foreign currency now,
transaction is executed at a certain point in the future, for example,
in 1, 3, 6, 9 months or a year
forward exchange rate

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UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS

Single and Multiple Exchange Rates

multiple exchange rates:
different exchange rates for different types of transactions
different exchange rates on two or more foreign exchange markets
different exchange rates because of tariffs and/or subventions on
foreign exchange transactions

usually because of balance-of-payments reasons

cause distortions in the relative prices of domestic and foreign
goods

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