ECONOMICS

Exchange Rate Economics

Exchange Rate Economics

Introduction

Since the end of the 70 different models have been developed theoretical attempt to explain why a crisis arises balance of payments. These models are usually classified into two groups: the so-called models of the first and second generation. (The first generation models are born with Krugman who adapted a previous model of Salant and Henderson on the pricing of a non-renewable to the particular case the pricing of the domestic currency. The main idea of these models is that the balance of payments crisis occurs invariably by the incompatibility of exchange rate policy with fiscal and government money involved. Second generation models already appear in the decade of the 90 and consider the crises do not arise directly from the mismanagement of a government, but devaluation expectations of private agents. Such expectations of devaluation can occur from many circumstances, for example, growth in unemployment or raising interest rates, and even simple rumors economic climate of the country in question.

Discussion

With more than 180 countries in the world, there are more than 16,000 possible exchange rates. Market practices allow traders to calculate all possible exchange rates based on prevailing dollar exchange rates. As already noted, the dollar typically serves as a vehicle currency for trades involving two other currencies; the exchange rate between any two non-dollar currencies at any point in time is based on that pattern of trades. For instance, the exchange rate between the British pound and the euro is calculated using the following formula:

The term on the left is the price of 1 euro in terms of pounds. It equals the price of 1 dollar in terms of pounds times the dollar price of 1 euro. The logic behind this formula is that it is based on the cost of using pounds to buy dollars and then using those dollars to buy Euros.

Exchange rates may be totally market determined, in which case that country is said to have a freely floating exchange rate. This is true of about 40 countries in the world, including almost all of the major developed economies. Market-determined exchange rates can be very volatile over the short run. The next section discusses the behaviour of floating exchange rates in the short and long runs. In the rest of the world, countries adopt various policies aimed at limiting exchange rate movements. These range from fixed exchange rate policies, wherein a government announces a fixed price of one unit of a target currency such as the dollar or the euro in terms of its currency, to allowing exchange rates to move over time but in a limited fashion. Policies such as these require the governments to purchase or sell their currencies in the foreign exchange market on a regular basis to limit exchange rate movements.

Market-determined exchange rates exhibit considerable volatility. A variety of studies shows that the volatility of short-run exchange rate returns is indistinguishable from stock or bond market return ...