# 18.2: Determining the Exchange Rate

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Learning Objectives

1. What is the structure of the foreign exchange market?
2. Why shouldn’t countries be proud that it takes many units of foreign currencies to purchase a single unit of their currency?

We can’t teach you how to predict future exchange rates because the markets are highly efficient (free floating exchange rates follow a random walk) and because many exchange rates are more or less heavily influenced by monetary authorities. Some countries try to maintain fixed exchange rates by pegging their respective currencies to gold or some other currency, like the U.S. dollar, euro, or Swiss franc. Many others allow exchange rates to float within a range or band, some of which are broader than others. Other countries allow the value of their currencies to freely float, determined solely by supply and demand. Nations that fix their exchange rates or engage in a so-called dirty float (within bands) find it necessary to make periodic adjustments to both the width and range of the bands over time. So trying to make a living predicting exchange rate changes is difficult indeed. That said, you should be able to post-dict why floating exchange rates changed or, in other words, to narrate plausible reasons why past changes, like those depicted in Figure 18.2 and Figure 18.3 , may have occurred. (This is similar to what we did with interest rates.)

The figures, like the exchange rates in Figure 18.1 , are mathematical reciprocals of each other. Both express the exchange rate but from different perspectives. Figure 18.2 asks how many USD it took to buy $C1, or mathematically USD/C$. Figure 18.3 asks how many $C it took to buy 1 USD, or C$/USD. In Figure 18.2 , USD weakens as the line moves up the chart because it takes more USD to buy $C1. The dollar strengthens as it moves down the chart because it takes fewer USD to buy$C1. Everything is reversed in Figure 18.3 , where upward movements indicate a strengthening of USD (a weakening of $C) because it takes more$C to buy 1 USD, and downward movements indicate a weakening of USD (a strengthening of $C) because it takes fewer$C to buy 1 USD. Again, the figures tell the same story: USD strengthened vis-à-vis the Canadian dollar from 2000 to early 2003, then weakened considerably, experiencing many ups and downs along the way due to relative differences in inflation, interest, and productivity rates in each country. USD appreciated during the financial crisis in an apparent “flight to quality” but weakened again during the 2010 recovery, bringing it back to parity with the Looney. We could do the same exercise ad nauseam (Latin for “until we vomit”) with every pair of currencies in the world. But we won’t because the mode of analysis would be precisely the same.

We’ll concentrate on the spot exchange rate, the price of one currency in terms of another today, and currencies that are allowed to float freely or at least within wide bands. The forward exchange rate, the price today of future exchanges of foreign currencies, is also important but follows the same general principles as the spot market. Both types of trading are conducted on a wholesale (large-scale) basis by a few score-big international banks in an over-the-counter (OTC) market. Investors and travelers can buy foreign currencies in a variety of ways, via everything from brokerage accounts to airport kiosks, to their credit cards. Retail purchasers give up more of their domestic currency to receive a given number of units of a foreign currency than the wholesale banks do. (To put the same idea another way, they receive fewer units of the foreign currency for each unit of their domestic currency.) That’s partly why the big banks are in the business. The big boys also try to earn profits via speculation, buying (selling) a currency when it is low (high), and selling (buying) it when it is high (low). (They also seek out arbitrage opportunities, but those are rare and fleeting.) Each day, over $1 trillion of wholesale-level ($1 million plus per transaction) foreign exchange transactions take place.

• At the wholesale level, the market for foreign exchange is conducted by a few score large international players in huge (> $1 trillion per day) over-the-counter spot and forward markets. • Those markets appear to be efficient in the sense that exchange rates follow a random walk and arbitrage opportunities, which appear infrequently, are quickly eliminated. • In the retail segment of the market, tourists, business travelers, and small-scale investors buy and sell foreign currencies, including physical media of exchange (paper notes and coins), where appropriate. • Compared to the wholesale ($1 million plus per transaction) players, retail purchasers of a foreign currency obtain fewer units of the foreign currency, and retail sellers of a foreign currency receive fewer units of their domestic currency.