Why do developing countries need partial convertibility

international economic Relations

Klaus-Peter Kruber

To person

Born in 1944, is professor for economics / politics and its didactics at the Christian-Albrechts-Universität zu Kiel and director at the institute for social sciences. His main research areas are conceptual approaches to economic education, the relationship between economic and political didactics, the history of theory of economic thought and international economic relations. Prof. Kruber studied economics and economic geography at the University of Bonn and then worked at the Universities of Erlangen and Wuppertal. In 1975/76 he was appointed professor at what was then the Kiel University of Education. Since 1994 he has been teaching economics / politics at the Faculty of Economics and Social Sciences at Christian-Albrechts-Universität.

Email: [email protected]

Anna Lena Mees

To person

After completing her studies, she works as a teacher at grammar schools (economics / politics and English) as an employee at the chair for economics / politics and its didactics.

Christian Meyer

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Christian Meyer is a research associate at the Institute for Social Sciences at the Christian-Albrechts-Universität zu Kiel. After completing his studies in economics / politics and mathematics (teaching post for grammar schools), he works there at the chair for economics / politics and its didactics.

Email: [email protected]

Foreign exchange markets, exchange rates and currency systems influence international trade. The IMF and World Bank are supposed to regulate international currency and financing relationships and effectively counter global currency crises.

IMF Director Christine Lagarde and the President of the World Bank Group, Robert Zoellick, at the annual joint IMF-World Bank conference 2011 in Washington. (& copy picture alliance / abaca)

introduction

International economic relationships differ from national ones, among other things, in that exports are paid for in foreign currencies and that foreign currencies are required for purchases abroad. Exporters offer foreign currencies (foreign exchange), importers ask for foreign exchange. Markets emerge on which exchange rates are formed.

The exchange rate is the price for a foreign currency unit (for example one dollar) expressed in the domestic currency. In April 2008 you had to pay 0.63 euros for one US dollar, or you received 1.57 US dollars for one euro. In the first variant one speaks of the price quotation of the dollar rate, in the second of its quantity quotation. Price and quantity quotations are reciprocal, i.e. one quotation is the reciprocal of the other.

Determinants of the exchange rate

The pricing of foreign currencies, for example the US dollar, follows the well-known laws of supply and demand. As the price of the US dollar rises, the demand for the US currency decreases, because shopping in the dollar currency area becomes more expensive, calculated in euros. At the same time, the supply of US dollars is increasing because, in terms of dollars, it is becoming cheaper for Americans to shop in Europe. The price of the dollar is formed at the intersection of the supply and demand curves.

The demand for foreign exchange results from
  • domestic demand for foreign goods and services (import),
  • taking out loans abroad, buying foreign securities or acquiring foreign companies by residents (capital export).


The supply of foreign currency is a consequence
  • the demand from foreigners for domestic goods and services (export),
  • taking out loans in Switzerland, buying domestic securities or acquiring domestic companies by foreigners (capital import).
Added to this are the supply and demand for foreign exchange due to financial transactions between states or international organizations (e.g. for development aid or payments to the UN).

Caricature: Export
Changes in exchange rates, in turn, affect international trade and capital movements. If there is an appreciation of the euro - US citizens now have to pay more for the euro, Europeans less for the dollar - this means from the German perspective that our export goods, calculated in foreign currency, will become more expensive. This tends to slow down exports. On the other hand, shopping in the dollar area is becoming cheaper, so that imports from there tend to increase and foreign production locations gain exchange rate-related cost advantages. This is problematic for companies that mostly pay their workforce and suppliers in euros and sell their products in US dollars, such as the European aircraft manufacturer Airbus. In this case, relocation of production to the dollar area is one approach to countering this problem. Conversely, a depreciation of the euro and, at the same time, an appreciation of the dollar tend to improve domestic export opportunities and make imports more expensive.

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Case study: changes in exchange rates

A German computer company wants to import 100 American computers. Assuming an exchange rate of 1: 2 (1 euro = 2 dollars) and a price of 1000 US dollars in the USA, the German importer has to pay 50,000 euros to buy 100,000 US dollars. However, if there is an appreciation of the dollar (this is equivalent to a depreciation of the euro), i.e. at a changed exchange rate (for example 1 euro = 1 dollar), the importer has to spend 100,000 euros to pay the computers in the USA his business is deteriorating and may fail.

From the point of view of an American, the appreciation of the dollar has a different effect. At an exchange rate of 1: 2, an American importer has to buy euros on the foreign exchange market for 200,000 US dollars if he wants to import five cars from Germany at a price of 20,000 euros each. After the dollar's appreciation, he only has to convert 100,000 US dollars into 100,000 euros to pay for the five cars and he'll think about buying more cars in Germany.

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Exchange rate fluctuations are the result of price and interest rate differences between home and abroad. For example, if the domestic price level rises more sharply than abroad, this leads to an increase in domestic demand for goods and services in relatively more stable foreign countries - there is an import pull. There is greater demand for foreign currencies. At the same time, foreign demand for domestic goods is falling: they are becoming comparatively more expensive, export opportunities are deteriorating, and less foreign currency is being earned. As a result, the supply and demand curves on the foreign exchange market shift and even out when there is a new exchange rate. In our example, the rate of the foreign currency rises. One speaks of an appreciation of the foreign currency or equivalent to a depreciation of the domestic currency. Likewise, different interest rate levels between two countries can trigger capital movements that affect the exchange rate through changes in the supply and demand for foreign exchange.

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Exchange rate theories

For a long time, the theory of purchasing power parity was fundamental to the theoretical explanation of exchange rates. It goes back to classical economics and, in its current form, goes back to the Swedish economist Gustav Cassel (1866-1945). It explains the exchange rate from the flow of goods between two countries and the associated supply or demand for foreign currency.

The basic model assumes that there is free trade between two countries (transport costs are neglected). Assuming a barrel of oil costs 120 dollars in country A and 40 euros in country B and the exchange rate is initially 1: 1. Then it is attractive for traders from A to buy oil from B and increasingly import it to country A. As a result of the increased supply of oil in A, the oil price drops there, in B it rises because the supply is becoming scarcer. Trading also changes the exchange rate, because for purchases in B, traders from A have to ask for euros for dollars. The dollar rate falls or the euro rate rises. At the end of this process, for example, a barrel of oil in country A could cost 100 dollars and in country B 50 euros at an exchange rate of 2: 1. Converted to the exchange rate, the purchasing power of a currency unit domestically equals that abroad.
In fact, of course, exchange rates are not formed for individual goods, but these are modeled into bundles of goods, so that it is a matter of aligning the price levels, not each individual price.
In general, for a bundle of goods that is offered domestically at the price Pi and abroad at the price Pa, the following relationship applies: Pa x W = Pi or, converted: W = Pi: Pa.
The nominal exchange rate W corresponds to the ratio of the price level measured in the respective national currency between home and abroad.
In addition to the absolute level of the exchange rate, its change is of particular interest. A change in the exchange rate (dW) occurs when the price level changes in one country or in both countries, in other words: when the inflation rates differ between two countries: dW = dPi - dPa.
So if the price level rises faster at home than abroad, it becomes more attractive to shop abroad. The demand for foreign currency is increasing (or equivalent: the domestic currency is increasingly being offered on foreign exchange markets). As a result, the domestic currency is devalued or the exchange rate of the foreign currency (in price quotation) increases.
The purchasing power parity theory only explains changes in exchange rates that are caused by price changes in the trade in goods. The model provided a sufficient explanation as long as international economic relations were essentially reduced to the trade in goods. Today, however, in addition to foreign trade, international financial transactions are increasingly influencing the exchange rate. The interest parity theory describes their influence.
It is assumed that, given the same investment risk, the respective rates of return (returns) of the investment options determine which country capital flows into. Not only the existing interest rate differentials are important, but also the exchange rate or expected changes in the exchange rate.
This can be illustrated by an example: A saver receives an interest rate of four percent with a one-year term on a fixed-income security at a domestic credit institution. If a foreign bank offers a security with the same interest rate and maturity, the foreign return is only calculated when the exchange rate is taken into account. The saver must first raise the investment amount in a foreign currency by buying foreign currency at the current rate (spot rate). For example, at a spot rate of 2: 1, he would have to pay 500 euros for 1000 dollars. At the same time, it is necessary to estimate the exchange rate that will be valid in one year, since at this point in time the investment amount plus interest will be exchanged back into local currency. If the investor expects an increase in the foreign currency, for example to 1: 1, he will make a profit even with the same interest, since he will receive a higher amount (1000 euros) back in the domestic currency
elder However, if the exchange rate of the foreign currency falls, there is a loss. The exchange rate (forward rate) valid in one year can only be estimated. If the investor is afraid of the exchange rate risk, he can sell the foreign currency that he will receive after the investment has expired when buying the security on the currency futures market (currency futures transaction).
If the rate of return abroad, taking into account the exchange rate, is higher than at home, the foreign currency is bought more often. This goes hand in hand with an increased supply of the domestic currency, so that a shift in supply and demand results in a devaluation of the domestic currency, which offsets the difference in returns. The same applies to an initial yield differential in favor of the domestic market: in this case, the domestic currency is revalued (or the foreign currency devalued) until the interest rate differential aligns.

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In addition to these rather long-term dominant real economic factors, speculative and political factors play an important role. Expectations about future price and interest rate developments have a significant influence on supply and demand in foreign exchange markets. A price increase on raw material markets (e.g. for oil) is often less the result of a supply shortage that has already occurred, but rather the result of feared bottlenecks as a result of a political crisis. Oil is billed in US dollars in international markets. In order to anticipate expected price increases, traders and consumers are now buying US dollars, thereby increasing demand on the currency markets and causing the dollar exchange rate to rise, which, calculated in domestic currency, multiplies the rise in oil prices (self-fulfilling prophecy).

Changes in expectations can have a "contagious" effect and spread quickly ("herd behavior"). If a speculative bubble bursts and suddenly everyone wants to "get out" of the currency in question, this can trigger enormous sales waves in the short term and cause significant exchange rate fluctuations. Likewise, capital flight triggered by political developments can cause a country's exchange rate to collapse. More recent approaches in exchange rate theory investigate such relationships; they work with game theory models and are based on the assumption of non-rational expectations.

It turns out that a large number of explanations for exchange rate changes have to be taken into account; monocausal approaches fall short. Real economic influencing factors tend to explain longer-term exchange rate trends, while short-term exchange rate fluctuations can be explained more with speculative influences.