Exchange Rates and
Exchange Rate
Regimes
Ing. Tomáš Heryán, Ph.D.
International Business Finance
FIU/NKIFA
• Exchange rates matter in many different ways to many different
constituencies in the world economy
• Much of issues in international finance is directly or indirectly concerned
with exchange rates
• Relationship of exchange rates with number of economic fundamentals is
documented theoretically as well as empirically
– International trade
– International investment
– Economic growth
– Inflation
– Economic competitiveness
Role of exchange rates
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• Nominal exchange rate vs. Real exchange rate
– While the nominal exchange rate expresses the relative price of currencies the real
exchange rate incorporates relative price levels and tells about purchasing power of
currencies
• Bilateral exchange rate vs. Effective exchange rate
– While the bilateral exchange rate refers to the relative price of two currencies the
effective exchange rates show the currency value against a basket of currencies
• Nominal bilateral exchange rate
• Real bilateral exchange rate
• Nominal effective exchange rate
• Real effective exchange rate
Basic types of exchange rates
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• The most common type of exchange rate
• Exchange rate at which the currency of one country can be swapped for that
of another country
• Most frequently quoted as price of one foreign currency unit in units of
domestic currency
• Important for international trade, price comparisons, clearing of
international transactions
• Change of the exchange rate
Nominal bilateral exchange rate
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
100
)(
% 1

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 
t
tt
E
EE
E
Czech National Bank exchange rate fixing (11/08/2017 and 11/08/2016)
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
2017 2016
2017 2016
Development of selected exchange rates with CZK
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
CZK/EUR
CZK/GBP
CZK/USD
CZK/CHF
Development of selected exchange rates with USD
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• Nominal bilateral exchange rate multiplied by the ratio of price levels in
foreign and domestic country
• Information about purchasing power of the currency
• Price of currency expressed in goods
• Measured and reported as index
– Ratio of prices of foreign and domestic goods expressed in domestic currency units
• Increase of the index means real depreciation of the home currency
Real bilateral exchange rate
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
t
t
tt
P
P
ERE
*

Changes in the real exchange rate
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
Change Intuition Effect in „RE“ equation
Pt* (price level in the
foreign country)
increases
Foreign goods increase in price. Therefore, it
takes more domestic goods to buy a unit of
foreign goods. The real value of the home
currency has fallen.
Because it is in the numerator,
the increase of Pt* increases
the value of REt
Pt (price level in the
home country)
increases
Domestic goods increases in price. Therefore, it
takes fewer domestic goods to buy a unit of
foreign goods. The real value of the home
currency has risen.
Because it is in the
denominator, the increase of
Pt decreases the value of REt
Et increases It takes more domestic currency units to buy a
unit of the foreign currency. The real value of the
home currency has fallen.
The increase in Et increases
the value of REt
• Real appreciation of the home currency is caused by either nominal
appreciation or higher inflation in the domestic economy than abroad
• Real appreciation can occur even in times of nominal depreciation if the
differential exceeds the rate of nominal depreciation
• Real appreciation means higher purchasing power of the home currency
relative to the foreign currency
• With real appreciation the same quantity of domestic goods can be traded
for more foreign goods
• Real appreciation of the home currency means that the domestic goods have
become more expensive compared to foreign goods, so that domestic export
may fall
Interpretation and meaning of the real appreciation
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
Simplified „beer“ example of real appreciation
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
1995
E = 18 CZK/DEM
35.20 CZK/EUR
P = 7 CZK
P* = 2.5 DEM = 1.28 EUR
RE = 35.20 * (1.28 / 7)
RE = 6.4277
1 beer in DE = 6.4 beers in CZ
1 beer in CZ = 0.15 beer in DE
2017
E = 26.10 CZK/EUR
P = 25 CZK
P* = 3.50 EUR
RE = 26.10 * (3.50 / 25)
RE = 3.654
1 beer in DE = 3.65 beers in CZ
1 beer in CZ = 0.27 beer in DE
E = (26.10 – 35.20) /
35.20 = -25.85 %
P = (25 – 7) / 7
= 257.14 %
P* = (3.50 – 1.28) /
1.28 = 173.44 %
RE = (3.654 – 6.427)
/ 6.427 = -43.15 %
Real appreciation of
CZK through
nominal
appreciation as well
as higher inflation
• Any currency may rise against one currency but depreciate against another
over any particular period – what is the total change?
• Nominal effective exchange rate measures development of domestic
currency against basket of the most important foreign currencies
• Each currency included has its own weight according to its significance for
foreign trade and investment in the particular country
• Expressed in index for since many currencies included in the basket
• n is number of currencies in the basket
• si is exchange rate of the national currency against the currency of the country i
• s*i is exchange rate of the national currency against the currency of the country i during
the base period
• wi is country’s weight (of the currency)
Nominal effective exchange rate (NEER)
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
iw
n
i i
i
s
s
NEER 
 






1
NEER in leading economic centers
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
appreciation
depreciation
Bilateral and effective exchange rates in the euro area
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• Real effective exchange rate is a weighted average of a country's currency
against a basket of other major currencies adjusted to the effects of inflation
• Widely used indicator of international competitiveness of the country
– Real appreciation (depreciation) means loosing (gaining) the competitiveness
• Reported as index in several versions differing in number of currencies
included in the basket
• n is number of currencies in the basket
• si is exchange rate of the national currency against the currency of the country i
• s*i is exchange rate of the national currency against the currency of the country i during
the base period
• wi is country’s weight (of the currency)
• pi is inflation rate in country i
• p is inflation in the home country
Real effective exchange rate (REER)
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
iw
n
i
i
i
i
p
p
s
s
REER 
 






1
Long-run REER developments
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
appreciation
depreciation
REER adjustments around the globe
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
appreciation
depreciation
NEER vs. REER development during transition
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
70
80
90
100
110
120
130
1993M
1
1993M
101994M
71995M
41996M
11996M
101997M
71998M
41999M
11999M
102000M
72001M
42002M
12002M
102003M
72004M
4
NEER REER
0
50
100
150
200
250
300
350
1990M1
1990M11
1991M9
1992M7
1993M5
1994M3
1995M1
1995M11
1996M9
1997M7
1998M5
1999M3
2000M1
2000M11
2001M9
2002M7
2003M5
2004M3
NEER REER
Czechia
Poland
very similar development of
NEER and REER in the late
stage of transition process
effect of high inflation in early stage of
transition in Poland: REER is increasing (real
appreciation) in spite of decreasing NEER
(nominal depreciation)
Decomposition of real exchange rate development
appreciation
depreciation
Classification of exchange rate regimes
Pegged
Regimes
Hard Pegs
Dollarization
Currency
Board
Monetary
Union
Traditional
Pegs
Single
Currency Peg
Basket Peg
Intermediate
Regimes
Floats with
Rule-Based
Intervention
Cooperative
Regimes
Crawling Peg
Target Zones
and Bands
Floats with
Discretionary
Intervention
Managed
Floating
Floating
Regimes
Free Floats
Independent
Floating
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• Hard pegs
– Exchange rate is pegged in a manner that makes a change in parity or an exit from the regime
extremely difficult and costly
• Traditional pegs
– Currency is linked to a single foreign currency or to a basket of currencies. Cost of adjusting the parity
or of abandoning the regime is lower than in case of hard pegs
• Floats with rule-based intervention
– Exchange rate is not pegged at a specific rate, but the central bank intervenes in a predetermined
manner to limit exchange rate movements
• Floats with discretionary intervention
– Exchange rate floats but is influenced by signifficant official intervention
• Free floats
– Exchange rate is allowed to float freely and the central bank does not intervene in the foreign exchange
market
Description of exchange rate regimes
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• Dollarization
– A foreign currency is used as a legal tender. Monetary policy is delegated to the anchor
country. Seigniorage accures to the issuing country.
• Currency board
– The exchange rate is pegged to a foreign (anchor) currency, with the régime and the parity
enshrined in law. The law would also specify a minimum amount of international reserves
to be held by the central bank to back a certain percentage of a pre-specified monetary
aggregate. The main difference from dollarization is that the seigniorage accrues to the
home country.
• Monetary union
– A group of countries uses a common currency issued by a common central bank.
Monetary policy is determined at union level. No option to adjust par-values internally or
externally. The common central bank can pursue any exchange rate policy.
Hard-peg regimes
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• Single currency peg
– The exchange is pegged to a fixed par-value to a single foreign currency
– The central bank is expected to trade at the announced par-value
– The rate is generally adjustable (through discrete devaluations or revaluations) in case of
fundamental disequilibria
– Credibility is greater the higher the level of central bank reserves
• Basket peg
– Currency is pegged to a basket consisting of two or more currencies
– Basket can be country-specific or be a composite currency such as SDR
– For country-specific baskets, basket weights may be publicly known or be secret, and
may be fixed or variable
Traditional-peg regimes
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• Cooperative regimes
– Cooperating central banks agree to keep the bilateral exchange rates of their currencies within a pre-set
range of each other
– Central banks use all monetary instruments as well as joint coordinated interventions
• Crawling peg
– Exchange rate is typically adjusting at a predetermined rate in predetermined interval
– Crawling peg may be combined with bands
– Specific design features determine whether the system resembles more a fixed or a flexible regime
• Target zones and bands
– Exchange rate is allowed to fluctuate within a pre-set range
– Endpoints of the range are defended through intervention
– Intra-band interventions may occur to avoid excess pressure at the margin
– Degree of exchange rate flexibility is determined by the width of the band or target zone
Floating regimes with rule-based intervention
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• Managed floating
– Exchange rates are free to float according to supply and demand
– Authorities have a view on the desired level and path of the exchange rate
– Intervention may take place occasionally
– Often combined with inflation targeting monetary policy
• Independent floating
– Exchange rate is completely determined in the foreign exchange market based on daily
supply and demand
– No official interventions takes place
– Requires little or no official reserves
– This regime place no restrictions on monetary policy
Other floating regimes
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
• Fixed rates provide stability in international prices for the conduct of trade
• Fixed exchange rates eliminates exchange rate risk
• Fixed exchange rates are inherently anti-inflationary, requiring the country
to follow restrictive monetary and fiscal policies
• Fixed exchange rates regimes necessitate that central banks maintain large
quantities of international reserves for use in occasional defense of fixed
rate
• Fixed exchange rates bind the central bank in pursuing monetary policy
• Fixed rates, once in place, may be maintained at rates that are inconsistent
with economic fundamentals
Fixed vs. flexible exchange rates
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
Questions and Applications
???What is the current exchange rate regime in the Czech
Republic???
• Exchange rate stability
– The value of the currency would be fixed in relationship to other currencies so traders and
investors could be relatively certain of the foreign exchange value of each currency in the
present and near future
• Full financial integration
– Complete freedom of monetary flows would be allowed, so traders and investors could
willingly and easily move funds from one country to another in response to perceived
economic opportunities or risk
• Monetary independence
– Domestic monetary and interest rate policies would be set by each individual country to
pursue desired national economic policies, especially as they might relate to limiting
inflation, combating recessions and fostering prosperity and full employment
Attributes of the „ideal“ currency
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
Attributes of the „ideal“ currency
Exchange Rates and Exchange Rate Regimes (International Business Finance – presentation 04)
increased capital
mobility
full financial
integration
monetary
independence
exchange rate
stability
pure floating
A country cannot be on all
three sides of the triangle
at once. It must give up
one of the three
‘attributes’if it is to
achieve one of the states
described by the corners
of the triangle.
monetary union
full capital controls
THANK YOU FOR YOUR
ATTENTION
J