Foreign Exchange Rates

Transcription

1 Foreign Exchange Rates The foreign exchange market (forex market) provides the means by which payments are made across national boundaries and in different national currencies. It is the market in which one currency is traded for another and thus in which the prices of a currency in terms of other currencies are set. The increasing interdependence of countries in recent years has led to a dramatic growth in the proportion of financial transactions that have an international aspect. At the same time, major international imbalances and the volatility of exchange rates have led to the development of new financial instruments and the growth of markets in which they are traded. As exports and imports have grown as a percentage of the GDP of all developed countries, so too has the proportion of firms which earns foreign exchange and/or requires foreign currencies to purchase intermediate or final goods. Such firms necessarily are exposed to foreign exchange risk resulting from variations in exchange rates. Firms have sought both to protect themselves from this risk and to seek profits through speculation on foreign exchange (forex) markets. The desire to protect against risk has led to the development of markets designed to provide insurance (forward and futures markets) and the exploitation of techniques such as currency swaps and options. At the same time, much attention has been paid to the need to forecast future changes in exchange rates. This has in turn produced a great deal of debate over the nature of foreign exchange markets. The Bank for International Settlements (BIS) estimated that the turnover of the market in 1995 was $1.2 to $1.3 trillion. In the London forex market alone, turnover was estimated to be $464bn. $186bn of this was in the spot market; $278bn in the forward market (of which 90 per cent were swap transactions i.e. where currencies are bought for immediate delivery in order to sell them in the future or vice versa). The proportion of trades involving sterling fell from 24 per cent to 16 per cent between 1992 and About half of all activity in London involved the $ with the $/DM rate still dominating at 22 per cent of transactions, compared with 24 per cent in per cent of business is done in the interbank market. The London market remains clearly the biggest market and, indeed, had the fastest growth rate (60 per cent) between 1992 and Other markets in order of size were: New York; Tokyo; Singapore; Hong Kong; Zurich and Frankfurt. Fears that the London market would suffer from sterling's non-membership of the European single currency after the beginning of 1999 were not borne out during the first year of trading of the Euro. Only a small part of the explosion in foreign exchange transactions can, however, be related in any way to the needs of international trade. A much higher proportion has derived from the great increase in international capital mobility which has characterised the past thirty years. Both large multinational firms and governments have sought to tap international capital markets to widen their access to funds and/or to lower the costs of borrowing. To meet these demands, international banks have grown hugely in size, new markets have opened up and expanded (most notably the Euromarkets), and again new instruments have been developed. The combination of increasing international interdependence and uncertainty has given governments a greater interest than ever in movements in the international value of their currencies and in the impact of capital mobility on the goals of economic policy and the stability of the international financial system. The post-war world has lurched from a system of fixed exchange rates to floating rates with widely varying degrees of government intervention and, in the case of Europe, back to fixed exchange rates and now a single currency across most of the European Union (EU). An exchange rate is simply the price of a country's currency expressed in terms of another currency. Thus, logically, each currency has an exchange rate with every other currency. Some of these rates are determined in markets by the forces of demand and supply. This, however, begs the questions of who demands and supplies the currencies and for what purposes they do so. Thus, we must ask two basic questions:

2 (a) why are currencies demanded or supplied? (b) to what extent are market forces subject to the various forms of control used by governments? In other words, we shall wish to know to what extent an apparently market-determined rate is freely determined or to what extent it is an administered price. 1. The nature of forex markets Forex markets are deceptively simple. The product (foreign exchange) consists of the currencies of the major developed countries - to the extent that the currencies of developing countries are traded officially, markets are so heavily controlled by governments that the rates of exchange have little to do with supply and demand. Market participants can be split into five groups: (a) the end-users of foreign exchange: firms, individuals and governments who need foreign currency in order to acquire goods and services from abroad; (b) the market makers: large international banks who hold stocks of currencies to allow the market to operate continuously and who make their profits through the spread between buying and selling rates of exchange; (c) speculators: banks, firms and individuals who attempt to profit from outguessing the market; (d) arbitrageurs: banks which make profits from buying in one market at the same time as selling in another, taking advantage of small inconsistencies which develop between markets; (e) central banks who, on behalf of their governments, enter the market to attempt to influence the international value of their currency - perhaps to protect a fixed rate of exchange, or to manage to varying degrees an allegedly market-determined rate. It is clear from the above list that it is possible for someone to play multiple roles in the market. For instance, the international banks may act in up to four capacities, while governments may be end-users on occasions, speculators on others. It appears, then, that the basis of the market must derive from the demand for and supply of currencies originating from end-users. The notion that rational economic motives underpin the behaviour of end-users leads to the view that exchange rates should be determined by the market fundamentals - economic factors thought to influence the demand for and supply of currency such as the balance of payments, relative rates of inflation and interest rate differentials across countries. Changes in these basic influences on demand and supply will cause exchange rate adjustments. However, according to holders of this view exchange rates will always move towards the new equilibrium position, defined as the set of exchange rates which will produce balance in the balance of payments. In the 1950s and 60s, concentration was on the current account of the balance of payments but later theories have, unsurprisingly, placed much greater emphasis on the determinants of the capital account. This approach to the foreign exchange market can be linked with the efficient markets hypothesis (see below) to give a complete economist's model of the operation of a free market in foreign exchange without government intervention. 1.1 The range of currencies and the expression of exchange rates Every Monday, the Financial Times publishes a table giving the value of the sterling against all other currencies. This table covers approximately 200 countries with the sterling quoted against some 150 different currencies, ranging from the Afghanistan Afghani to the Zimbabwe dollar, including such well-known currencies as the Pataca, the Colon, and the New Dong.

3 Thus, although most countries have their own currencies for internal purposes, not all countries do so, because there are some monetary unions in which a single currency is used in a number of independent countries. As well as the internal use of a currency, there is certain to be some international demand for all currencies to allow the purchase by foreigners of domestic goods and services (every country, even Yemen and Burma, have some form of tourist industry). The international demand for quite a lot of currencies, however, remains fairly small. The currencies of developing countries generally are not acceptable in international trade. Nonetheless, there remains the potential for a set of market-determined exchange rates for each currency. Even where such a market does not exist officially, there will be black-markets, expressing demand and supply conditions. Such demand and supply conditions can be shown in a standard diagram. However, care needs to be taken in the definition of the rate and in the labelling of the axes of exchange rate diagrams. Because an exchange rate is a relative price, it can be expressed in two directions - if the pound goes up against the dollar, the dollar goes down against the pound. Now, suppose we are interested in the exchange rate of sterling. What do we really wish to know? Sterling is our medium of exchange, our numéraire. Thus, logically we wish to know the price of all other currencies in terms of sterling. When we want to know the price of something, we ask how much of our medium of exchange does it cost to buy one unit of the good in question. Thus, for exchange rates, we should ask: How much sterling does it cost to buy $1 or 1 yen or 1 DM...? Our answer would then be: the exchange rate of is: 0.62 = $1; = 1 yen; 0.31 = 1 DM. In other words, we should be quoting the price of the foreign currency in each case. This is known as the direct quotation of exchange rates and is the form used in most countries. Fig. 1 shows the expression of market conditions in this form. Price (Domestic Currency per S 1 unit of foreign currency) D 1 D 2 O Foreign Currency Fig. 1 Direct quotation of the domestic currency Note that on the vertical axis we have the price of the foreign currency (say, $) in terms of the domestic currency ( ). That is, the amount of sterling needed to buy $1. On the horizontal axis, we have the quantity of the foreign currency (US $) supplied and demanded. Note further

4 that if there is an increase in demand for US $ (the demand curve shifts up), the exchange rate rises. That is, it now costs more sterling to buy $1 than before - the value of sterling has fallen. Many American and European books and articles thus have some confusion in expression. In ordinary conversation in Britain, if one talks about the exchange rate of the $ falling, we mean that the $ has lost value against other currencies. However, if we express the exchange rate in direct form (as is done in most parts of the world and is often done in economic models), a fall in the exchange rate will mean an increase in the value of the $. Thus, you must be very careful in considering the way in which exchange rates are expressed. The UK (and some ex-british colonies) use the indirect quotation in which the price of the domestic currency is expressed. That is, we ask how much foreign currency is needed to buy one unit of the domestic currency. In terms of sterling, we ask: How much American currency, Japanese currency, German currency etc. we can obtain for 1 sterling. Our answers will be in the form: 1 = $1.61; 1 = 174 yen; 1 = DM This method has some advantages but it does conflict with the normal idea of a price. The diagram for it, of course, will have the price of the domestic currency (sterling) in terms of the foreign currency (US dollars) on the vertical axis and the quantity of sterling demanded and supplied on the horizontal axis. Now, an increase in demand for $ will be shown as an increase in the supply of sterling in order to acquire the extra dollars. The supply curve for sterling will move down and the exchange rate will fall - meaning here that the value of sterling also falls (see Fig. 2). Price (foreign currency per unit of S 1 domestic currency) S 2 O D 1 Fig. 2 Domestic currency Indirect Quotation of the Domestic Currency Box 1 provides additional information on the expression of exchange rates and Exercise 1 gives you some practice in the manipulation of rates. As we have said above, in practice there is very little international demand for most currencies. Foreign citizens and firms are unwilling to accept them in settlement of debt and governments will not hold them in their foreign exchange reserves or use them to intervene in currency markets. That is, these currencies are not part of international liquidity (the world money supply). Currencies of a few industrial countries (hard currencies) are willingly held by other governments and are part of the international trading system. A small number of these currencies (key currencies) are freely used in transactions not involving the issuing countries and are used by central banks as intervention currencies. The most important currency in international markets is still the $US. It is used in perhaps up to 95% of all transactions on foreign exchange markets. This accounts for the considerable importance to everyone of fluctuations in the value of the $.

5 Box 1: The expression of exchange rates Indirect quotation The standard British way of expressing the value of sterling is to quote the amount of foreign currency that exchanges for 1: 1 = US$ ; 1 = ; 1 = dollars Euros yen The first of the two figures in each case is the bid rate the rate at which market makers are prepared to buy the home currency (sterling). The second figure is the offer rate - the rate at which they are prepared to sell the home currency. Thus, we have: bid rates: 1 = US$ = = offer rates: 1 = US$ = = The difference between the two (the bid-offer or bid-ask spread) covers the market-makers' costs and provides their profits. To obtain a single figure for an exchange rate, the mid-point between the bid and offer rates is taken: 1 = $1.6058; 1 = ; 1 = Direct quotation Given an indirect quotation, the direct quotation can be calculated as its reciprocal. Thus, if we take the reciprocal of the indirect rates above, we obtain the following direct quotations of sterling (the rates at which market makers are prepared to buy and sell the foreign currency): = $1; = 1 Because the unit value of the Japanese currency is so small, it would be inconvenient to express the sterling equivalent of a single yen in direct form (one would need too many decimal places to show the small differences between bid and offer rates). Therefore, it is conventional to express the rate in terms of 100: Note that, with direct quotation, the bid rate is always higher than the offer rate. This is an exact reflection of what is happening in Figure 1 N.B. On the Currencies & Money page of the Financial Times, you are given separately the closing mid-point (the mid-point between the bid and offer rates at the close of the market for the day) and the bid- offer spread. Thus, instead of being told: 1 = $US , you would be given a closing mid-point of 1 = $US and a bid-offer spread of (using only the last three figures of the full exchange rate).

6 Exercise 1 You are given the following information about exchange rates: Closing mid-points 1 = SFr (indirect quotation of sterling against the Swiss franc) $1 = C$ (indirect quotation of the US$ against the Canadian dollar) 1 = (indirect quotation of the Euro against the Japanese yen) Bid-offer spreads /SFr $/C$ / Write out the above exchange rates in full, giving bid and offer rates. 2. Calculate each of these rates in direct terms. 3. Look up the Financial Times and compare the exchange rates reported on the day you read this chapter with the above rates, which were the exchange rates at the close of trading on 30 th April Work out which of the above currencies have weakened and which have strengthened since the 30 th April Spot and Forward Rates of exchange as shown in the FT About 2/5 of foreign exchange transactions are spot transactions i.e. they are purchases/sales of foreign currency for immediate delivery. Immediate delivery means that the transaction must be completed within 2 working days of the contract being made (the date of the actual payment of funds is called the value date). The exchange rates which apply to these transactions are known as spot rates of exchange and the market in which these transactions take place is the spot foreign exchange market. The bid-offer spread (see above) is often quoted in terms of points or pips where 1 point is.0001 and a pip is Thus, in our rates quoted above, the bid-offer spreads are: 1 = US$ bid/offer spread =.0004 cents = 4 points = 40 pips 1 = bid/offer spread = 10 points = 100 pips Holding stocks of currencies obviously involves taking a risk that the values of currencies held will fall causing a loss. This, plus of course administration costs, provides the justification for the market-makers' margin. In the case of the major currencies we can see that the margin is really very small. Consider the case of someone holding sterling and using it to buy dollars, then changing his/her mind and converting the amount immediately back into sterling. Now, trades in these markets are very large. We are not talking here about people buying $ at a high street bank for a holiday in the US but about major transactions between international banks and firms. So, we shall use the figure of 1 million. The market-maker will be prepared to sell us $ at the bid rate of 1 = $ giving us $1,605,600. Converting that back into sterling at the offer rate of $ gives us 999,750 - a total margin of 250, or (.025 per cent). For currencies that are less heavily traded, you will see that, on average, the bid/offer spreads (and thus the margins earned by market-makers) are a good deal higher than on the more important currencies. For example, some bid-offer spreads for currencies against sterling on the 11/2/2000 were: Euro per cent; yen per cent; Canadian $ 0.2 per cent; Australian $ 0.18 per cent; drachma 0.11 per cent; Thai baht 0.15 per cent

7 These differences may seem a little strange. Clearly, several forces are at work. We might, however, say that, ceteris paribus, the size of the spread will be positively related to the perceived risks to banks in holding the currency and hence to its past variability. This variability is in turn likely to be influenced by the size of the market. The thinner or shallower the market is, the more easily the market can be moved by a small number of large transactions. Markets such as the /$US market are very deep and the rate is unlikely to be affected by a small number of large transactions. Again, the less accepted currencies are in international trade, the more likely it is that they are subject to varying degrees of exchange control. This introduces an extra element of uncertainty since what happens to the exchange rate will depend significantly on the behaviour of the authorities in those countries. Forward rates of exchange relate to contracts entered into now for promised delivery in the future. The most common periods are 1-month and 3-months although periods up to 10 years are not completely unknown. 2.1 Change on the Day This column gives the change in the exchange rate of the various foreign currencies against since the close on the previous day. Thus, on Thursday, 10 th February 2000, the change for the $ against was Since exchange rates are indirect against and the closing mid-point was 1 = $1.6058, we know that the closing mid-point the previous day must have been $ The negative sign in the change on the day tells us that the value of has fallen during the day. On the same day, however, the closing mid-point for the drachma against was and the change on the day was That is, sterling had strengthened against the drachma. The previous day's closing mid-point must have been 1 = ( ) = drachma. Thus, a quick glance down the change on the day column allows us to see which currencies sterling was weakening against and which currencies it was strengthening against. 2.2 Day's mid (high and low) The column headed day's mid, gives the high point and the low point of the value of other currencies against during the day's trading. For example, the exchange rate of the $ against fluctuated on the 10 th February 2000 between $ (high) and $ (low). This gives us an indication of the volatility of the exchange rate. It also gives us a picture of the day's trading. We know (see above) that the rate at the beginning of the day's trading was $ Thus, at some point during the day the strengthened. This was probably early in the day since the finished at $1.6058, only very slightly above the day's low. This suggests that news must have come to the market during the day, which caused the $ to strengthen against. This might have been news relating particularly to the $ or to sterling. 2.3 The Source of the figures These are average figures taken by the Financial Times from major market-makers in the London market at about 5 p.m. However, the market does not have a physical location and does not, then, in any real sense close. Trading takes place via computer link, telephone and telex among the major participants. In addition, trading takes place on foreign exchange markets in other countries and so the market is a 24-hour market. The value of will go on changing across the world over the whole 24 hours and when the London markets open the following day rates will have changed, perhaps considerably, since those quoted as the closing London rates in the FT. It is for this reason that the FT also gives us the small column headed in New York.. The FT of 11 th February, 2000 showed that the closing spot exchange rate in New York on 10 th February was 1 = $ In other words, the had again strengthened in New York after the close of the London market. To cover the whole 24 hours, trading takes place in a number of major markets across the world whose trading hours overlap. The three principal forex markets are London (the most important in terms of volume of transactions), New York and Tokyo. However, because of

8 overlapping times, these three markets do not cover the whole 24 hours. Thus, significant markets have developed elsewhere, notably in Frankfurt and Paris, Los Angeles, Hong Kong, Singapore and Bahrain. 2.4 Official versus Tourist rates of exchange There are two obvious differences between official and tourist exchange rates. Firstly, the tourist rates are worse for both buyer and seller (that is, there is a much bigger spread between buying and selling rates). Secondly, tourists often also face commission charges. How can one explain this? Remember that the spread plus any commission charges cover costs and provide profits for market-makers. Tourist transactions are on average small. Thus, administrative costs (including office rental etc) are likely to be high relative to turnover. Again, a small central city foreign exchange office will, for the convenience of customers, hold a wide range of currencies, many of which have quite large risk associated with them. Thus, a certain amount of the larger margins and charges may be related to the costs of providing the service. In addition to this, however, there is certainly an element of what the market will bear. The principal forex markets are characterised by large numbers of operators and a high degree of knowledge of available rates. In other words, the market approaches the text-book perfectly competitive ideal. The considerable degree of competition forces down margins to very low levels. Market-makers may still, however, do very well because of the large average size of the transactions. Tourist forex markets are characterised by a much lower degree of knowledge and a much smaller degree of competition. By and large, tourists take the rate which they are offered, grumble about it though they may. 2.5 Other points of interest Sometimes you will see two exchange rates quoted for the one currency. This is a quite common arrangement in developing countries and simply shows the operation of multiple exchange rates - a form of currency control. That is, it is a device for rationing scarce foreign exchange. The exchange rate residents of the country will obtain will depend on the purposes for which they wish to acquire foreign currency. The more generous rate is likely to be available only to people and firms who show the central bank that they wish to use foreign currency for purposes approved of by the government - perhaps the import of capital equipment or consumer goods regarded as essential imports. People wishing to acquire foreign currency for other purposes (such as tourism, or the import of luxury goods) will have to pay much more domestic currency to acquire a given amount of foreign currency. Sometimes, the more generous rate applies only to the government itself. This arises because the government has first claim on the country's scarce foreign exchange reserves, e.g. for repaying government debt, financing embassies abroad, buying arms and for other governmental commitments. For these purposes, a very generous official rate of exchange might be used. Any foreign exchange remaining after the government has taken what it needs might then be sold on the open market, with the exchange rate determined by demand and supply. This system was used by Iran in the early 1990s and, at one stage, the official value of the Iranian currency was 23 times higher than its market rate. Multiple exchange rates are less common than they once were, largely because the IMF is opposed to their use. Whenever the IMF imposes conditions on the economic policy of governments to whom it lends, one condition is very likely to be the abandonment of multilateral exchange rates and the institution of a market rate of exchange. 3. Exchange rate Indices Governments like to know not just what is happening to the value of the country's currency against particular other currencies, but also what is happening generally to the value of the

9 domestic currency. For example, the value of the $ might rise against but this may have more to do with the strength of the $ than with any weakness of. Thus, we might find that at the same time that is losing value against the $, it is gaining value against the Euro. Thus, exchange rate indices are prepared showing the average performance of the domestic currency against a number of other currencies (a currency basket). This gives us the effective exchange rate. Naturally, the relationship of with some currencies is much more important to the trading position of the UK than relationships with other currencies. Thus, the ERI (exchange rate index) prepared by the Bank of England is a weighted average of sterling's exchange rate with several other currencies, with weights being based on imports and exports, including competition in third markets. The current ERI uses as a base the average value of for the year It was last rebased (that is, the weights were changed on 1 st February At the close of the forex market in London on 10/2/00, the Sterling Index told us that the weighted average value of sterling was per cent of its value in an average appreciation over that period of 8.6 per cent. During this period, however, had gained value in relation to some currencies and lost value in comparison with others. This information is provided in the last column of the Pound Spot Forward Against the Pound table. A quick glance down this column on 11/2/00 showed that the index of the US$ against sterling was 107.6, indicating that the $ had strengthened over the period. The Japanese yen had strengthened a great deal (index 148.2). Currencies that had weakened significantly against sterling over the period included the Finnish markka, the drachma, the Italian lira and the peseta. As in the calculation of any index, the base year chosen is very important. We said above that the Bank of England index uses the average value of in 1990 as its base. It was in November 1990 that sterling became a member of the Exchange Rate mechanism of the European Monetary System and the currency had been quite strong in the periods before and after this. The currency later came under pressure and weakened sharply after being forced out of the EMS in September Thus, an effective exchange index that used 1993, say, as its base year would look rather different from the current Bank of England index. Table 1.4 (page 13) in Pilbeam (1998) shows the construction of a nominal effective exchange-rate index and Table 1.5 (page 15) shows effective exchange rate indices based on the IMF Multilateral Exchange Rate Model for seven currencies over the period The choice of base year is particularly important here for sterling. In the early 1980s, the UK was approaching its peak as an oil producer and there had recently been a large increase in world oil prices. At the same time, the newly-elected Conservative government of Mrs Thatcher was keeping interest rates high in an attempt to control money supply growth. The value of sterling was, therefore, high. It rose further in 1981 before commencing a steady decline, which lasted until Sterling rose sharply again in 1988 before commencing another steady decline, which only came to an end in It is worth noting that the IMF's effective exchange rate index for sterling in 1990 (the year used as the base year of the current Bank of England index) was around 20 per cent down on The beginning of the strengthening of sterling can be seen in the figure for The weights used by the IMF are different from those used by the Bank of England index and so we can make no direct comparison between the two indices. However, with the Bank of England index at 100 in 1990 and around 108 in early 2000, we should expect the IMF effective exchange rate index, on the base of 1980 = 100, to be currently somewhere between 85 and The SDR and the Euro The SDR (the Special Drawing Right of the International Monetary Fund) is a weighted average of the 5 currencies in G5 -, $, DM,, and the French franc. Its value in comparison with other currencies is given in the exchange rate tables in the FT. The exchange rate for the SDR against sterling was 1 = SDR All IMF accounting is performed in SDRs.

10 SDRs were issued to IMF member countries in the 1970s and early 1980s and give countries a right to borrow in the currencies they nominate. They form part of the international reserves of IMF members. The Euro is, of course, the currency of the Economic and Monetary Union of the EU. Its initial value when trading in the currency began at the beginning of 1999 was derived from the weighted average of the currencies of the member countries, with weights depending on each country's GDP and its importance in international trade. The value of the Euro is now determined by demand and supply. 5. Real exchange rates The spot exchange rate we have dealt with so far is also known as the nominal exchange rate. Clearly, if we wish to consider a country's competitive position we wish to know not just its nominal exchange rate but also the differences in inflation rates in the respective countries. Thus, it is quite common to calculate the real exchange rate between two currencies by taking account of inflation rate differences as well as nominal exchange rates. Consider a simple example taken from Understanding Markets 1, but modified to make the exchange rates a little more up-to-date. Assume an exchange rate of 1 = $ (11/2/96). Suppose that a particular piece of textile machinery that is manufactured in both the US and the UK costs 10,000 in the UK and will thus cost a US importer $16,058. Allow an extra $2,000 for transport and tariffs, making the landed price of the British machine in the US $18,058. Suppose that the US machine sells in the US for $19,500. At these prices, if we assume that the two machines are of the same quality, the British machine is very competitive. However, we can see that the UK machine's competitive advantage will disappear in two circumstances - firstly, if the nominal exchange rate of changes. Suppose the exchange rate changes to 1 = $1.80 (sterling rises in value). Then, the landed price of the British good in the US becomes $18,000 + $2,000 = $20,000. Alternatively, suppose that there is no change in the nominal exchange rate but that the US industry suffers no inflation, while costs and prices in the UK rise by 11%. The UK price of the British machine rises to 11,100. At our present nominal exchange rate of 1 = $1.6058, this converts into $17,824. Add on our $2,000 for transport costs and tariffs and we have a landed US price of $19,824. In both of these cases, we can say that the real exchange rate of sterling has risen. A rise in the real exchange rate (expressed in indirect terms) means a deterioration of a country's competitive position in foreign markets. Real exchange rates are, however, calculated as indices. An increase in the nominal value of a currency or an increase in domestic prices relative to those of other countries will push the index up and indicate a loss of competitiveness of domestic goods in international markets. The real exchange rate index can be calculated as: S r = SP/P* where S r is the index of the real exchange rate; S is the nominal exchange rate in indirect form, expressed as an index; P is an index of the domestic price level; and P* is an index of the foreign price level. Table 1.3 on page 12 of Pilbeam (1998) shows the construction of nominal and real exchange rate indices and Figures 1.2, 1.3 and 1.4 show graphs of movements in the nominal and real exchange rates for the US dollar-pound, the deutschmark-dollar and the yendollar. 6. Real effective exchange rates It is possible to combine effective exchange and real exchange rate indices to produce real 1 K. Bain and P. Howells, Understanding Markets, Brighton: Harvester Wheatsheaf, 1987

11 effective exchange rate indices. These are seldom quoted because their calculation involves several indices and the selection of weights. However, Pilbeam (1998) provides the IMF real effective exchange-rate indices for seven currencies over the period (Table 1.6, page 17). This shows an effective real exchange rate index for the UK in 1995 of 78.6 in comparison with the nominal effective exchange-rate index (see Table 1.5) for that year of This indicates that inflation must, on average, have been higher in the UK over this period than its trading partners. Can you see why this must have been so? This gives a clue to the present concerns of British industry and trade unions over the current high value of sterling. Although the effective exchange rate of sterling is still significantly below its level in 1980, the real effective exchange rate might be quite close to its level in In , a large amount of British manufacturing industry was wiped out by the then high value of sterling. Reading Pilbeam, K (1998), International Finance (2 nd edn.), Basingstoke: Macmillan Howells, P and K. Bain (1998) The Economics of Money, Banking and Finance, Harlow: Addison Wesley Longman Howells, P and K. Bain (1994) Financial Markets and Institutions (2 nd edn.), Harlow: Longman