Exchange Rate Forecasting

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Opening Case 8: Mundell Wins Nobel Prize in Economics

One major finding by Robert A. Mundell, who won the Nobel Prize in economics in 1999, has become conventional wisdom: when money can move freely across borders, policy-makers must choose between exchange rate stability and an independent monetary policy. They cannot have both. Professor Mundell remains a fan of the gold standard and fixed exchange rates at a time when they are out of favor with most economists. "You have fixed rates between New York and California, and it works perfectly," he has said. This statement implies that if the US dollar works well for 50 US states, a common currency such as the euro should also work well for its member states, the eurozone countries.

The Nobel committee praised Mundell's research into common-currency zones for laying the intellectual foundation for the 11-country euro. In 1961, when European countries were still faithful to national currencies, he described circumstances in which nations could share a common currency. Mundell's Nobel Prize in economics has renewed the focus on the fixed exchange rate system. First, economists and policymakers failed to forecast recent currency crises in Asia, Europe, Latin America, and Russia. Second, advocates of flexible exchange rates had argued that under the floating-rate system, exchange rates would be stable, trade imbalances would fall, and countries would not need reserves, but none of these predictions proved to be true.

"The benefits of the euro will derive from the transparency of pricing, stability of expectations, lower transaction costs, and a common monetary policy run by the best minds that Europe can muster," Mundell wrote in 1998. The stability of expectations under a single currency would reduce exchange rate uncertainty, prevent speculative attacks, and eliminate competitive devaluations. The benefits of switching to a single currency come with costs, however. Probably the biggest cost is that each country relinquishes its right to set monetary policy to respond to domestic economic problems. In addition, exchange rates between countries can no longer adjust in response to regional problems. Still, economists and policy-makers believe that the benefits of the euro far exceed its costs.

Mundell believes that the euro will eventually challenge the dollar for global dominance. He said in 1998: "The creation of the euro will set new precedents. For the first time in history, an important group of independent countries have voluntarily agreed to relinquish their national currencies, pool their monetary sovereignties, and create a supercurrency of continental dimensions. The euro will create an alternative to the dollar in its role as unit of account, reserve currency, and intervention currency." As a result, he regards the introduction of the euro as the most important event in the history of the international monetary system since the dollar took over from the pound the role of dominant currency during World War I.

Sources'. G. Eudey, "Why is Europe Forming a Monetary Union?" Business Review, Federal Reserve Bank of Philadelphia, Dec. 1998, p. 21; R. Mundell, "The Case for the Euro," The Wall Street Journal, Mar. 25, 1998; and M. M. Phillips, "Mundell Wins Nobel Prize in Economics," The Wall Street Journal, Oct. 14, 1999, pp. A2, A8.

Because future exchange rates are uncertain, participants in international markets never know with certainty what the spot rate will be in 2 months or in 1 year. Thus, currency forecasts are a necessity. In other words, the quality of a company's decisions depends on the accuracy of exchange rate projections. If investors forecast future spot rates more accurately than the rest of the market, they have an opportunity to realize large monetary gains.

This chapter covers four related topics: (1) measuring a change in exchange rates; (2) forecasting the needs of a multinational company (MNC); (3) forecasting floating exchange rates; and (4) forecasting fixed exchange rates. Floating exchange rates are rates of foreign exchange determined by the market forces of supply and demand, without government intervention on how much rates can fluctuate. Fixed exchange rates are exchange rates which do not change, or they fluctuate within a predetermined band.

O 8.1 Measuring Exchange Rate Changes

An exchange rate is the price of one currency expressed in terms of another currency. As economic conditions change, exchange rates may become substantially volatile. A decrease in a currency's value relative to another currency is known as depreciation, or devaluation. Likewise, an increase in a currency's value is known as appreciation, or revaluation. MNCs frequently measure a percentage change in the exchange rate between two specific points in time; that is, the current exchange rate and the forecasted exchange rate 1 year ahead.

When the exchange rates from two specific points in time are compared, the beginning exchange rate is denoted as e0 and the ending exchange rate is denoted as el. The percentage change in the value of a foreign currency relative to the home currency is computed as follows:

Alternatively, the percentage change in the value of a domestic currency is computed as follows:

A positive percentage change represents a currency appreciation, while a negative percentage change represents a currency depreciation.

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  • rhoda
    When money can move freely across borders, policy makers must choose between?
    8 years ago

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