Manipulation of Exchange Rate...

[Snuffy]

I have a question that I hope some of the intellectuals here can answer for me. I always thought that the exchange rate was based on a worldwide consensus of the value of the currency. That if the Dominican government needs to buy dollars to for example purchase oil and they don't have the dollars then they need to exchange pesos for dollars either at home or abroad. Now I can understand if they are able to force an exchange rate at home. But how does that work if they are wanting to buy dollars abroad. If some bank will not sell them dollars at 29 to 1 but demand 36 to 1 do they pay the 36 to 1? At some points they must have to go outside the country for dollars?

I'm obviously in the dark on how this works and would like someone to enlighten me. thank you.

[NALs]

Determining of the Currency Exchange Rate

I will try to explain in the best way I possibly can how the exchange rates are determined worldwide. This is based on the exchange rate floating, not fixing.

Each nation has an adopted currency from which economic transactions can be made with. The reason for currency (as oppose using a good or service) to pay for a good or service is used, is because its more efficient and allows for more material gain.

Let's use Dominican Pesos (DOP) vs United States Dollar (USD) for the sake of discussion. Let's also assume that the two currency are the only two currency in the world. Let's also assume that the DR produces only agricultural products and the US produces material goods only.

With no trade between the two countries, each currency will be worth 1:1 also known as at par. 1 DOP will buy you 1 USD and vice versa. However, with no trade, that would mean that the DR will have an overabundance of agricultural products and a complete absence of material goods and the US will have an overabundance of material goods and a complete absence of agricultural products. Thus, in order for both nations to be better off, the two will have to trade.

In order for the DR to be able to buy American material goods, the DR will need to get USD’s because that is the currency that the US recognizes and is the only currency that can be used to purchase US material goods. On the contrary, the US will need to get DOP’s if it wishes to buy Dominican agricultural products, because that is the currency the DR recognizes and must be used to purchase Dominican agricultural products.

The way the pricing of the currency is done is based on supply and demand. In order for the DR to be able to buy American stuff, it will need to first buy American dollars. At an exchange rate of 1:1, each Dominican peso will be redeemed with one American dollar. Thus, the exchange rate remains at par. With the Americans, the same ordeal follows and the exchange rate also remains at par.

Now, let’s add a new twist. In the above examples, we were assuming a simple purchasing of foreign currency for the sake of redeeming them for foreign goods. Now, let’s add a new twist, which correlates somewhat with reality.

The only way Dominican businesses can get their hands on American currency in order to buy and import American goods is through the Dominican banking system. The only way the Dominican banking system can get the dollars need by the Dominican merchants is through deposits of American dollars or through reserves. Every time a Dominican merchant asks to exchange his pesos for dollars, the reserves for dollars in the Dominican banking system diminishes by the amount demanded.

If there is only 1 million USD’s in the Dominican banking system reserves and 1 million USD’s in the American system, depending on the availability and the demand the price of each currency will either go up or down.

Let’s assume that the Dominican economy (the merchants, etc) are demanding 3 million USD’s from the Dominican banking system in order for them to be able to buy American products and import them into the Dominican economy. Obviously, there are only 1 million USD’s, this means that in order for the banking system to avoid running out of dollars and causing an economic collapse, the premium paid on the currency must rise to meet demand. Thus, the value of 1 USD will now cost 3 DOPs. At the same time, the value of 1 DOP will now cost 33 USD cents. If the total demand of Dollars by the Dominican economy rises to 10 million, then the value of 1 USD will be 10 DOPs and the value of 1 DOPs will be 10 USD cents.

Thus, in order for a Dominican merchant be able to import American product, he will need 10 Dominican pesos for every 1 US dollar he wishes to purchase. On the contrary, in order for an American merchant be able to import Dominican products, he will need 10 US cents in order to buy 1 Dominican pesos.

At the same time all of this is occurring, the interest rates paid on deposits fluctuates according to the scenario. When both currencies are at par, the interest rate will be 0%, because there is no demand and no shortage of either currency in either market.

However, as the reserve amount of USD’s in the Dominican banking system diminishes, the Dominican banking system must find a way of attracting more US dollar into it’s system in order to be able to supply the demand of the Dominican merchants for more Dollars. Thus, the interest rate on deposits of US dollars increases as well as the reserve of dollars decreases. This will motivate US dollar owners to put their dollars in the Dominican banking system in order to gain from the good interest rate.

If more dollars fills the Dominican system than its being extracted, eventually the reserves will reach their previous levels and the interest rates will subsequently drop until they reach zero, assuming the Dollars simply keeps flowing in.

This was a very simple, diluted version of how exchange rates are decided. If you need further explanation, simply ask…

-Nal

[Snuffy]

Very clear explanation and appreciated.

Let me see if I have this right...

Demand from merchants in DR for dollars goes up...thus interest rate payout goes up to attract more dollars...and exchange rate to those merchants increases to cover cost of higher interest rate payout.

right or wrong?

[TimInDR]

Originally Posted by Nal0whs

Determining of the Currency Exchange Rate

I will try to explain in the best way I possibly can how the exchange rates are determined worldwide...........................
..............
This was a very simple, diluted version of how exchange rates are decided. If you need further explanation, simply ask…

-Nal

Fantastic post. Thanks. That was a lot better than that on-line economics course I took.

[mondongo]

Originally Posted by Nal0whs

Determining of the Currency Exchange Rate
With no trade between the two countries, each currency will be worth 1:1 also known as at par. 1 DOP will buy you 1 USD and vice versa.

In your scenario, you cannot assume that the exchange rate is 1:1. In order to predict the exchange rate (once trading begins), you need a priori knowledge of what similar items cost in the local currency.

[hugoke01]

Originally Posted by Nal0whs

Determining of the Currency Exchange Rate



Currency Exchange Rates.This was a very simple, diluted version of how exchange rates are decided. If you need further explanation, simply ask…
-Nal

I liked your explanation which is indeed a great explanation on how currencies exchanges are determined ..
The real world is somewhat different ..
a) The theory of offer and demand is totally correct in a floating system but there are other factors playing " The speculation factor" ... Every day billions of USD /Euros /Yens etc. are bought and sold by analysts (looking at inflation , economic and political stability , public debt etc )but also based on speculation for short term gains . The speed this is done with, makes it impossible to have a physical stock currency exchange market..it's all computerized (Swift system ) .
Furthermore although the system is floating when a currency is under pressure Central Banks normally will intervene ..

b)Psychological factors have their impact as well ..the Lewinsky case , Changing of presidents of the FMI or the European Bank make rates fluctuate as well ..a.o.

Nal, if I'm wrong just feel free to correct me ..

I have a question for you :

What determines the exchange rate US$ versus Dominican Peso today ? Does this not require a continuous intervention of the Central Bank ( with great risks involved for the banking system and the people in the DR )

Many thanks

[mondongo]

Originally Posted by Snuffy

Very clear explanation and appreciated.

Let me see if I have this right...

Demand from merchants in DR for dollars goes up...thus interest rate payout goes up to attract more dollars...and exchange rate to those merchants increases to cover cost of higher interest rate payout.

right or wrong?

Interest rates have been going down significantly, not up over the last year+.

[hugoke01]

SIZE=2]The DR has probably an excess of dollars today ... at the rate of the USD today most people (especially those with a lot of money )have exchanged )their pesos in USD has most people expect the peso to go down ,,speculation !! Most of these Dollars want even be used as they will return into pesos the day the dollar is back at 35 or whatever plus there is a serious intervention of the Central Bank manipulating the USD and the Peso. [/SIZE]

Originally Posted by mondongo

Interest rates have been going down significantly, not up over the last year+.

.

[NALs]

Originally Posted by hugoke01

I have a question for you :

What determines the exchange rate US$ versus Dominican Peso today ? Does this not require a continuous intervention of the Central Bank ( with great risks involved for the banking system and the people in the DR )

Many thanks

The exchange rate here is determined by the amount of dollars available in the banking system.

Remember, in the past, countries backed their currencies against a metal (usually gold or silver). Today, currencies are mostly fiat (legal tender simply because the government says it is, thus a legal tender cannot be redeem for any precious metal).

The way currency value is maintained is through using another stronger currency that is much more widely accepted worldwide in order to be able to purchase foreign products (such as US Dollars or Euros).

Depending on the total amount of US Dollars available at the central bank and independent banks nationwide and the amount being demanded, the price will be the equilibrium point between the supply and demand equation.

The central bank can only manipulate the exchange rate by either: buying or selling bonds and/or adjusting the interest rates which depending if the interest is adjusted up or down, the economy could either be flooded with dollars (or the dollars could leave the country: this is what was happening through the Hipolito years and due to the scarcity which became very severe, the price of the dollar skyrocketed from 16:1 when Hipolito started to well into the 50s).

After Leonel came to power, his previous proven record of responsible management of government finances and the economy overall (much more responsible than Hipolito) lead to an influx of money that was taken out of the country by panicked investors.

As the dollars started to flood into the banking system and the economy, the price of the dollar began to fall.

Usually, the flow of foreign capital into an economy remains rather constant, but when it abruptly changes (in the case of the DR, the flow dramatically increased in the first few months after Leonel took control again), the exchange rate began adjusting. The exchange rate has stabilized, meaning that the flow of dollars into the Dominican economy is more or less constant allowing for very minute changes in the exchange rates (remember, exchange rates are always changing), changes that are so small that its impact are not felt or even seen.

Many people continue to cling on the idea that the peso is overvalued, but I have found no evidence of such. The peso is floating against the dollar as freely as it was during the Hippo years, the difference now is a stable and much more sound government is in place compared to the chaotic fiasco we went through with Hippo.

In fact, we had no real government during Hippo's rule. The country was on a free fall with no resposibility being taken by anyone.

Today, of course, things are different.

Can you believe that we are going to end this year with one of the fastest growing economies in Latin America, again?!!

The years are surely coming back!!

[NALs]

Originally Posted by mondongo

In your scenario, you cannot assume that the exchange rate is 1:1. In order to predict the exchange rate (once trading begins), you need a priori knowledge of what similar items cost in the local currency.

Yes, I can assume such, because in the example I used, the two countries were going to trade goods that one country did not had.

Thus, the US gave the DR material goods (electronics, cars, etc) and the DR gave the US agricultural goods (food, coconut oil, cotton, etc).

Remember, this is all hypothetical for the sake of simplicity. I can give everyone a much more realistic scenerio, but be forewarned, its complicated to read and even more to understand for those who don't have a basic understanding of this from the start.