Manipulation of Exchange Rate...

Snuffy

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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

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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

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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

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Nal0whs said:
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

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Nal0whs said:
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

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Nal0whs said:
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

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Snuffy said:
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

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Interest rates

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

NALs

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hugoke01 said:
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

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mondongo said:
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.
 

NALs

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Snuffy said:
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?
Yes, but the exchange rate goes up to reflect the scarcity of the foreign currency in the local banking system.

Think of this like selling a soft drink.

On a pleasant day, out of 10 soft drinks, you might sell on average 3 at a price of 1 legal tender for each soft drink.

On a hot day, the demand for soft drinks increases. In an hour, you might sell as much soft drinks as you normally sell during the course of a week. Thus, assuming that the price will increase to reflect demand this is what would happen:

At 8 am you have in inventory 10 soft drink bottles ready for sale. Because its a hot day, you know that people will be willing to spend more to quench their thirst and heat then they would on a pleasant day, so let's say you add a premium of 1/2 a legal tender to the original price. Thus, at 8 am, a bottle of soft drink costs 1.5 legal tenders, instead of the usual 1 legal tender.

To reflect how a currency exchange rate work with this example, every time you sell a bottle of soft drink, the price for the remaining bottles increases (let's say by 1/2 a legal tender for the sake of discussion). Thus, this is what happens:

10 = 1.5 legal tender each
9 = 2 legal tender each
8 = 2.5 legal tender each
7 = 3 legal tender each
6 = 3.5 legal tender each
5 = 4 legal tender each
4 = 4.5 legal tender each
3 = 5 legal tender each
2 = 5.5 legal tender each
1 = 6 legal tender each
0 = 0 legal tender each

As you can see above, when you had 10 bottles in inventory, the price was at 1.5. The more you sold, the less you have in inventory to supply future demand, thus the price will be adjusted accordingly, until it reaches the all time high of 6 legal tender for 1 bottle of soft drink.

Now, let's assume you get a new shipment of 10 more bottles every 3 hours. If on a regular day, you sell only 1 bottles per hour, in the period of the initial 3 hours of business, you would have sold only 3 bottles and then you would get 10 more bottles to your inventory. This means, that after the initial 3 hours, you now have 17 bottles at hand. To correspond to this, you adjust your price down (assuming all of your costs is zero, for the sake of this example).

Etc, etc, etc....
 

mondongo

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hugoke01 said:
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] .

hugo, that's an interesting point. when you look at where some of these US$ have gone....one place is to the Central Bank.

Since the beginning of Fernandez administration, Central Bank hard currency reserves have increased by a whopping US$1Billion. That's really where a lot of the excess hard currency has gone.
 
May 12, 2005
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This has been a very interesting and informative thread. I really had no idea exactly how exchange rates were determined. I only took 1 econ class back in my college days, macro economics. Besides I was never a math person or a numbers guy so I'm gald it was explained in a way that even my simple brain could understand. Keep up the good work folks.
 

duhtree

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$ exchange

what I found interesting was that I found myself with too many pesos and wanted to change them into dollars. after trying several alternatives I got as good, if not better, a deal from the combios. They became quite competitive and when the dust settled I was buying dollars at $29.05 peso. At the time the peso was exchanging for $28.90-95. There must be a lot of dollars out there.
 
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Nals,

Good posts and a fair primer on basic economic theory. Let me add some info on the reality of the situation.

1. The value of the dollar is not determined vis-a-vis the peso.. the dollar is indifferent towards the peso as the amount of dollars and dollar related obligations in world-wide circulation dwarfs the peso circulation. As a result the only factor that influences the exchange rate is the peso side of the equation, which is under control of the island government.

2. As a result of 1. The value of the dollar versus the peso is determined like the example Nals gave in the soda sale.. More demand for dollars.. price goes up.. Current demand for dollars is mostly influenced by the following factors;

Demand side;the governement bills for energy and debt payments and trade demands (imports), as these are the highest dollar expenditures and

Supply side; the influx of dollars through tourism, remittances and trade (export) as these will mostly determine how many dollars are on the island and available for exchange.

3. Let's have a look at these factors;
If you look at the demand side, the bill for energy will rise as a result of rising oil prices, the debt payments will be lower after the restructuring of debt (which basically is agreeing a longer repayment period at lower interest, while paying a penalty now).. imports will also be rising but this will be more than offset by growing experts so the demand for now looks stable..

If you look at the supply side, tourism seems to grow slightly, remittances are stable and trade is growing.. so it looks like the supply side will provide a surplus..

4. Conclusion
As a result you might think that the dollar price will go down.. ie less pesos for the dollar .. however because for some time now the government forced parties to trade pesos with them at a lower than realistic rate (which they could do because they are the law and which they needed to do in order to pay for debt and oil for the countries basic needs).. there is still some unbalance.. therefore I think peso rates will remain stable for now until the real rate matches the current rate or until one of the above-mentioned factors changes in outlook..

As can be seen from the previous point, it is the governments needs (which imo only partially reflect the countries needs) which are a large part of the equation in the setting of the dollar/peso pricing. As long as the govt runs an inbalanced budget (payroll, debt, energy, big projects like the Metro) they have little room to pay for good policies.. so the problems from debts and energy are very real and are very big and affect the Dominican society.. controlling the exchange rate is therefore going to continue for a while..

Regards,

MD
 

cobraboy

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Nahls and MD-

Well said.

I somewhat disagree with the extent "manipulation" has occurred based on one Real World Adam Smith "Supply and Demand" driven point:

If the government has seriously altered the peso/dollar ratio, then why hasn't a black market developed? In a country where corruption is not uncommon and margins are low, you'd think it would.

That to me is prima facea evidence that the value is ~near~ equilibrium. Not perfect, but close enough where there is no economic benefit to be gained by going beyond normal outlets to exchange money.
 
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cobraboy said:
Nahls and MD-

Well said.

I somewhat disagree with the extent "manipulation" has occurred based on one Real World Adam Smith "Supply and Demand" driven point:

If the government has seriously altered the peso/dollar ratio, then why hasn't a black market developed? In a country where corruption is not uncommon and margins are low, you'd think it would.

That to me is prima facea evidence that the value is ~near~ equilibrium. Not perfect, but close enough where there is no economic benefit to be gained by going beyond normal outlets to exchange money.

I think no black market has developed because most dollars that were coming in where under govt control.. i.e. export payments, remittances and touris payments went through banks and exchange houses.. there where some instances of exchange houses and banks forcibly relieved of a huge stock of dollars ;)

The relatively small amount in free circulation (free-standing cambio guys) was never enough to influence the rate..
 

NALs

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MerengueDutchie said:
The relatively small amount in free circulation (free-standing cambio guys) was never enough to influence the rate..
I think stating what I quoted from you without injecting the words "it could very possibly be..." would be an iffy proposition.

The informal economy here is very large, with a good chunck of the population living off this and (as many of us know), everything in the informal economy is not taxed or accounted for in official data and takes much needed money out of the formal economy which is the one used to account for monetary policies and data.

Thus, the large presence of an informal economy (with many informal vendors illegally accepting US Dollars in lieu of Pesos as a form of payment for their goods/services) probably is putting some unnecessary pressures on the official exchange rate and the economy all together.
 
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Nal0whs said:
I think stating what I quoted from you without injecting the words "it could very possibly be..." would be an iffy proposition.

The informal economy here is very large, with a good chunck of the population living off this and (as many of us know), everything in the informal economy is not taxed or accounted for in official data and takes much needed money out of the formal economy which is the one used to account for monetary policies and data.

Thus, the large presence of an informal economy (with many informal vendors illegally accepting US Dollars in lieu of Pesos as a form of payment for their goods/services) probably is putting some unnecessary pressures on the official exchange rate and the economy all together.

Live and learn I see.. I always assumed that the illegal economy was mostly run on peso's.. apart from indirect effects...hence the limited influence on the formal economy.. you have any idea how big this informal dollar part is?