4.1.8 Exchange Rates Flashcards
Exchange rates
The purchasing power of a currency in terms of what it can buy of other currencies.
Exchange rate systems
1) Floating
2) Fixed
3) Managed
Floating system
A free floating system is where the value of the currency is determined purely by market demand and supply of the currency, with no target set by the government and no official intervention in the currency markets.
- Both trade flows and capital flows affect the exchange rate under a floating system. Most systems are floating, including the UK.
Managed system
Managed floating is where the value of the currency is determined by demand and supply but the Central Bank will try to prevent large changes in the exchange rate on a day to day basis. This is done by buying and selling currency and by changing interest rates e.g. the Brazilian Real, Swiss Franc and the Japanese Yen.
- An adjustable peg system is where currencies are fixed against another but the level at which they are fixed can be changed.
- Crawling peg systems are a form of this but have a mechanism which allows the value to change.
- Managed float or dirty float is where the government intervenes to improve macroeconomic stability.
Fixed system
A fixed system is when a government sets their currency against another and that exchange rate does not change. The country can decide to devalue its currency overnight to improve international competitiveness of its industry.
- One example was the gold standard, where each major trading country made its currency convertible into gold at a fixed rate.
- Today, no country uses the gold standard.
Revaluation vs Devaluation of a currency
• A revaluation of the currency is when the currency is increased against the value of another under a fixed system.
• Devaluation of the currency is a decrease in the value of one currency against another under a fixed system.
Appreciation vs Depreciation of a currency
• An appreciation of the currency is an increase in the value of the currency using floating exchange rates.
• A depreciation is a fall in the value of the currency under floating exchange rates.
Factors affecting floating exchange rates
Floating exchange rates are determined by the interaction of demand and supply, and so are affected by changes in demand and supply:
- The demand for pounds is determined by: the amount of British goods that foreigners want to buy; the number of foreigners wanting to invest in the UK, visit the UK or place their money in British banks; and the amount of speculation on the pound.
- The supply of pounds is determined by: the amount of foreign goods people in the
UK want to buy; the number of British firms that want to invest abroad, the amount of British people wanting to go on holiday abroad or place their money in foreign banks; and the amount of speculation on the pound.
- Therefore, in general, the currency is affected by the level of exports and imports, the level of investment, those going on holiday and speculation.
- Speculation is the single most important determinant of the short-term price- if speculators fear a fall in the pound, the pound will fall as they will sell their pounds and buy another currency.
- However, in the long term, the currency is determined by economic fundamentals: exports, imports and long-term capital flows.
Government intervention in currency markets through foreign currency transactions and the use of interest rates
There are two main methods the government can use to influence the value of their currency:
1) If they want to increase or decrease demand for their currency, a government can use interest rates. An increase in interest rates will strengthen the pound as people will convert their money to pounds to put them in English banks, so demand for pounds will rise. Falls in interest rates will decrease demand for the pound so weaken the currency.
2) Also, governments can use gold and foreign currency reserves to manipulate the value of their currency. If the value of the pound is too high and they want to weaken it, they can increase supply by buying foreign currency or gold with pounds. To strengthen the pound, they can increase demand by selling their foreign currency or gold in exchange for pounds. (Central banks have found that this method tends to have little impact on currencies in the long term.)
- They are also able to limit supply of currency by introducing currency controls, and by doing so they can fix the value of the currency.
Competitive devaluation/depreciation and its consequences
This is where a country deliberately intervenes in foreign exchange markets to drive down the value of their currency to provide a competitive boost to their exporting industries.
- A weaker currency will encourage exports and discourage imports and therefore the balance of payments should improve assuming the Marshall-Lerner condition.
-However, the problem is that this can cause inflation and this may reduce competitiveness, leading to a fall in the balance of payments.
- Another problem is that other countries may follow and reduce their currency as well, however this is unlikely if there is a current account deficit, but if the country who devalues has a surplus, other countries are likely to retaliate.
Impacts of changes in exchange rates
- the current account of balance of payments (Marshall-Lerner condition and J-curve effect)
- economic growth and employment/unemployment
- rate of inflation
- foreign direct investment (FDI) flows
Current account of balance of payments (impact of changes in exchange rate)
- The Marshall-Lerner condition states that the sum of the price elasticities of imports and exports must be more than one (i.e. elastic) if a currency devaluation is to have a positive impact on the trade balance.
- The J-curve shows how the current account will worsen before it improves. People will not immediately recognise that British exports are cheaper and it will take a while to find a source for them, whilst UK consumers will not see that imports are more expensive and may be unable to switch straight away. Demand tends to be inelastic in the short run.
Therefore, the amount sold of each will stay the same but the price of exports will fall, so the value will fall, and the price of imports will rise, so the value will rise. However, in the long term, the current account deficit will fall as demand becomes more elastic.
Economic growth and unemployment (impact of changes in exchange rate)
A weaker exchange rate is likely to increase exports, since they become cheaper, and decrease imports so lead to an increase in AD.
- This will increase employment and economic growth.
Rate of inflation (impact of changes in exchange rate)
Falls in the exchange rate will increase inflation as imports become more expensive, causing a rise in prices and a fall in SRAS.
- Also, the net exports section of AD will increase and so inflation will rise further.
FDI (impact of changes in exchange rate)
A fall in the currency may increase FDI because it becomes cheaper to invest.
- However, if the currency is continuing to fall then this is an indication that an economy has serious economic difficulties which will discourage investment.
