Chapter 27 - Exchange rates Flashcards
What is the exchange rate?
The price of one currency in terms of another.
How does exchange rate work?
The demand for pounds arises from overseas residents (e.g. in the USA or the euro area) wanting to purchase UK goods, services or assets, whereas the supply of pounds emanates from domestic residents wanting to purchase overseas goods, services or assets. The balance of payments accounts itemise these transactions, which entail the demand for and supply of pounds. Notice that the demand for currency is a derived demand - therefore pounds are demanded when people holding dollars or other currencies want to buy British. Similarly, pounds are supplied when people holding sterling want to buy foreign goods, services or assets.
The demand curve is downward sloping because when the €/£ rate is low, UK goods, services and assets are relatively cheap in terms of euros, so demand is relatively high. When the €/£ rate is relatively high, Europeans receive fewer pounds for their euros, so the demand will be relatively low.
The supply curve of pounds is upward sloping. When the €/£ rate is relatively high, the supply of pounds will be relatively strong, as UK residents will get plenty of euros for their pounds and so will demand European goods, services and assets, supplying pounds in order to buy the foreign exchange needed for the transactions. When the €/f rate is low, European goods, services and assets will be relatively expensive for UK residents, so fewer pounds will be supplied.
The market is in equilibrium at e*, where the demand for pounds is just matched by the supply of pounds. This position has a direct connection with the balance of payments. If the demand for pounds exactly matches the supply of pounds, this implies that there is a balance between the demand from Europeans for UK goods, services and assets and the demand by UK residents for European goods, services and assets. In other words, the balance of payments is in overall balance.
The demand for UK exports in world markets depends upon a number of factors. In some ways, it is similar to the demand for a good. In general, the demand for a good depends on its price, on the prices of other goods, and on consumer incomes and preferences. In a similar way, you can think of the demand for UK exports as depending on the price of UK goods, the price of other countries’ goods, incomes in the rest of the world and foreigners’ preferences for UK goods over those produced elsewhere.
However, in the case of international transactions the exchange rate is also relevant, as this determines the purchasing power of foreigners’ incomes in the UK. Similarly, the demand for imports into the UK depends upon the relative prices of domestic and foreign goods, incomes in the UK, preferences for foreign and domestically produced goods and the exchange rate. These factors come together to determine the balance of demand for exports and imports.
What is a fixed exchange rate system?
A system in which the government of a country agrees to fix the value of its currency in terms of that of another country
What is foreign exchange reserves?
Stocks of foreign currency and gold owned by the central bank of a country to enable it to meet any mismatch between the demand and supply of the country’s currency
Suppose the authorities announce that the exchange rate will be set at e-f. Given that this level is set independently by the government, it cannot be guaranteed to correspond to the market equilibrium, and in the diagram it is set above the equilibrium level. At this exchange rate the supply of pounds exceeds the demand for pounds. This can be interpreted in terms of the overall balance of payments. If there is an excess supply of pounds, the implication is that UK residents are trying to buy more American goods, services and assets than Americans are trying to buy British: in other words, there is an overall deficit on the balance of payments.
In a free market, you would expect the exchange rate to adjust until the demand and supply of pounds came back into equilibrium. However, with the authorities committed to maintaining the exchange rate at e-f such adjustment cannot take place. However, the UK owes the USA for the excess goods, services and assets that its residents have purchased, so the authorities then have to sell foreign exchange reserves in order to make the books balance.
Notice that the position of the demand and supply curves depends on factors other than the exchange rate that can affect the demand for British and American goods, services and assets in the respective countries. It is likely that, through time, these will shift in position. For example, if the preference of Americans for British goods changes through time, this will affect the demand for pounds.
In the long term, the system will operate successfully for the country so long as the chosen exchange rate is close to the average equilibrium value over time, so that the central bank is neither running down its foreign exchange reserves nor accumulating them.
A country that tries to hold its currency away from equilibrium indefinitely will find this problematic in the long run, as it will cause a persistent trade imbalance. A persistent disequilibrium may need to be addressed by realigning the value of the currency, either by reducing the price of its currency (a devaluation) to tackle persistent current account deficits, or by raising the price of the currency (a revaluation) to deal with persistent surpluses.
What is devaluation?
Process whereby a government reduces the price of its currency relative to an agreed rate in terms of foreign currency
What is revaluation?
Process whereby a government raises the price of domestic currency in terms of foreign currency
What is a floating exchange rate system?
A system in which the exchange rate is permitted to find its own level in the market
What causes a change in the exchange rate in a fixed exchange rate system?
When a fixed exchange rate system is in operation, changes in the exchange rate are rare by the very nature of the system. The authorities maintain the rate at the agreed level, and changes only occur when the authorities realise that the agreed rate is causing persistent problems by being a long way from the equilibrium value.
What are the key factors that determine the exchange rate in a floating exchange rate?
- relative inflation rates
- the trade balance
- net investment in the UK
- speculation
- relative interest rates and monetary policy
How does relative inflation rates affect a floating exchange rate?
Exchange rate equilibrium also implies a zero overall balance of payments. If the exchange rate always adjusts to the level that ensures this, it might be argued that the long-run state of the economy is one in which the competitiveness of domestic firms remains constant over time. In other words, you would expect the exchange rate to adjust through time to offset any differences in inflation rates between countries.
What is the purchasing power parity theory?
The purchasing power parity theory of exchange rates argues that this is exactly what should be expected in the long run if there are differences in inflation rates between countries. The nominal exchange rate should adjust in such a way as to offset changes in relative prices between countries.
How does the trade balance affect a floating exchange rate?
The exchange rate in a free market is determined by the demand and supply for the currency. This means that changes in the balance between exports and imports can affect the exchange rate. An increase in the demand for exports implies an increase in the demand for sterling, so would lead to an appreciation of the currency (ceteris paribus).
How does net investment in the UK affect a floating exchange rate?
An increase in foreign direct investment would have similar effects. If the UK becomes an attractive prospect for foreign investors, this could also lead to an appreciation - or at least upward pressure on the exchange rate.
How does speculation affect a floating exchange rate?
In the short run the exchange rate may diverge from its long-run equilibrium. An important influence on the exchange rate in the short run is speculation. So far, the discussion of the exchange rate has stressed mainly the current account of the balance of payments. However, the financial account is also significant, especially since regulation of the movement of financial capital was liberalised. Some of these capital movements are associated with foreign direct investment, but sometimes there are also substantial movements of what has come to be known as hot money: that is, stocks of funds that are moved around the globe from country to country in search of the best return. The size of the stocks of hot money is enormous, and can significantly affect exchange rates in the short run. Changes in the domestic real interest rate can have a significant effect on these flows.
Such movements can influence the exchange rate in the short run. The returns to be gained from such capital flows depend on the relative interest rate in the country targeted, and on the expected exchange rate in the future, which in turn may depend on expectations about inflation.
Suppose you are an investor holding assets denominated in US dollars, and the UK interest rate is 2% higher than that in the USA. You may be tempted to shift the funds into the UK in order to take advantage of the higher interest rate. However, if you believe that the exchange rate is above its long-run equilibrium, and therefore is likely to fall, this will affect your expected return on holding a British asset. Indeed, if investors holding British assets expect the exchange rate to fall, they are likely to shift their funds out of the country as soon as possible - which may then have the effect of pushing down the exchange rate. In other words, this may be a self-fulfilling prophecy. However, speculators may also react to news in an unpredictable way, so not all speculative capital movements act to influence the exchange rate towards its long-run equilibrium value.
What is hot money?
Stocks of funds that are moved around the world from country to country in search of the best return
How does interest rates and monetary policy affect a floating exchange rate?
Financial flows into or out of the UK may be induced by the relative level of interest rates. If UK interest rates are high relative to elsewhere, this may attract an inflow of financial capital, so putting upward pressure on the interest rate and leading to an appreciation. The significance of this is that changes in the stance of monetary policy will have an effect on the exchange rate under a floating exchange rate system. These become an important part of the operation of monetary policy. Indeed, the decision of the monetary authorities in setting interest rates may be partly influenced by movements in the exchange rate.
How does adjustment to shocks affect different exchange rate systems?
Every economy has to cope with external shocks that occur for reasons outside the control of the country. A key question in evaluating exchange rate systems is whether there is an effective mechanism that allows the economy to return to equilibrium after an external shock.
Under a floating exchange rate system, much of the burden of adjustment is taken up by changes in the exchange rate. For example, if an economy finds itself experiencing faster inflation than other countries, perhaps because those other countries have introduced policies to reduce inflation, then the exchange rate will adjust automatically to restore competitiveness.
However, if the country is operating a fixed exchange rate system, the authorities are committed to maintaining the exchange rate, and this has to take precedence. Therefore, the only way to restore competitiveness is by deflating the economy in order to bring inflation into line with other countries. This is likely to bring with it a transitional cost in terms of higher unemployment and slower economic growth. In other words, the burden of adjustment is on the real economy, rather than on allowing the exchange rate to adjust.
The Bretton Woods system operated for more than 20 years in a period in which many economies enjoyed steady economic growth. However, in the UK the system brought about a stop-go cycle, in which the need to maintain the exchange rate hampered economic growth, because of the tendency for growth to lead to an increase in imports and therefore to a current account deficit. The increasing differences between inflation rates in different countries led to the final collapse of the system, suggesting that it was unable to cope with such variation.
Furthermore, a flexible exchange rate system allows the authorities to utilise monetary policy in order to stabilise the economy - remember that under a fixed exchange rate system, monetary policy has to be devoted to the exchange rate target.
How does stability affect different exchange rate systems?
When it comes to stability, a fixed exchange rate system has much to commend it. After all, if firms know that the government is committed to maintaining the exchange rate at a given level, they can agree future contracts with some confidence. Under a floating exchange rate system, trading takes place in an environment in which the future exchange rate has to be predicted. If the exchange rate moves adversely, firms then face potential losses from trading. This foreign exchange risk is reduced under a fixed rate regime.
What is the evaluation of the consequences of exchange rate changes?
Under a flexible exchange rate system, the exchange rate adjusts to maintain international competitiveness in the long run. However, it also responds to external events and to financial movements induced by speculators. Such changes are not under the control of the authorities, but yet can have an impact on the real economy through the effect on prices of imports and exports.
The exchange rate may also be affected by policies introduced by the monetary authorities to address other policy targets. Suppose that two countries have been experiencing rapid inflation, and one of them decides to tackle the problem. It raises interest rates to dampen domestic aggregate demand, which leads to an appreciation of its currency. For the other country, the effect is a depreciation of the currency. (If one currency appreciates, the other must depreciate.) The other country therefore finds that its competitive position has improved, and it faces inflationary pressure in the short run. It may then also choose to tackle inflation, which in turn will affect the other country. These spillover effects could be minimised if the countries were to harmonise their policy action, but this is not always straightforward to achieve.
Critics of the flexible exchange rate system argue that it is too flexible for its own good. If governments know that the exchange rate will always adjust to maintain international competitiveness, they may have no incentive to behave responsibly in designing macroeconomic policy. They may be tempted to adopt an inflationary domestic policy, secure in the knowledge that the exchange rate will bear the burden of adjustment. In other words, a flexible exchange rate system does not impose financial discipline on individual countries. In this situation, changes in the exchange rate can result in inflationary pressure.
Under a fixed exchange rate system, changes in the exchange rate are few and far between. However, if the exchange rate is held away from its equilibrium level for a long time, speculation may begin to reinforce the pressure for a devaluation (or revaluation), and the economy may take some time to adjust when the change is eventually made.
What is appreciation?
A rise in the exchange rate within a floating exchange rate system
What is depreciation?
A fall in the exchange rate within a floating exchange rate system
