Exchange rate Flashcards
Marshall Lerner Condition
States that currency devaluation benefits the trade balance only if the demand for goods and services is responsive enough to changes in prices
Exchange rate
The external price of one currency, usually measured in terms of another currency. It is determined in forex markets where currencies are traded. Supply and demand for each determine the prices for one another
Real exchange rates
The real exchange rates of the pound takes the ERI (exchange rate index) and adjusts for inflation:
=Sterling index X (Index of domestic PL/Index of weighted foreign PL)
It tells us how competitive UK products will be in overseas markets with inflation factored in.
Exchange rate systems
-Free floating exchange rates (cleanly floating)
-Dirty floating exchange rates (managed floating)
-Adjustable peg exchange rates
-Rigidly fixed exchange rates
Dirty floating exchange rates
Exchange rates are officially floating, but there will be some “behind the scenes” intervention by a central bank, for example, to manage or guide the exchange rate.
Adjustable peg exchange rates
The exchange rate is fixed, but the rate at which it is fixed, may need to be altered
Assumptions of free floating exchange rate
-People want/need foreign currency solely for import/export transactions (no currency speculation or capital flows)
-It is trade flows that determines exchange rates; demand for currency is derived demand
-People do not hold on to foreign currency balances; any surplus foreign currency is sold on
Free floating exchange rates explanation
As currency is bought for the sole purpose of trade, the quantity of the pounds demanded=value of exports (where foreign buyers need pounds) and the quantity of pounds supplied=value of imports (where UK buyers need foreign currency to spend on imports). At equilibrium, D=S so the money value of imports and exports are equal (X=M)
Free floating exchange rate graph (change in the exchange rate)
To import more goods, UK buyers need more euros so they need to sell more of their pounds, thus increasing the supply of pounds in forex markets. There is an excess supply of pounds. The exchange rate falls as those holding pounds are desperate for euros and are willing to accept a lower price and a new equilibrium is found at P2. This makes imports less attractive and UK exports more price competitive. The reverse applies
The main advantage of free floating exchange rates
The self correcting properties of market forces (the invisible hand) as any deficit of surplus in the BOP will be short lived as the exchange rate will adjust and restore equilibrium. This means that the government can focus on other things
Free floating exchange rates
advantages-Independent monetary policy
If locked into an exchange rate, our monetary policy cant be entirely independent because changes in partner economies have consequences for us e.g. if inflation is higher abroad, we gain a competitive price advantage, the exchange rate appreciates which offsets the increased nominal prices of imports.
