Exchange Rate Systems Flashcards
Exchange Rates
The price of one currency for another. Eg £1 = $1.60
Floating Exchange Rate
Where the market forces (Demand and Supply factors) determine the price for the currency.
There is no intervention, hence a gloating exchange rate.
Floating exchange rate with intervention is known as managed exchange rate.
Example of when demand shifts right.
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Example of when demand shifts left.
http://image.ibb.co/n33G7o/20180609_010908.jpg
Example of when supply shifts right.
http://image.ibb.co/e32tno/20180609_010930.jpg
Example of when supply shifts left.
http://image.ibb.co/dQDNf8/20180609_010912.jpg
How do shifts in demand for currency occur?
FDI - If firms invest into a country, they need to convert their currency to local currency, increase demand for local currency. Eg Tim Hortons expanding to UK, they have to exchange their CAD to GBP, increasing demand for the pound.
Tourism
If Interest Rates Are High - More overseas firms will save in the UK, converting their overseas currency to GBP, increasing demand for the pound.
Rise in incomes abroad - helps for tourism so they can afford it.
How do shifts in supply for currency occur?
Converting currency to another. Eg if someone was to sell their pounds for USD, demand for USD increases, supply for pound also increases.
Lower Interest Rates - Saves will look overseas, converting their pounds to foreign currencies.
Firms moving away from the country.
Increase in incomes domestically - increases tourism to other countries, converting pounds to other currencies.
Fixed Exchange Rates
A rate of exchange between at least two currencies, which is constant over a period of time.
To support a fixed exchange rate, the government or central bank are required to hold large amounts of currency reserves.
Example of Fixed Exchange Rates
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As the exchange rate is higher than the fixed rate of £1=$1.50, the bank of England/central bank can buy foreign currency. Therefore, the supply of the £ into foreign currency market increases. As a result, supply increases from S to S1. Subsequently, the exchange rate falls/the £ depreciates from P ($1.60) to P1 ($1.50). This is good as the target rate of $1.50 has been achieved.
http://image.ibb.co/buyGOT/20180609_032357.jpg
As the exchange rate is lower than the fixed rate of £1 = $1.50, the Bank of England/Central Bank can use foreign currency to buy more pounds. Therefore, the demand of the £ into foreign currency market increases. As a result, demand increases from D to D1. Subsequently, the exchange rate increases/the £ appreciated from P($1.40) to P1($1.50). This is good as the target rate of $1.50 is achieved.
Pros and Cons for floating exchange rates
No need for government/central bank to buy foreign currency which can be costly.
A weaker pound is good go reduce the trade deficit (SPICED - WPIDEC)
However, if the exchange rate is too volatile, it puts off foreign investment.
Pros and Cons for Fixed Exchange Rates
Ensures Stability
However, costly to hold high levels of foreign currency, and £ won’t weaken to improve exports.
Nominal Exchange Rate
Real Exchange Rate
Nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic currency.
The real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country.
Purchasing Power Parity Theory of Exchange Rates
Definition + Example
The hypothesis that long run changes in exchange rates are caused by differences in inflation rates between countries.
£1 = $1.60 (nominal exchange rate)
Basket of goods in UK = £100 - 10 Products
Basket of goods in US = $160 - 10 Products
So if you exchange £100 for $160, both give you same 10 products.
Lets say there is inflation in the USA, so basket of goods now cost $170
So for US citizens in the UK, they have purchasing power parity due to items appearing cheaper in the UK
However, usually exchange rates would increase. £1 = $1.70 which would benefit the UK
If exchange remains at £1 = $1.60 after inflation, the pound is under-valued compared to the $, and the US dollar is over-valued compared to the £
To solve this, real exchange rates can be used.
The theory is, the economy will re-adjust itself. However, in the reality, speculation causes changes in the value of the currencies (eg Brexit, people not sure on economic state)
Currency or Exchange Controls
Limits on the purchase and sales of foreign currency, usually through its central bank.
Devaluation of a Currency
When a government or central bank officially fixes a newer lower exchange rate for the currency in a fixed or pegged system of exchange rates.
Revaluation of a Currency
When a government or central bank officially fixes a new higher exchange rate for the currency in a fixed or pegged system of exchange rates.
Managed exchange rate system
An exchange rate system where free markets determine the value of a currency (floating exchange rate) but where central banks intervene from time to time to change the value of their currency.
There are many forms of managed exchange rate systems that sometimes are incorrectly refereed to as fixed exchange rate systems:
Adjustable Peg System - An exchange rate system where currencies are fixed in value in the short term but can devalued or revalued in the longer term.
Crawling Peg System - An adjustable peg system of exchange rates where there is an inbuilt mechanism for regular changes in the central value of the currency.
Managed float - Where the exchange rate is determined by free market forces but government intervenes from time to time to alter the free market price of currency.
