Exchange rates Flashcards
Floating exchange rate system
-Determined by supply and demand in foreign exchange market
-Governments and central banks do not actively intervene to fix the rate
-Fluctuates freely
Fixed exchange rates
-Gov or central bank sets specific rate and is committed to maintaining it
-To keep rate stable, authorities may buy or sell their own currency as needed
Managed exchange rates
-Hybrid approach where authorities occasionally intervene to influence the ER
-Some flexibility however also a commitment to maintain certain degree of stability
Revaluation vs appreciation of currency
Revaluation:
-Increase in official ER set by gov or Cbank
-Deliberate policy move to strengthen value of currency
Appreciation:
-Natural increase in value of currency due to market forces
-e.g. increased demand in foreign exchange market
Devaluation vs depreciation
Devaluation:
-Deliberate policy action by gov or Cbank to reduce exchange rate - exports cheaper, imports more expensive
Depreciation:
-Value of currency decreases due to market forces
-e.g. decreased demand for the currency
Factors influencing floating exchange rates
Interest rates:
-High interest rates attract foreign capital which increases demand for the currency
Speculation:
-Traders’ perception of future exchange rate movements can drive short-term fluctuations
-If people think currency will appreciate in the future, demand will increase in the present as profit could be made by selling in the future
Gov. finance:
-Gov with high level of debt is at risk of defaulting
-Investors lose confidence so sell bonds
-currency depreciates
Trade balance:
-If country struggles to finance trade deficit currencies may depreciate as a result
-Import more so less demand for currency
Gov intervention in currency markets
- An increase in interest rates relative to other countries makes investments in the country more attractive - receive a higher rate of return - increases demand for the currency causing an appreciation - hot money flows
- Buying and selling foreign currency to manipulate the domestic currency
-China kept large reserves of the US dollar by purchasing government bonds in order to undervalue the yuan
Competitive devaluation/depreciation
and its consequences
-Multiple countries intentionally lowers their exchange rates to gain competitive advantage in international trade and economic growth
Consequences:
-Inflation - high cost of imports and demand-pull inflation from increased AD (exports cheaper, imports more expensive)
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Impacts of changes in exchange rates:
the current account
-Marshall-lerner condition: a depreciation of the domestic currency will improve the trade balance if the sum of price elasticities of demand for exports and imports is greater than 1
-The J curve: In short-term balance may worsen after a depreciation of currency as it takes time for demand elasticities to adjust
-Time lag in changing volume of imports/exports
-trade contracts, search for alternatives, price inelasticity in SR
Impacts of changes in exchange rates:
economic growth and un/employment
-Weak currency can boost exports, stimulating economic growth, potentially reducing unemployment
-If currency appreciates households switch from domestic to imported goods - depends on inflation, elasticity, marginal propensity to import (high in UK)
Impacts of changes in exchange rates:
Inflation rate
-A depreciating currency makes importing raw materials and other factors of production more expensive- leading to higher COP - SRAS shifts inwards
-Increases cost-push inflation
-increases demand pull inflation caused by higher exports
EVAL:
1.Depends on how dependent domestic firms are for imported raw materials - the UK imports over half of its oil - more expensive
2. Extent of cost-push inflation depends on how much other factors are rising (eg wages)
Impacts of changes in exchange rates:
FDI flows
-Impact attractiveness of a country for FDI
-Weak currency makes wages and production costs cheaper so the country is more internationally competitive so may make assets more appealing to foreign investors
impact of exchange rates - AD
. AD
-production costs for domestic firms fall relative to those of foreign competitors, making the country’s EXPORTS MORE COMPETITIVE in foreign markets as they are cheaper to buy
-the domestic firms production should increase, which increases domestic employment - multiplier effect
-Reduce imports as they are now relatively more expensive
-This may encourage domestic production of goods that were previously imported- acting as a protectionist policy
EVAL:
1.-depends on price elasticity of demand of exports and imports
-UK tend to provide services and they compete more on quality rather than price - legal/financial sectors
-Some UK exports are relatively price inelastic and so will not benefit from the depreciating currency
- In long run as firms are more competitive without effort- reduced incentives to cut costs - declining productivity - declining supply -excess demand - rising prices
broader eval points
- Exchange rate only shows value of one currency in terms of another.
-Depreciation of the pound against the dollar may be offset by the appreciation of the pound against the euro as the currency fluctuates independently - varying IR, inflation.
-The significance of the depreciation depends on which country it is depreciating against - depreciation against the yuan is more significant than against the Thai Baht - china is a large trading partner - The openness of a country to trade - more open to trade will be more affected than closed countries
