L25 - The Balance of Payments and Exchange Rates - Part 1 Flashcards
What are the two exchange rate markets
- Spot market –> A spot rate is a contracted price for a transaction that is taking place immediately (it is the price on the spot).
- Forward Market –> is the settlement price of a transaction that will not take place until a predetermined date in the future; it is a forward-looking price. Forward rates typically are calculated based on the spot rate.
What is the rise and fall of the external value of the pound called?
- A rise in the external value of the pound (i.e. a rise in the exchange rate) is called an appreciation of the pound.
- A fall in the external value of the pound (i.e. a fall in the exchange rate) is called a depreciation of the pound.
- Note: Because the exchange rate expresses the value of one currency in terms of another, when one currency appreciates, the other must depreciate.
What is the exchange rate?
The exchange rate between two currencies is the amount of one currency that must be paid in order to obtain one unit of another currency.
How is the exchange rate determined?
- The exchange rate is just a price, albeit a very important price.
- Since it is determined in a competitive market in which there are many buyers and many sellers, we can analyse its behaviour using the demand and supply analysis.
- Note: Because one currency is traded for another in the foreign exchange market, it follows that a demand for foreign exchange (dollars) implies a supply of pounds, while a supply of foreign exchange (dollars) implies a demand for pounds.
- The demand for pounds arises from all international transactions that generate a receipt of foreign exchange:
- UK exports
- Income payments and transfers
- Capital inflows
- reserve currency –> amount of foreign currency kept by the central bank
- The sources of supply of pounds in the foreign exchange market are merely the opposite side of the demand for pounds.
What does the the graph of foreign exchange look like?
- spot market
- With Price of £1 in $ on the y-axis and the quantity of pounds in the x-axis
- downwards line of demand for pounds and upwards line of supply for pounds
- the demand curve is negatively sloped because if the pound were to depreciate, an importer from another country would need less pounds to buy something, so as long as demand is elastic importers will import more UK goods which will lead to a increase in the number of pounds needed
- For the supply curve is the opposite, when the pound appreciates foreign exports become cheaper for UK buyers so more are sold and a greater quantity of pounds is spent on them, thus more pounds will be offered in exchange for dollars
What causes a flexible exchange rate?
The simplest answer to this question is changes in demand or supply in the foreign exchange market.
- e.g. is the demand for the pound exceed supply, the pound will appreciate, till equilibrium ( also as the pound appreciates the amount needed to by foreign goods is also reduced)
- if supply for the pound exceeds demand the pound will depreciate till equilibrium
What causes the shifts in demand and supply that leads to changes in exchange rates?
- a rise in the domestic price of exports
- a rise in the foreign price of imports
- Changes in price levels
- Capital movements
- If the price level of one country is rising relative to that of another country, the equilibrium value of its currency will be falling relative to that of the other country.
- The degree of exchange rate variability experienced since the advent of floating in the early 1970s has been bigger than was expected.
Why have exchange rates been volatile?
- This question remains at the centre of debate and controversy among researchers and policy commentators.
- Purchasing power parity (PPP) theory holds that over the long term the average value of the exchange rate between two currencies depends on their relative purchasing power.
- The theory holds that a currency will tend to have the same purchasing power when it is spent in its home country as it would have if it were converted to foreign exchange and spent in the foreign country.
- Note: PPP exerts a strong influence on exchange rates in the long term, but there are often significant deviations from PPP in the shortto medium term.
Where did the exchange rates regimes evolve from?
- Exchange rate regimes evolves from gold standard to multiple regimes: fixed (Bretton Woods system), flexible and those in-between.
- Under fixed exchange rates the authorities intervene in the foreign exchange market to maintain the exchange rate within a specified range.
- To do this, they must hold sufficient stocks of foreign exchange reserves.
- Under a flexible [or floating] exchange rate regime the exchange rate is market-determined by supply and demand for the currency.
- Fluctuations in exchange rates can be understood as fluctuations around a trend value that is determined by the purchasing power parity (PPP) rate.
- Today’s exchange rate regime is generally one of free floating, which means that demand and supply forces are free to determine the exchange rate.
- However, some central banks do intervene in the market from time to time to try to influence their country’s exchange rate.
What does the supply of pounds actually mean?
- supply of pounds by people who are seeking dollars is the same as the demand for dollars by holders of pounds
- its therefore merely the opposite side of the demand for dollars e.g.:
- UK residents seeking to buy foreign goods
- paying share to US shareholders
- FED sterling reserve –> wants to sell the pounds for another currency as it deems the sterling-denominated assets offer a poor return
What is a problem with fixed or pegged exchange rates?
- With fixed exchanged rates and an undervalued currency, the monetary authorities will be acquiring reserves (always exchanging domestic currency for foreign to bring down the price)
- With an overvalued currency, the monetary authorities will be losing reserves (as constantly buying domestic currency with foreign reserves)
- If nothing is done to alter the situation the currency will have to be devalued sooner or later, and if a flight from the currency occurs devaluation may be forced on the authorities sooner rather than later
What is a floating rate regime or a managed float regime?
A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate.
What is a foreign exchange market like?
- is like any other competitive market
- the forces of demand and supply lead to an equilibrium price at which quantity demanded is equal to quantity supplied
How can a rise in the domestic price of exports cause a change in the exchange rate?
- Say if there ways a rise in the sterling cost of a UK product
- The effect on the demand for pounds depends on the elasticity of of foreign demand for the UK products
- INELASTIC - then more will be spent the demand for pounds to pay the bigger bill will shift the demand curve right so the pound to appreciate
- ELASTIC - the total amount spent will decrease and thus fewer pounds will be demanded, the demand curve will shift left adn the pound will depreciate
How can a rise in the foreign price of imports cause a change in the exchange rate?
- suppose there is an increase in the dollar price of a US product
- if UK demand is elastic - spend fewer dollars for US product than they did before, therefore supply less pounds, this will shift the supply curve left and the pound will appreciate
- If UK demand was in elastic - spend more dollars for US product, therefore supply more pounds which would shift the supply curve to the right depreciating the pound