The Open Economy - Exchange Rates Flashcards
What does it mean to describe an economy as open?
Describing an economy as ‘open’ is to state that goods, services and money can flow in and out of the economy in the manner which we have been discussing.
Reasons to demand a currency - trade
Other things equal, if exports increase then foreign purchasers will require more of the ________ ___________ in order to make these purchases. This extra demand for the domestic currency on foreign exchange markets would be expected to increase the value of the currency with respect to the __________ _______ ↑.
Other things equal, if exports increase then foreign purchasers will require more of the domestic currency in order to make these purchases. This extra demand for the domestic currency on foreign exchange markets would be expected to increase the value of the currency with respect to the foreign currency,
i.e. E ↑.
Reasons to demand a currency - investment
Other things equal, if foreign investors wish to invest in the ________ _______(either through FDI or portfolio investment) then they will require the domestic currency in
order to make this investment. This extra demand for the domestic currency on foreign exchange markets would be expected to __________ the value of the currency with respect to the _________ ________, i.e. E ↑.
Note
The above demand for the domestic currency is argued to alter E because it is demand on the foreign exchange markets, with an implied exchange for some other currency. If a UK resident requests a bank loan then we might think of that as a case of there being more demand for pounds, but this is
________ _______(the bank customer is not offering a different currency in exchange for the loan) and hence would not be expected to affect the exchange rate.
The above demand for the domestic currency is argued to alter E because it is demand on the foreign exchange markets, with an implied exchange for some other currency. If a UK resident requests a bank loan then we might think of that as a case of there being more demand for pounds, but this is
domestic demand (the bank customer is not offering a different currency in exchange for the loan) and hence would not be expected to affect the exchange rate.
Reasons to demand a currency - interest rates
Suppose that you had £1,000,000 spare but wanted to keep it in a liquid form. If UK deposits paid 3% interest but Chilean deposits paid 10% there would be an incentive to…
Other things equal (including a belief that the exchange rate won’t change ‘a lot’), higher interest rates would be expected to…
Suppose that you had £1,000,000 spare but wanted to keep it in a liquid form. If UK deposits paid 3% interest but Chilean deposits paid 10% there would be an incentive to convert the Sterling deposit to pesos and hold it in a Chilean account until it was needed, then convert back.
Other things equal (including a belief that the exchange rate won’t change ‘a lot’), higher interest rates would be expected to increase the demand for a currency
Sterling volumes
In 2022, the UK had exports worth £833.9 bn and imports worth £901.8 bn . UK investment abroad amounted to £172.6 bn and inward investment from the rest of the world amounted
to £237 bn. (ONS Pink Book 2023)
During 2022, the daily average turnover of Sterling on foreign exchange markets was approximately £____bn (Bank for International Settlements Triennial Survey, 2022). (N.B. the
previous figure is for ‘spot’ transactions only)
In 2022, the UK had exports worth £833.9 bn and imports worth £901.8 bn . UK investment abroad amounted to £172.6 bn and inward investment from the rest of the world amounted
to £237 bn. (ONS Pink Book 2023)
During 2022, the daily average turnover of Sterling on foreign exchange markets was approximately £200 bn (Bank for International Settlements Triennial Survey, 2022). (N.B. the
previous figure is for ‘spot’ transactions only)
Exchange rate regimes II
Why in the short-term, has sterling been more volatile relative to the USA dollar?
How does this compare to both Nigeria and Argentina?
In the short-term, sterling has been more volatile relative to the USA dollar, because the UK has a floating exchange rate, i.e. Sterling is freely traded on foreign exchange markets and
neither the Bank of England nor the government attempt to influence (overtly) the value of Sterling.
Both Nigeria and Argentina have had some form of fixed exchange rate, meaning that the central bank/government does try to control the value of the currency, which makes the exchange rate more stable (for as long as the policy is maintained)
Consequences of floating (5)
- Uncertainty for businesses and individuals as to what the future exchange rate might be.
- Potential for inflation if the currency loses value and some imports are necessary.
- Possible volatility of international flows, as the value of the currency varies.
- Possible volatility of the exchange rate (‘currency crises’), as international flows vary (e.g. ‘capital flight’).
- Flexibility, in that exchange rate variation might help to smooth the economic cycle (for example, if during a recession the exchange rate falls then this might encourage exports).
Consequences of fixing (3)
- Not the potential volatility or flexibility arising from floating.
- Asymmetric risks - a central bank can always create more of its own currency and sell it for foreign currencies, to reduce the exchange rate, but it cannot create more foreign currency and buy domestic currency in order to increase the exchange rate. (See again the Naira and
Peso) - ‘Black Wednesday’ - the European Exchange Rate Mechanism was a system of fixed exchange rates between western European currencies: markets believed that Sterling was over-valued relative to the Deutschmark and the UK did not have sufficient foreign currency reserves
to prevent a devaluation/exit.
