Exchange rates

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Freely floating exchange rates

Exchange rate: the price of one currency expressed in the terms of other currencies.

Floating system: the value of the exchange rate is determined by the supply and demand of the currency on the foreign exchange market.

Appreciation: an increase in the value of the exchange rate in comparison to other currencies operating within a floating exchange rate system.

Depreciation: a decrease in the value of the exchange rate in comparison to other currencies operating within a floating exchange rate system.

When comparing the value of two different currencies, one exchange rate is the inverse of the other.

Causes of a changes in floating exchange rates

  • An increase in the demand of a country’s exports will cause an appreciation in the currency as the demand for the currency will increase.

  • In contrast, if domestic demand for import increases then the domestic currency is more likely to depreciate as there is a greater relative demand for other currencies.

  • A lower interest rate tends to decrease foreign investment in the country, so more of the domestic currency will be sold and the exchange rate will depreciate.

  • A high domestic inflation rate will usually decrease the demand for exports, as they are become comparatively more expensive, so the exchange rate will begin to fall.

  • Foreign direct investment into a country will increase the demand for its currency and therefore contribute to an appreciation in the exchange rate.

  • Portfolio investment, including stocks, shares and bonds, in another country can increase the demand for that country’s currency which will increase the supply of the domestic currency. Therefore, the domestic exchange rate may depreciate.

  • Exchange rate fluctuations may be a result of speculation as investors demand different currencies as they try to take advantage of changing interest rates and other variables, with the aim of making a profit.

The effects of exchange rate changes

  • Employment: unemployment may increase as a result of appreciation because this would increase the relative price for exports and therefore reduce the demand for exports. In turn, exporters’ profits would deteriorate and the export industry may shrink.

  • Inflation: if the currency appreciates and this results in unemployment, then consumption would likely decrease. This may then lead to a reduction in demand pull inflation. In addition, if the economy relies on intermediate goods, like oil, then the higher exchange rate could help to lower cost push inflation.

  • Economic growth: as a result of falling exports and higher unemployment, appreciation is likely to lead to lower rates of economic growth in the long run.

  • Balance of payments: the current account balance tends to worsen when the currency appreciates because exports become more expensive in comparison to imports. Therefore, the demand for exports usually falls, whilst the demand for cheaper imports increases.

Fixed exchange rates

Fixed exchange rate: the central bank buys and sell foreign currencies to ensure that the value of its currency remains at a single fixed rate.

Revaluation: the price of the currency is deliberately increased in a fixed exchange rate system.

Devaluation: the price of the currency is deliberately decreased in a fixed exchange rate system.

This diagram indicates how a fixed exchange rate system operates. Inflation may occur which causes imports to seem more attractive and supply of £s to increase, so the currency would then naturally depreciate. However, because of the government’s intentions, the central bank would start to buy £s and therefore artificially increase demand for its currency. This then allows the value of the currency to remain at the same stable level. (In reality, neither the USA nor the UK have fixed exchange rate systems.)

Managed exchange rates

Managed exchange rate: the government usually sets a range between which the exchange rate should remain, the central bank then periodically intervenes if the exchange rate moves below or above this desirable range. Intervention may involve the interest rate being manipulated or the currency being bought or sold.

Overvaluation:

  • Imported goods become cheaper so there is downward pressure on the inflation rate.

  • Competition from the cheaper foreign imports forces domestic producers to become more efficient

  • Exports become relatively expensive, so the export industries receive lower profits

  • The balance of payments worsens due to fewer exports and greater imports

Undervaluation:

  • Exports become cheaper so the export industry grows

  • Imports become more expensive, so domestic consumers favour domestic goods.

  • Imports become more expensive, which may result in imported cost push inflation as raw materials and intermediate goods are more costly

  • The balance of payments improves as exports increase and imports fall.

Advantages of a floating exchange rate

  • Monetary policy can continue to be used as the government is not intervening in the pricing of the currency. For instance, the interest rate can be manipulated to encourage growth as the currency is able to depreciate freely.

  • Trade imbalances can naturally adjust. For instance, if the currency appreciates as a result of the demand for exports increasing, then this demand will gradually fall because the price of exports increases as the currency appreciates.

  • These exchange rate changes are smooth and continuous, as the government will not suddenly intervene.

  • Speculation may be lower as there is no strict value that is perceived to be ideal of the currency to be at, therefore, there is less opportunity to make a profit on the changes in its value.

  • The central bank does not need to hold ass much in foreign reserves as they have no reason to use these reserves as a mechanism to intervene in the exchange rate.

Disadvantages of a floating exchange rate

  • There is increased uncertainty as the exchange rate has no fixed value, so investors, exporters and importers face greater risks and be less confident in the market. This in turn tends to lead to lower rates of cross border investment.

  • The government may be more likely to employ inflationary policies in order to achieve short term growth, as they are not restrain from using monetary policy.

Advantages of a fixed exchange rate

  • There is less uncertainty as the currency maintain its fixed value, so it may be a safer opportunity for investors.

  • Inflationary growth is not an option, so the government must act with discipline in reaching its macroeconomic aims.

  • The exchange rate can be manipulated to combat high inflation.

Disadvantages of a fixed exchange rate

  • The government cannot use monetary policy to achieve domestic goals, as this would also effect the exchange rate.

  • Expansionary fiscal policy cannot be used to finance a deficit as this could affect the money supply and interest rates.

  • The exchange adjustments are abrupt, rather than being fluid, which could be very disruptive both domestically and for foreign investors.

  • Trade deficits cannot automatically be corrected, instead contractionary fiscal policy may be necessary.

  • The central bank must keep large foreign exchange reserves so that they can intervene in the exchange rate.

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