Transcript Exchange-Rates

Exchange Rates
Countries choose their exch. rate system:
1.
2.
3.
4.
Free - Floating
Managed - Floating
Fixed (may be rigidly fixed or somewhat flexible – eg.
adjustable peg)
Monetary Union with other countries
Floating Exchange Rates

Value of currency determined solely by mkyt forces

No target set by gov’t – no intervention

Sterling has floated freely on foreign exchange markets
since the UK crashed out of the ERM, Sept. 1992
Managed Floating Exchange Rate

Currency usually determined by mkt forces

Some intervention (demand-management policies)

Interest rates may also used

No specific long-term target for currency
Fixed Rates

Some pegged at one level, others have target bands
(crawling peg)

Central banks buy or sell currency to keep it at desired
level

Revaluations may occur, though seen as undesirable
The Case for Floating Exchange
Rates

Less need for foreign currency reserves for use in
intervention – gov’t not involved

Useful tool for automatic macroeconomic adjustment (eg.
High trade deficit can lead to drop in currency, helping
correct)

May be less vulnerable to currency speculators (those
who sell a currency if they believe it is about to be
devalued)
The Case for Fixed Exchange Rates
• Currency stability improves trade
• Some flexibility (occasional ‘realignments’)
mean gov’t can adjust the economy
• Domestic producers can improve int’l
competitiveness through  costs
Explaining the High £
 Since
mid-90’s £ has been above its purchasing power
parity rate – why?

Independent monetary policy boosted market
confidence in low inflation (key in currency mkts)

UK economy relatively strong with recessions
elsewhere, esp Europe

Escaped uncertainties of the Eurozon
The J Curve

In the short term, a devaluation is likely to lead to a
deterioration in the current account position before it
starts to improve

Due to the inelasticity of imports… people take a while
to change their buying and the immediate effect is to
increase the total spent on imports and decrease the
total spent on exports
Marshall-Lerner Condition

Devaluation will lead to an improvement in the current
account so long as the combined price elasticities of
exports and imports are greater than 1

Eg. If PEDimports = 0.3 and PEDexports = 0.5, then, although
exports are going to rise, they will not rise significantly
enough to counter the decrease in price – the same
holds true here for imports… no improvement

If If PEDimports = 0.9 and PEDexports = 0.7, then the net
change will improve the trade deficit