Transcript 3.2 PPT.Foreign Exchangex

FOREIGN
EXCHANGE
Exchange rates and
currency
Exchange Rate
• The value of one currency
expressed in terms of
another
• Determined by the supply
of and demand for the
currency on the foreign
exchange market
TYPES OF EXCHANGE RATES
• FIXED
• FLOATING
• MANAGED
Fixed Exchange Rate
Value is fixed to:
• Value of another currency
• Average value of a selection
of other currencies
• Value of some other
commodity such as gold
• Reduces uncertainty for an
economy
• Government will keep inflation
in control
• Reduces speculation
• Danger of setting the wrong rate
and worsening an economy.
Floating Exchange Rate
•
Value of a currency changes based on market forces
of supply and demand.
•
That is the supply of demand of the currency in the
foreign exchange market.
•
NO government intervention.
•
Any change in supply and demand curve leads to a
change in the exchange rate.
•
Appreciation: increase in value of a currency
Depreciation: decrease in value of a currency
Supply goes up
What happens to
exchange rate?
What factors affect exchange rate?
•
Relative interest rates – high rate = currency appreciation
•
Rise in domestic income relative to incomes in other countries
= currency depreciates
•
Demand for imports or demand for exports
•
Perceived investment opportunities lead to currency
appreciation
•
Speculative sentiments
•
Global trading patterns – high trade = currency appreciation
•
Changes in relative inflation rates – high inflation leads to
exports becoming less competitive in international market
• Combining the elements
of
both
fixed
and
floating
MANAGED
rates
EXCHANGE RATE
(“DIRTY FLOAT”) • Exchange rates are
mostly free to float in the
markets.
• However, central banks
may periodically
intervene to stabilize
rates in the short term.
• Ex: Singapore dollar
How do central banks influence
the exchange rate?
• Buying and selling of currency
• Change interest rates
• Contractionary monetary policy
• Protectionist policy
Exchange Rates and Balance of
Payments
•
A Depreciation in exchange rate should lead to
increase in demand for exports and a fall in demand
for imports
improvement in balance of
payments
•
An Appreciation in exchange rate should lead to a
decrease in the demand for exports and a rise in the
demand for imports
worsening in the
balance of payments
•
However, volumes and actual income and
expenditures depend on the relative price elasticity of
the imports or exports
Effects of high exchange rates
• Downward pressure on inflation – imports will
be cheaper
• More imports can be bought with same amount
of money
• High value of currency forces domestic firms to
be more efficient to be more competitive in the
international market
• Hurts domestic industry and export industries
Effects of low exchange rates
• Greater employment in export industries
• Greater employment in domestic industries
Depreciation
leads to increase
in exports and
decrease in
imports
Which should lead
to an
improvement in a
nation’s balance of
payments.
However, this is
not necessarily
the case.
Marshall Lerner Condition
•
Tells how successful a
devaluation of currency will
be in improving the balance
of payments.
•
States that reducing the
value of the currency will
only be successful if the
price elasticity of demand
(PED) for exports plus PED
for imports is greater than 1.
Welker Marshall Lerner
The J Curve
•
Explains what happens to the
current account deficit over time
when there is a devaluation or
depreciation in a currency.
•
In the long run there might be an
improvement in the current
account deficit but in the short run,
the current account deficit grows
larger before getting better.
•
Why? It takes time for nations to
realize prices or currency value has
fallen and to react. They have
obligations (contracts) they must
fulfill.