Transcript Exchange Rates

Exchange Rates
The Exchange Rate expresses the
value of one currency against another.
The Rate at which one country can
exchange its currency for another
EG it may cost 80million Rupees
for £1 million. The Exchange rate
is 8:1
Determining Exchange Rates
• 1) Governments can buy and sell currency in
order to influence its price (the Exchange
rate)…….OTHERWISE
• 2) Assuming that Governments do not get
involved and Exchange rates are free to float
and Currencies will find their own price
levels through the forces of Demand and
Supply
• Foreign Exchange is brought and sold on the
Foreign Exchange Markets (FOREX)
Appreciation
• The Currency will APPRECIATE rise in
value against another currency
Eg £1: $2 to £1:$3, if there is an Increase
in demand for a currency
Appreciation
The USA export Coca Cola to the UK
A can costs $1
How much will it cost in the UK if the
exchange rate is:
£1:$2
£1:$3
Depreciation
• The Currency will DEPRECIATE fall in
value against another currency Eg £1: $2
to £1:$1, if there is an increase in supply
of a currency.
Depreciation
• What happens to the cost of a can of
coke?
The exchange rate is now:
£1:$2
£1:$1
High demand for currency:
Appreciating exchange rate
• BUT……………….
What causes an Increase in Demand for a
currency ?
(Explain why each would cause the currency to appreciate)
• Demand for UK Exports
• Inward Investment from foreign national
• Speculation in the foreign exchange market
Increase in supply of currency:
Depreciating Currency
• An Increase in imports creates a supply of
the £ as people give them up to buy
foreign goods in foreign currencies.
• An increase in the number of UK firms
investing in foreign companies.
• Speculation against the £
Assuming no government involvement with the
EXR, then the market is deemed to be
free-floating
• The $ : £ exchange rate will be determined by forces of
DEMAND AND SUPPLY
Demand for currency
Supply of currency
Exports Create a demand
for £ from Americans
Imports create a supply of £, as
the British require $ to buy
American goods
Inward investment in the
UK create a demand for £
from Americans
Outward investment creates a
supply of the £, as the British
want $ to invest in America
Speculation in favour of
currency creates a
demand for £ from
Americans
Speculation against creates a
supply of currency because the
British want $ they think will be
worth more
Floating Exchange Rates
The sterling has floated freely since 1992
Free floating
• The value of a currency is determined by
forces of demand and supply in foreign
exchange markets.
• No target for the exchange rate is set by the
government.
• There is no need for official intervention in the
currency by the central bank.
What are the advantages of a free floating
exchange rate?
•
Advantages
•
Reduced need for currency reserves: little requirement for the Bank of England to
hold large scale reserves of gold and foreign currency to use in possible official
intervention in the markets. Money can be spent else where in economy
•
Automatic correction of BOP deficit: Deficit = Imports > Exports. As this happens
demand for the currency should fall leading to a depreciation of the currency.
Depreciation should lower the price of exports and improve Balance of payments
•
Autonomy for domestic monetary policy: Economy can meet domestic
macroeconomic objectives such as stabilizing growth or controlling inflation
•
Monetary policy is more effective: if interest rates increase this will cause the
exchange rate to appreciate. This will lower import prices, reducing cost-push
inflation and increase export prices leading to reduction in demand and reinforcing
domestic monetary policy
•
Adjusting to external shocks: if demand for exports decreased due to a world
recession, the demand for pounds would decrease, the exchange would depreciate
and exports would be more price competitive
•
Reduced speculation: rates reflect purchasing power parity (PPP) so it is unlikely to
be over or under valued
What are the disadvantages of a free floating
exchange rate?
•
•
Disadvantages
Economic policy: governments may pursue short-run economic growth at
the expense of higher inflation. The reliance on exchange rate
depreciations to off-set domestic inflation is likely to be unsustainable in the
long-run. Depreciation of the currency will raise import prices and make
domestic inflation worse
•
Automatic correction of BOP deficit: This does not always happen. It
depends on the price elasticity of demand for exports and imports. There is
also likely to be a short-adjustment – the current account deficit weakens
before it improves
• J-Curve
– Shows the trend in a country’s balance of
trade following a depreciation of the exchange
rate.
• Marshall-Lerner condition
– States that for a depreciation of the currency
to improve the balance of trade the sum of the
price elasticities of demand for exports and
imports must be greater than 1
Fixed Exchange Rate
• Gold standard in the interwar period-currencies linked
with gold.
• Achieves exchange rate stability BUT at the expense of
other objectives e.g. balance of payments (no option to
devalue)
• Normally strict exchange flows
• Countries who have joined the EMU have fixed their
currencies
What are the advantages and
disadvantages of a fixed system?
Advantages
• Promotes trade and investment because of lower currency risk/less
uncertainty.
• Places discipline on domestic producers to keep costs down and remain
competitive.
• Reinforces gains in comparative advantage.
• In a free floating system businesses hedge against currency volatility by
buying the currency they need in the forward currency markets (buying
in advance). Businesses don’t need to do this in a fixed system.
• Reduces risk of currency speculation.
• Imposes discipline on government policy.
Disadvantages
• Sacrifice other policy objectives to maintain parity.
• Reserves of foreign currency must be held for semi-fixed system opportunity cost.
Managed floating
• Governments can buy and sell currency in
order to influence its exchange rate e.g. to
prevent a fall in the currency.
Semi-fixed or Pegged
•
•
•
•
Bretton Woods System - 1940s and 1970s.
Exchange rate is given a specific target
Currency can move between permitted bands.
Interest rates may be used to control currency
(increase ROI if exchange rate is depreciating this
stimulates demand for Sterling as hot money flows
in, and decrease ROI if currency is appreciating) or
BoE may buy and sell currencies.
• Bank of England will have to keep large reserves to
maintain the exchange rate
Semi-fixed or Pegged
• The ERM membership -1990-1992.
• In 1990 the UK joined the ERM with the aim of achieving
exchange rate stability in order to promote trade.
• Under the ERM the UK had to set interest rates
• But the weakness of the British economy at that time
(high unemployment, housing recession etc) meant that
there was pressure to reduce interest rates
• Inflation came down, but the sterling was weak.
• Speculators attacked and sold Sterling, UK tried to
increase ROI to prevent depreciation - they failed.