Exchange RatesIB Chapter 23

Floating Exchange rates The exchange rate between two

currencies is the price of one in terms of the other

The first diagram shows the market for dollars

The demand for dollars comes from the UK which offers pounds in exchange

The supply of dollars come from the US to buy the pound

Both countries demand each other’s currency to Purchase each other’s goods To purchase each other’s services To invest in each other’s firms To speculate To put funds in each others banks

when the rate of interest increases Equilibrium price is 50p ($1 exchanged for

50p)

Floating Exchange rates Demand for US goods and services

increases which increases the demand for the dollar

D shifts to D1 The dollar is now worth more (£1) – it

has appreciated The sterling has depreciated against the

dollar – it is worth less in terms of the dollar

Weak pound exports cheap (WIDEC) Assuming that exports are elastic the

BoP will improve If exports improve the UK will have to

supply more sterling (when the US demands it in exchange for the dollar)

S shifts to S1 The price of the pound (in terms of the

dollar) goes down http://www.youtube.com/watch?v=yCjwXz7ZXwU

Greek guy – BoP and exchange rates

Floating Exchange rates Things that increase the demand for the £ from the US

Increase in interest rates relative to the US causes a flow of hot money (dollars coming to the UK)

A rise in demand for UK exports by the USIf speculators think the value of the sterling will fall

and the dollar to increase they will buy sterling A floating exchange rate is one that is dictated by the

market

Advantages of a Floating Exchange rate Automatic adjustment mean that a country with

a large balance of payments will see their exchange rate depreciating which means the price of exports will fall and become more competitive leading to an improvement in the BoP

Reduced speculative pressure – if there are fixed exchange rates speculators will sell and then repurchase when the price has fallen

If there is a large amount of speculation this may force governments to reduce the value of the currency Speculators will gain by selling it at one price

and buying back at a lower price Under floating exchange rates countries

cannot be forced to devalue and speculators have no idea how far a central bank will allow its currency to fall

The currency is more stable If government does not have to maintain the

level of a fixed exchange rate it will not have to hold such large foreign exchange reserves

Advantages of a Floating Exchange rate If government does not have to

maintain the level of a fixed exchange rate it will not have to hold such large foreign exchange reserves

Freedom (autonomy) for domestic monetary policy: This is arguably the most important advantage of having a floating exchange rateabsence of an exchange rate

target allows short term interest rates to be set to meet domestic economic objectives such as controlling inflation or stabilising the economic cycle

Disadvantages of a Floating Exchange rate No guarantee to solve BoP problem – depends

on the PEDs for exports and imports Effect on domestic inflation – when the

currency depreciates imports increase in price Raw materials more expensive and firm’s

costs go up Pass on to consumer with higher prices Demand for higher wages

Uncertainty – since the removal of exchange controls massive capital flows can occur leading to large changes in a currency’s price Rapid increases lead to unemployment Falls lead to increasing inflation

Foreign currency reserves have not really become redundant because most governments buy and sell their currency to maintain what they think should be an optimal value

Exchange controls: restrictions on the ability to trade foreign currencies by a country’s central bank

Trade weighted index The sterling Exchange Rate Index (ERI) is the same as the

Effective Exchange Rate Index (EER) a weighted index of sterling's value against a basket of

currencies the weights used calculated by the importance of trade between the UK and each country.

used by economies to compare their exchange rate against those of their major trading partners

Factors affecting exchange rates Relative interest rates

An increase in the relative rate of interest in the UK should lead to an increase in the demand for sterling

Hot money – enormous pool of money owned by companies and rich individuals that moves around the world seeking the highest interest rate (return) with least risk

This will increase the demand for sterling making it appreciate in value

Imports cheaperExports more expensive If imports/exports are elastic BoP will

be affectedMay lead to rise in unemployment

Factors affecting exchange rates Inflation has led to the depreciation of sterling

(when inflation is rising faster than the US) Less revenue from exports To maintain export earning the UK must

increase exports In the UK foreign demand (exports) tends to

be price elastic so this should benefit the BoP Imports appear to be inelastic so more is

spent on imports Overall depreciation benefits UK – Marshall-

Lerner condition holds All depends on the PEDs Depreciation leads to increasing inflation

possibly leading to inflationary spiral If more exports are required there may be a

need for more capacity – government may need to take steps to ensure that the goods are not consumed domestically (with imports being more expensive)

Evaluation

Factors affecting exchange rates Foreign Direct Investment (FDI) Less revenue from

exports FDI = flows of capital (long term investment

opposed to short term hot money) Usually to set up a factory or purchase shares

in a foreign business Increase in FDI increases demand leading to

appreciating currency Increasing inflows of FDI into Asia leads to an

appreciation of the Asian currencies Trade and current account deficits

Importing more increases the supply of their currency which depreciates the value

If the deficits are persistent or a large percentage of GDP speculators may feel the value will fall and sell

Causes uncertainty

Fixed exchange rates Fixed exchange rates have fallen out of fashion with the increased supply-side

emphasis on markets The UK’s exchange rate was fixed between 1944 and 1972 Then again in 1990 to 91 when the UK joined the ERM (Exchange Rate

Mechanism) The major problem – when rates were fixed they were realistic but changes in

the market meant they were very different from the market rate This was due to

Difference in inflation rates between countries causing the £ to depreciate Difference in growth rates – high growth rates (long term) reduces prices of

goods causing the currency to appreciate Fixed exchange rates vulnerable to speculation

Fixed exchange rates If the government fixes the exchange

rate at 50p to the dollar as seen in the diagram

Initial equilibrium where B dollars are demanded

An increase in the demand for dollars to D1 creates a disequilibrium situation because supply is fixed at B

If the dollar was would have appreciated to 60p with a floating exchange rate

The central bank would sell AB dollars out of its foreign currency reserves to stop the dollar appreciating to 60p

It may also have regulations in place to restrict exchanges between sterling and other currencies

Fig 18.4 P212

Fixed exchange rates If the imbalance were maintained there would be

a continuous drain on reserves The authorities could

Abandon the fixed rate allowing sterling to find its own level with market forces

Take steps to restrict the demand for dollars by following a deflationary domestic policy Could be an increase in taxationMore likely to be an increase in interest

ratesNotice that if you use fixed exchange rates

you would need to use monetary policy which you need to control inflation

Variations of the totally fixed rate could be used Adjustable peg – currencies could be changed

to new fixed values Crawling peg – could change values weekly or

monthly

Fixed exchange rates – a run on the currency

A further problem with fixed rates was speculation where hot money flows would virtually determine whether the currency was revalued or devalued

The diagram shows fixed rates in terms of Pounds and Deutschmarks (as was the case with the ERM)

2.95 DMs to the pound is the fixed rate If speculators thought the pound was

overvalued and only maintained by high interest rates they would sell (S to S1) and buy back later at the devalued price

If UK authorities wanted to support the sterling they would buy AB sterling

If the market still thought devaluation was going to happen more banks and financial institutions will sell pound shifting the supply to S2

Revalued: when the authorities increase the value of their currency against others

Devalued: when the authorities decrease the value of their currency against others

Fixed exchange rates – a run on the currency

The authorities could Raise interest rates to increase

demand for the currencyInvestors may still be reluctant

to buy a currency that they think is overvalued

They could raise a loan to borrow foreign currency in order to purchase sterling and maintain its value

Governments don’t like official loans If they borrow money from the IMF for

example there are normally conditions that regard future economic policy

The UK chancellor had to borrow DMs from the Bundesbank but the speculative flows were too large and the UK was forced to leave the ERM

Fig 18.5 P213

IMF: International Monetary Fund – a multinational institution set up in 1947 to operate the adjustable peg exchange rate system

Fig 18.5 P213

The case for a fixed exchange rate Reinforcing comparative advantage

Read ‘Fixed or Flexible?’ on P214

A managed float A fixed rate make it impossible to

concentrate the use of the rate of interest on inflation targeting

A free floating exchange rate can lead to large changes in the price of imports and exports

A managed float where sterling is free to fluctuate between levels is the alternative

In the diagram assume that the UK government sets an upper limit (a ceiling price) of 2 Euros to the £

The lower limit (floor price) is 1 Euro to the £ If the price were any lower it would make

imports into the UK too expensive and bring inflationary pressure

The exchange rate can be seen as a trade off between too much inflationary pressure from import prices and competitive export prices to improve the balance of payments

Fig 18.6 P215

Dirty float: manipulation of a floating rate to gain advantages over trading partners

A managed float The authorities will try to manage the

exchange rate by buying and selling pounds

When the pound rises near to two Euros the authorities will sell

As it falls lower to 1 euro it will buy Should they manipulate the currency

in order to gain advantage over their trading partners this is known as dirty float

The upper and lower levels are not publicised by the authorities so it is difficult to speculate

By using the managed float the authorities can obtain the advantages of both floating and fixed exchange rates

Fig 18.6 P215

Dirty float: manipulation of a floating rate to gain advantages over trading partners

P290 Student Workpoint

Key Terms• Depreciation = A decrease in the value of a country’s

currency in a floating exchange rate system.• Appreciation = An increase in the value of a country’s

currency in a floating exchange rate system.• Devaluation = A decrease in the value of a country’s

currency in a fixed exchange rate system.• Revaluation = An increase in the value of a country’s

currency in a fixed exchange rate system.

VideosMjmfoodieWork through all of the student workpoints in the Exchange rate chapter (to hand in)HL work through the two HL assessment advices (to hand in)Next week: During each lesson there will be some kind of assessment on international economicsRevise for homework (revise for homework)