16. exchange rates

8/12/2019 16. Exchange Rates

1/4

1 OUP: this may be reproduced for class use solely for the purchasers institute

Revision Exchange rates

16

What factors shift the demand for, and supply of,a currency?The demand for a currency (Assume that we are discussingthe euro.)

People will demand, or want to buy, the euro in the foreignexchange market in order to:

buy European exports of goods and services (and to travelin Europe)

invest in European firms (portfolio investment or foreigndirect investment FDI) save their money in European banks or other financial

institutions make money by speculating on the currency.

Thus, the demand for the euro will rise if these conditions apply.

European goods and services are demanded more. This could be because European inflation is lower than that of othereconomies,, making European goods more competitive; orforeign incomes have risen; or tastes have changed in favourof European goods.

European investment prospects improve. European interest rates increase, making it more attractive to

save in European financial institutions. People think the value of the euro will rise in the future, so

they buy it now.

The supply of a currency (Assume that we are discussingthe euro.)

The euro will be supplied on the foreign exchange market inorder for:

Europeans to buy overseas goods and services (and to traveloutside Europe)

Europeans to invest in foreign firms

Exchange rate: The value of one currency expressed in terms of another,e.g. 1 = US$1.42.

Fixed exchange rate: An exchange rate regime where the value of a currencyis xed, or pegged, to the value of another currency, e.g. the Yuan has beenpegged against the US$ so that US$1 = 6.8275 CNY (China Yuan Renminbi).Floating exchange rate: An exchange rate system where the value of acurrency is allowed to be determined solely by the demand for, and supply of,the currency on the foreign exchange market. It is the equilibrium exchange rate.Managed exchange rate: An exchange rate system where the value of thecurrency is allowed to oat, but with some element of interference from thegovernment. Usually, the central bank sets an upper and lower exchange ratevalue and then allows the currency to oat within those limits, interveningwhen the exchange rate moves beyond the limits to bring it back within them.


2/4

2


OUP: this may be reproduced for class use solely for the purchasers institute

Europeans to save their money in foreign banks or otherfinancial institutions

people who hold euro to speculate on either the value of theeuro or the value of foreign currencies.

Thus, the supply of the euro will rise if these conditions apply.

Europeans increase their demand for foreign goods andservices. This could be due to the fact that European inflationis relatively higher than that of other economies, makingforeign goods more competitive; or European incomes haverisen; or tastes have changed in favour of foreign goods.

Foreign investment prospects look good. Foreign interest rates increase, making it more attractive to

save in foreign financial institutions. People think the value of the euro will fall in the future, so

they sell it now.

P r i c e o

f e u r o

i n

U S $

1.251.301.35

Quantity of euro

D D (for euro from the US)

S (of euro from EU)

DD (for euro from the US)

P r i c e o

f e u r o

i n

U S $

1.251.301.35

Quantity of euro

S (of euro from EU)

S

S

0 0

Advantages and disadvantages of high and lowexchange rates

High exchange rate Low exchange rateAdvantages There will be downward pressure on in ation,

because imports are cheaper.

More imports can be bought.

It forces domestic producers to improvetheir efciency.

There will be greater employment in exportindustries.

There wil be greater employment in domesticindustries.

Disadvantages It will damage export industries.

It will damage domestic industries.

In ation will occur because of higher import pricesand prices of raw materials and nished goods.

Reasons for government intervention in theforeign exchange marketThere are a number of reasons why governments may intervenein the foreign exchange market to influence the value of theircurrency. They may wish to:

lower the exchange rate in order to increase employment raise the exchange rate in order to fight inflation maintain a fixed exchange rate avoid large fluctuations in a floating exchange rate achieve relative exchange rate stability in order to improve

business confidence improve a current account deficit, which is where spending on

imported goods and services is greater than the revenuereceived from exported goods and services.


3/4

3



Means of government intervention inthe foreign exchange marketThere are two main methods.

1. By using their reserves of foreign currenciesto buy, or sell, foreign currencies if thegovernment wishes to increase the value ofthe currency, then it can use its reserves offoreign currencies to buy its own currency onthe foreign exchange market. This willincrease the demand for its currency and soforce up the exchange rate.

In the same way, if the government wishes tolower the value of its currency, then it simply

buys foreign currencies on the foreignexchange market, increasing its foreigncurrency reserves. To buy the foreign currencies,the government uses its own currencyand this increases the supply of the currencyon the foreign exchange market and so lowersits exchange rate.

2. By changing interest rates if the governmentwishes to increase the value of the currency,then it may raise the level of interest rates inthe country. This will make the domesticinterest rates relatively higher than thoseabroad and should attract financialinvestment from abroad. In order to putmoney into the country, the investors willhave to buy the countrys currency, thusincreasing the demand for it and so itsexchange rate.

In the same way, if the government wishes tolower the value of the currency, then it maylower the level of interest rates in the country.This will make the domestic interest ratesrelatively lower than those abroad and shouldmake financial investment abroad moreattractive. In order to invest abroad, theinvestors will have to buy foreign currencies,

thus exchanging their own currency andincreasing the supply of it on the financialexchange market. This should lower itsexchange rate.

Advantages and disadvantages offixed and floating exchange ratesAdvantages of a fixed exchange rate A fixed exchange should reduce uncertainty

for all economic agents in the country.

Businesses will be able to plan ahead in theknowledge that their predicted costs andprices for international trading agreementswill not change.

If exchange rates are fixed, then inflation mayhave a very harmful effect on the demand forexports and imports. The government will beforced to take measures to ensure thatinflation is as low as possible, in order to keep

businesses competitive on foreign markets.Thus, fixed exchange rates ensure sensible

government policies on inflation. In theory, the existence of a fixed exchange

rate should reduce speculation in the foreignexchange markets.

Disadvantages of a fixed exchange rate The government is compelled to keep the

exchange rate fixed. The main way of doingthis is through the manipulation of interestrates. However, if the exchange rate is indanger of falling, then the government will

have to raise the interest rate in order toincrease demand for the currency, but thiswill have a deflationary effect on theeconomy, lowering demand and increasingunemployment. This means that domesticmacroeconomic goals (low unemployment)may have to be sacrificed.

In order to keep the exchange rate fixed andto instil confidence on the foreign exchangemarkets, a country with a fixed exchange ratehas to maintain high levels of foreign reservesin order to make it clear that it is able todefend its currency by the buying and sellingof foreign currencies.

Setting the level of the fixed exchange rate isnot simple. There are many possible variablesto take into account and, also, these variableswill change with time. If the rate is set at thewrong level, then export firms may find thatthey are not competitive in foreign markets.If this is the case, then the exchange rate willhave to be devalued, but again, finding theexact right level is very difficult.

A country that fixes its exchange rate at anartificially low level may create internationaldisagreement. This is because a low exchangerate will make that countrys exports morecompetitive on world markets and may beseen as an unfair trade advantage. This maylead to economic disputes or to retaliation.

Advantages of a floating exchange rate As the exchange rate does not have to be kept

at a certain level, interest rates are free to be

employed as domestic monetary tools and can be used for demand management policies,such a controlling inflation.


4/4

4



In theory, the floating exchange rate shouldadjust itself, in order to keep the currentaccount balanced. For example, if there is acurrent account deficit, then the demand forthe currency is low, since export sales arerelatively low, and the supply of the currencyis high, since the demand for imports isrelatively high. This should mean that themarket will adjust and that the exchange rateshould fall. Following this, export prices

become relatively more attractive, importprices relatively less so, and so the currentaccount balance should right itself. (This willdepend upon the Marshall-Lerner condition

being satisfied see Chapter 27.) As reserves are not used to control the value

of the currency, it is not necessary to keephigh levels of reserves of foreign currencies

and gold.

Disadvantages of a floating exchange rate Floating exchange rates tend to create

uncertainty on international markets.Businesses trying to plan for the future find it

difficult to make accurate predictions aboutwhat their likely costs and revenues will be.Investment is more difficult to assess andthere is no doubt that volatile exchange rateswill reduce the levels of internationalinvestment, because it is difficult to assess theexact level of return and risk.

In reality, floating exchange rates are affected by more factors than simply demand andsupply, such as government intervention,world events like 9/11 and speculation. Thismeans that they do not necessarily self-adjustin order to eliminate current account deficits.

A floating exchange rate regime may worsenexisting levels of inflation. If a country hasrelatively high inflation to other countries,then this will make its exports lesscompetitive and make imports more

expensive. The exchange rate will then fall, inorder to rectify the situation. However, thiscould lead to even higher import prices offinished goods, components and rawmaterials, and cost-push inflation, which mayfurther fuel the overall inflation rate.

16. exchange rates

Documents