at the end of the lesson u should be able to: explain er determination in a fixed er system...
TRANSCRIPT
at the end of the lesson u should be able to:
• explain ER determination in a fixed ER system– revaluation and devaluation– government intervention by buying and
selling the currency
• The ER of a country is fixed in terms of another anchor currency.
• This is known as pegging the ER where a rate is fixed & then guaranteed by the govt.
• e.g. pegging of Ringgit against US$. from 1998 - 2005
Fixed ER System
• A fixed ER is maintained by intervention through central banks (in UK through Bank of England [BOE] via the Exchange Equalization A/C), which holds they country's reserves of foreign currencies.
• When the govt states that the official price or ER for its currency, they will buy or sell that currency as required in order to maintain the ER @ the official level.
• Assume that official ER between RM & US$ is at RM 1 = US$0.26
Fixed ER System
$US/RM
Qty of $RM
s
s
0.26
0.24
D
D
D 1
D 1
Fixed rate
12102
setting rate above equlibrium
Setting rate above equilibrium
• Govt. wishes to set the rate at US$0.26 = RM 1 i.e. above the equlibrium
• At this price, SS > DD by 10 m(12 - 2)
• if it is left to the free market forces, it will tend to fall towards the equilibrium
• Therefore if govt. wishes to maintain this rate, it will have to buy up 10m and this will shift DD to D1D1.where SS = DD.
$US/$RM
S 1
S 1
0.28
0.26
D
D
S
S
Qty of $RM
Fixed rate
Setting rate below equilibrium
18 20 22
• Govt. wishes to fix the ER at price US$0.26 = RM1 i.e. below the equilibrium
• At that price DD > SS by 4m (22-18) and this will push the price up to US$0.28.
• Therefore in order to maintain the price at US$0.26, govt. have to sell 4m and this will shift SS to S1S1
Setting rate below equilibrium
• an increase in the value of a nation’s currency b4, £1 = US$2now £1 = US$3
• deliberate action by the govt
a decrease in the value of a nation’s currencyb4, £1 = US$2now £1 = US$1.50
• deliberate action by the govt
• Central Bank sells and buys currency in the foreign exchange market.
• Limit currency depreciation by buying
the currency.
• Prevent excessive appreciation of currency by selling.
Managed Float
Upper Limit
Lower Limit
D1
D1
D
D
S
S
S 1
S 1
ER
Quantity of $
P
E
Setting rate below equilbrium
• OP is the equilibrium or par value with a upper and lower limits.
• If there is an increase in SS to S1S1, this will reduce the value of the $ in the free market to below the agreed level (E).
• To maintain the currency at the lower limit, central bank must buy $ with the foreign exchange reserves thus pushing DD to D1D1 where SS =DD
Managed Float
Upper Limit
Lower Limit
D1
D
D
S
S
S 1
S 1
ER
Quantity of $
P
E
Setting rate below equilibrium
• OP is the equilibrium or par value with a upper and lower limits.
• If there is an increase in DD to D1, this will increase the value of the $ in the free market to above the agreed level (E).
• To maintain the currency at the upperr limit, central bank must sell $ with the foreign exchange reserves thus pushing SS to S1s1 where SS =DD
Managed Float