exchange rates economics – a course companion blink & dorton, p274-288

EXCHANGE RATES

Economics – A Course CompanionBlink & Dorton, P274-288

EXCHANGE RATESWhat is an exchange rate?

• An exchange rate is the value of one currency expressed in terms of another currency.

• Currencies are exchanged (traded) on the foreign exchange market. This is the largest market in the world in terms of cash movements.

• The market includes the trading of foreign currencies between governments, central banks, private commercial banks, MNCs and other financial institutions.

EXCHANGE RATE SYSTEM

• There are a number of exchange systems operating in the world.

• The way that a country manages its exchange rate is known as its exchange rate regime.

There are three main type: Fixed Exchange Rate Floating Exchange Rate Managed Exchange Rate

Fixed Exchange Rate

A fixed exchange rate is an exchange rate regime where the value of the currency is: fixed OR pegged to the value of another currency ORPegged to the average value of a selection of

currencies ORdetermined by the value of some other

commodity, such as gold.

Fixed Exchange Rate

• As the value of the variable that the currency is pegged to changes, then so does the value of the currency.

• Deciding upon, and the maintaining, the fixed value of the currency is usually carried out by the government or the central bank.

Fixed Exchange Rate

Revaluation of Currency• If the value of a currency in a fixed exchange

rate regime is raised, then we say that this is a revaluation of the currency.

Devaluation of the Currency• If the value is lowed, then we say that there is

a devaluation of the currency.

Floating Exchange Rate

• A floating exchange rate is an exchange rate regime where the value of the currency is allowed to be determined solely by the demand for and supply of, the currency on the foreign exchange market.

• There is generally no government intervention to influence the value of the currency.

Floating Exchange Rate

Appreciation of the Currency• If the value of the currency in a floating exchange

rate regime rises, then we say that this is an appreciation of the value of the currency.

Depreciation of the Currency• If the value falls, then we say that there has been

a depreciation of the value of the currency.

Understanding Exchange RatesExamples

20th Jan: $1AUS = 79 US cents ($AUS 190 million)20th Nov: $1AUS = 95 US cents. ($AUS 158 million)

What does this mean?The Australian dollar has appreciated against the US dollar. Application - Exercise• If Qantas (The Australian Airline) were to purchase an

aircraft from Boeing for $US150 million, how much would it save by buying the aircraft in November, rather than January??

Qantas – Foreign Exchange Case Study

• (1/.79)-(1/.95)=0.213 [exchange rate differential]

0.213*150 million = 32.0 million

What will cause the US dollar to rise or fall?

The demand for the US dollar will rise if:• US Investment prospects improve• US interest rates increase, making it more attractive

to save there, than in other countries.• Speculators believe the US dollar will rise in the future• There is an increase in incomes in other countries,

which increases demand for all things including imports from the US.

• A change in consumer tastes in favor of US products.

What will cause the US dollar to rise or fall?

The demand for the US dollar will fall if:• US Investment prospects become negative. • US interest rates decrease, making it less attractive to

invest there, than in other countries.• Speculators believe the US dollar will rise in the future• There is an increase in incomes in other countries,

which increases demand for all things including imports from the US.

• A change in consumer tastes in favor of US products.

Managed Exchange Rate

• In realty there is no currency in the world that is allowed to be completely freely floating.

• Even when governments try to be as non-interventionist as possible, there will comes times when the currency is subject to extreme fluctuations and the government or central bank will feel they must intervene

• In the same way frequent changes in the exchange rate, if completely free floating may cause uncertainty for businesses, which is not desirable for trade, so governments will be forced to intervene in order to stabilize the exchange rate.

Managed Exchange Rate

• Most exchange rate systems in the world are managed exchanged rates.

• Theses are exchange rate regimes where the currency is allowed to float, but with some element of interference from the government.

Managed Exchange RateUpper & Lower Exchange Rate Value

• The most common systems are where a central bank will set an upper and lower exchange rate value and then allow the currency to float freely, so long as it does not move out of the band.

• If the exchange starts to get close to the upper or lower level, then the central bank will intervene in the foreign exchange market for its currency.

• Central banks do not make the upper and lower level values public, for fear of speculation, but they do exist.

Possible Advantages & Disadvantages of High & Low Exchange Rates

• The actual level of the exchange rate will have marked economic effects upon a country and we need to understand fully why governments intervene to influence the value of the exchange rate.

POSSIBLE ADVANTAGES OF A HIGH EXCHANGE RATE

Three possible advantages of a high exchange rate are:

• Downward pressure on inflation• More imports can be brought• A High Value of a currency forces

domestic producers to improve their efficiency.


Downward Pressure on Inflation• If the value of the exchange rate is high, then the price

of finished imported goods will be relatively low.• In addition, the price of imported raw materials and

components will reduce the costs of production for firms, which could lead to lower prices for consumers.

• The lower prices of imported goods also puts pressure on domestic producers to be competitive by keeping prices low.


More Imports can be brought• If the value of the exchange rate is high, then

each unit of the currency will more buy more foreign currencies and so more foreign goods and services.

• This would include both visible imports, such as technology, and invisible imports such as foreign travel.


A high value of a currency forces domestic producers to improve their efficiency• A high exchange rate will threaten their

international competitiveness so they will be forced to lower costs and become more efficient in order to maintain competitiveness.

• While this might result in laying off workers, there are other means of increasing efficiency that will result in greater economic productivity for the country.

POSSIBLE DISADVANTAGES OF A HIGH EXCHANGE RATE

Some possible disadvantages of a high exchangerate include:

•Damage to export industries•Damage to domestic

industries


Damage to Export Industries • If the value of the exchange rate is high, then

export industries may find it difficult to sell their goods and services abroad, because of the relatively high prices.

• This could lead to unemployment in these industries.


Damage to Domestic Industries• With greater levels of imports being

purchased because imports are now relatively less expensive, domestic producers may find the increased competition causes a fall in the demand for their goods and services.

• This may lead to a further increase in the level of unemployment as firms cut back.

POSSIBLE ADVANTAGES OF LOW EXCHANGE RATES

Two main advantages of low exchange rates could be:

• Greater employment in export industries.• Greater employment in

domestic industries.


Greater Employment In Export Industries

• If the value of the exchange rate is low, then exports from the country will be relatively less expensive and so more competitive.• This in turn may lead to more

employment in the export industries.


Greater Employment in Domestic Industries• The low exchange rate will make imports more

expensive than they were.• This will encourage domestic consumers to

buy domestically produced goods, instead of imports, and this may also raise employment.

POSSIBLE DISADVANTAGE OF A LOW EXCHANGE RATE

Inflation• A low value of the currency will make imported

final goods and services, imported raw materials and imported components more expensive.

• The raw materials and components are needed by firms and are costs of production that will rise, possibly leading to higher prices in the economy.

• Final goods and services will have higher prices.• Thus there is a serious likelihood of inflation.

SUMMARY – HIGH & LOW EXCHANGE RATES

• A high value of a currency may be good to fight inflation, but it may create unemployment problems.• A low value of a currency may be

good for solving unemployment problems, but it may create inflationary pressure.

GOVERNMENT MEASURES TO INTERVENE IN THE FOREIGN EXCHANGE MARKET

Governments might interfere in the FOREX market 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 floating exchange rate• Achieve relative exchange rate stability in order to

improve business confidence• Improve a current account deficit, (where spending on

imported goods is greater than the revenue received from exported goods and services)

Government Intervention in the Foreign Exchange Market

There are two main methods of governmentinterference:

1. Using their reserves of foreign currencies to buy or sell foreign currencies.

2. By Changing Interest Rates.

1. Using Reserves of Foreign Currencies to buy or sell foreign currencies

Government Wishes to Increase Value of Currency• If the government wishes to increase the

value of the currency then it can use its reserves of foreign currencies to buy its own currency on the foreign exchange market.

• This will increase demand for its currency and so force up the exchange rate.

1. Using Reserves of Foreign Currencies to buy or sell foreign currencies

Government wishes to lower value of its Currency• If the government wishes to lower the value of

its currency, then it simply buys foreign currencies on the foreign exchange market, increasing its foreign exchange reserves.

• To buy foreign currencies, the government uses its own currency on the foreign exchange market and so lowers its exchange rate.

2. Changing Interest Rates

Governments wants to INCREASE the value of the currency• If the government wishes to increase the value of the

currency, then they may raise the level of interest rates in the country.

• This may make the domestic interest rates relatively higher than those abroad and should attract financial investment from abroad.

• In order to put money into the country, the investors will have to buy the country’s currency, thus increasing demand for it and so its exchange rate.

2. Changing Interest Rates

Government wants to LOWER the Value of the Currency• If the government wishes to lower the value of its currency,

then they may lower the level of interest rates in the country.

• This will make the domestic interest rates relatively lower than those abroad and should financial investment abroad more attractive.

• In order to invest abroad, the investors will have to buy foreign currencies, thus exchanging their own currency and increasing the supply of it on the financial exchange market.

• This should lower its exchange rate.

ADVANTAGES OF A FIXED EXCHANGE RATE

1. A fixed exchange rate should reduce uncertainty for all economic agents in the country. Businesses will be able to plan ahead in the knowledge that their predicted costs and prices for international trading agreements will not change.


2. If the exchange rate is fixed, then inflation may have very harmful effect on the demand for exports and imports. Due to this, the government is forced to take measures to ensure that inflation is as low as possible, in order to keep businesses competitive on foreign markets Thus fixed exchange rates ensure sensible government policies on inflation.


3. In theory, the existence of a fixed exchange rate should reduce speculation in the foreign exchange market. However, in reality, this has not always been the case and there are often attempts to destabilize fixed exchange rate systems in order to make speculative gains.

DISADVANTAGES OF FIXED EXCHANGE RATE

1. The government is compelled to keep the exchange rate fixed. The main way of doing this is through the manipulation of interest rates. However, if the exchange rate is in danger of falling, then the government will have raise the