exchange rates. exchange rate systems for an economy open to international trade, the exchange rate...

Exchange ratesExchange rates

Exchange Rate SystemsExchange Rate Systems

• For an economy open to international trade, the exchange rate is a crucial variable.

• It influences the competitiveness of firms.• From WW2 – 1970’s: FIXED exchange rate• (value of currency was fixed to $US).• After this most countries allowed their

currencies to FLOAT.

The Foreign Exchange MarketThe Foreign Exchange Market

The market for foreign exchange is just like any other market, with the price being determined by demand and supply.

If a UK resident wants to buy goods from abroad, you need to purchase foreign exchange. You will need to sell £ to buy $.

Balance of payments & exchange ratesBalance of payments & exchange rates

Exchange ratesDetermination of the

exchange rate

Exchange ratesDetermination of the

exchange rate

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Determination of the rate of exchangeDetermination of the rate of exchange

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Analysis of DiagramAnalysis of Diagram

• When UK residents wish to buy goods from the USA or invest in the USA, they will SUPPLY pounds to obtain dollars.

• The higher the exchange rate, the more dollars they will get for their pounds (making American goods cheaper)

• The HIGHER the exchange rate, the MORE pounds that will be supplied.

• When US residents wish to buy UK goods, they DEMAND pounds by selling dollars.

• The lower the $price of pounds (ex rate), the cheaper it will be to obtain UK goods and services, hence the MORE pounds they are likely to demand.

Analysis of DiagramAnalysis of Diagram

• EQUILIBRIUM exchange rate is where demand = supply.

• What is the mechanism that equates this?• IF the exchange rate were above the

equilibrium, supply of pounds being offered to banks would exceed demand.

• The banks, wishing to make money by EXCHANGING currency, would lower the exchange rate to encourage a greater demand and reduce excess supply.

• IF we were below the equilibrium,banks would find themselves with too few pounds to meet the demand. At the same time they would have an excess supply.

IN REALITY…IN REALITY…

The process of reaching an equilibrium is extremely rapid.

Foreign exchange dealers in the banks are continually adjusting the rate as new customers make new demand for currencies.

ALSO, the banks have to watch what the other banks are doing as they are constantly in competition.

Exchange Rate and Balance of PaymentsExchange Rate and Balance of Payments

• The equilibrium position has a direct connection with the balance of payments.

• If the demand for pounds = supply of pounds, this means there is a balance between the demand from overseas residents for UK g/s, and the demand by UK residents for overseas g/s.

FIXED EXCHANGE RATESFIXED EXCHANGE RATES

In the Bretton Woods conference after WW2, it was agreed to establish a fixed exchange rate system.

E.g. from 1950 – 1967, the sterling exchange rate was set at $2.80

The level will not necesserily correspond with the market equilibrium.

If ex rate is set above the equilibrium, supply exceeds demand.

This equates to a balance of payments deficit.


In a free market, exchange rate should adjust automatically.

Under a fixed exchange rate, this can’t happen.

Authorities have to sell foreign exchange reserves to make the books balance.

FIXED EXCHANGE RATEFIXED EXCHANGE RATE

During the DOLLAR STANDARD, the pound was set at too high a level.

This meant British goods were relatively uncompetitive.

In 1967, a DEVALUATION was announced.

During the $ standard, we went through a ‘stop – go’ cycle of growth.

When the government tried to stimulate economic growth, the effect was to suck in imports. This created a BOP deficit which needed to be financed by selling foreign exchange reserves.


• THIS HAD TWO EFFECTS:

1. In selling foreign exchange reserves, domestic money supply goes up. There is upward pressure on prices, threatening inflation.

2. The Bank of England has finite foreign exchange reserves.


• Conclusion:

• The fact that intervention to maintain domestic money supply means that under a fixed exchange rate system, the monetary authorities are unable to pursue an independent monetary policy.

• Basaically, the money supply and exchange rate cannot be controlled independently of one another.

THE EFFECTS OF DEVALUATIONTHE EFFECTS OF DEVALUATION

• Why? To improve COMPETITIVENESS• Lower £ = Increased demand for imports,

ceteris paribus.

• This WON’T ALWAYS improve the Current Account.

• Why?• A) Elasticity of Supply of Exports.• B) Import will be more expensive.

• Therefore, c / acc may WORSEN before it improves.

THE EFFECTS OF DEVALUATION THE EFFECTS OF DEVALUATION

At ‘A’, a devaluation pushes the current account further into deficit because of the inelasticity of domestic supply.

Only after ‘B’, when firms have had time to expand output to meet demand for exports, does c/acc begin to move to surplus.


If competitiveness improves but demand does not respond strongly,there may be a negative effect on the c/acc.

If the demand for exports is price inelastic, a fall in price, would lead to a fall in revenue.


Exchange ratesChanges in theexchange rate

Exchange ratesChanges in theexchange rate

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Floating exchange rates: movement to a new equilibriumFloating exchange rates: movement to a new equilibrium€

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Floating exchange rates: movement to a new equilibriumFloating exchange rates: movement to a new equilibrium


Exchange ratesSpeculation against

exchange rate movements

Exchange ratesSpeculation against

exchange rate movements

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Exchange ratesMovements in the sterling exchange rate over time

Exchange ratesMovements in the sterling exchange rate over time

$ / £ exchange rate and £ exchange rate index: 1976-2003$ / £ exchange rate and £ exchange rate index: 1976-2003

$ / £

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$ / £ exchange rate and £ exchange rate index: 1976-2003$ / £ exchange rate and £ exchange rate index: 1976-2003

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1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

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Exchange ratesMovements in the

dollar/euro exchange rate from 1999 to 2003

Exchange ratesMovements in the

dollar/euro exchange rate from 1999 to 2003

Fluctuations between the euro and the dollarFluctuations between the euro and the dollar


US interest rate


US interest rate

ECBinterest rate


$ / €US interest

rate

ECBinterest rate

$ / €

exchange rates. exchange rate systems for an economy open to international trade, the exchange rate...

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