Exchange Rates IB Chapter 23. Floating Exchange rates The exchange rate between two currencies is...
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Transcript of Exchange Rates IB Chapter 23. Floating Exchange rates The exchange rate between two currencies is...
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)