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Exchange Rates
IB 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
http://www.youtube.com/watch?v=yCj
dollar) goes down
wXz7ZXwU
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 US
If 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 rate
 absence 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 cheaper
 Exports more expensive
 If imports/exports are elastic BoP will
be affected
 May 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 – MarshallLerner 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 taxation
More likely to be an increase in interest
rates
Notice 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 currency
Investors 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
IMF: International Monetary
Fund – a multinational
institution set up in 1947 to
operate the adjustable peg
exchange rate system
Fig
18.5
P213
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
Dirty float: manipulation of a
floating rate to gain
advantages over trading
partners
Fig
18.6
P215
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
P290 Student Workpoint
Dirty float: manipulation of a
floating rate to gain advantages
over trading partners
Fig
18.6
P215
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.
Videos
Mjmfoodie
 Work 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
economics
 Revise for homework (revise for homework)