Download Exchange Rate Systems

Exchange Rate Systems
Floating exchange rate systems
Fixed exchange rate systems
Semi fixed exchange rate systems
Freely floating exchange rate
• a system whereby the price of one currency is
determined by the forces of supply and demand
Fixed exchange rate
• an exchange rate system in which the value of one
currency has a fixed value against another countries
Semi-fixed exchange rate
• an exchange rate system that allows a currency’s
value to fluctuate within a permitted band of
fluctuation.
Freely floating exchange rate
• The value of the pound is determined purely
by market demand and supply of the currency
• Both trade flows and capital flows affect the
exchange rate under a floating system
• No target for the exchange rate is set by the
Government
• There is no need for official intervention in
the currency market by the central bank
Demand and Supply
There are 3 main reasons why foreign exchange
is bought and sold:
1. International trade
• Imports and exports (X-M)
2. Short-term capital flows
• Speculative demand
• ‘Hot money’
3. Long-term capital movements
• Investment (FDI)
• Demand for the £ has risen
• £ is now worth more, it has
appreciated in relation to the $
• £ has appreciated - worth more in
terms of the $
Demand for £ rises
• Changes the prices of imports and
exports:
• Price of UK goods in the US has
increased
• When a currency appreciates
exports increase in price, imports
decrease in price
• When a currency depreciates
exports decrease in price, imports
increase in price
Supply of $ increases
June 2014
Advantages of a freely floating
system
• Reduced need for currency reserves
– Needed for semi fixed systems
• Freedom for domestic monetary policy
– Interest rates and QE
• Useful instrument for macroeconomic
adjustment – controlling AD and inflation
– (X-M); W and J
• Partial automatic correction of a trade
deficit
– Marshall-Lerner condition
Disadvantages
• Uncertainty
– fluctuations
• Lack of investment
– Weak £ a sign of weak economy?
• The floating exchange rate can be
inflationary if price stability not prioritised.
– Weak £ imports expensive (cost push)
• Does a floating rate automatically remedy a
trade deficit?
– J-curve (remember!)
Marshall-Lerner condition
• Can you remember what this is?
The Marshall-Lerner Condition
• If demand for exports is first assumed to be relatively price
elastic then the fall in the price of exports caused by the fall in
the exchange rate will lead to a proportionately greater increase
in the quantity of exports demanded. This would improve the
balance of payments.
• If demand for imports is also assumed to be relatively price
elastic then the rise in the price of imports caused by the fall in
the exchange rate will lead to a proportionately greater
decrease in the quantity demanded of imports.
• So, providing the sum of the elasticity's is greater than -1,
there will be an improvement in the Balance of Payments on
current account (balance of trade improves)
Marshall-Lerner condition
• If you look at Net Exports (X-M) you
can tell if the PEDXN is > 1 or < 1.
Marshall-Lerner condition
• If PED > 1 = Elastic
• If PED < 1 = Inelastic
Marshall-Lerner condition
•
Effect on the Balance of Payments on
current account?
1.
2.
3.
4.
If
If
If
If
the currency
the currency
the currency
the currency
weakens and PED > 1
weakens and PED < 1
appreciates (PED > 1)
appreciates (PED < 1)
The J-Curve
• Short term
• Long term
Evaluation
• The extent to which a floating system is
advantageous for a country depends
upon the price elasticity of imports and
exports.
• Marshall-Lerner Condition – BoP will only
improve if imports/exports are price
responsive.
• J-curve – BoP may get worse before it
gets better
Inflation and the exchange rate
• With the use of a diagram, explain the
effect of a fall in the exchange rate in
the UK on the rate of inflation. (10)
Mark scheme
• For providing a relevant definition, eg, exchange rate, inflation
(up to 2 marks).- maximum 2 marks for definitions
• A fall in the exchange rate will reduce export prices and/or
increase the price of imports (1 mark) this will increase the
demand for UK products (1 mark). The rise in AD will create a
buoyant environment in which firms can increase prices (1 mark)
leading to demand-pull inflation (1 mark). This initial increase in
prices will lead to higher wage demands (1 mark) increasing
firms’ costs and hence prices (1 mark). Award one mark for
each link in a logical chain of reasoning.
• Diagram (2 marks)
• Question (Jan 2012)
To what extent would a significant fall
in the exchange rate of the pound
sterling achieve a sustained reduction in
unemployment in the UK? (25 marks)
Fixed Exchange rates
‘Pegged’
• Not popular recently but were fixed between
1944 and 1972 and 1990/91 (ERM)
• Commitment to a single fixed exchange rate
• No permitted fluctuations from the central
rate
• Achieves exchange rate stability but perhaps
at the expense of domestic economic stability
• Bretton-Woods System 1944-1972 where
currencies were tied to the US dollar
• Gold Standard in the inter-war years currencies linked with gold
Advantages of Fixed Exchange Rates
1. Avoid Currency Fluctuations. If the value of currencies fluctuate
significantly this can cause problems for firms engaged in trade.
1. For example if a firm is exporting to the US, a rapid appreciation in
sterling would make its exports uncompetitive and therefore may go
out of business.
2. If a firm relied on imported raw materials a devaluation would
increase the costs of imports and would reduce profitability
2. Stability encourages investment. The uncertainty of exchange rate
fluctuations can reduce the incentive for firms to invest in export
capacity. Some Japanese firms have said that the UK's reluctance to
join the Euro and provide a stable exchange rates maker the UK a less
desirable place to invest.
3. Keep inflation Low. Governments who allow their exchange rate to
devalue may cause inflationary pressures to occur. This is because AD
increases, import prices increase and firms have less incentive to cut
costs.
4. A rapid appreciation in the exchange rate will badly effect
manufacturing firms who export, this may also cause a worsening of
the current account.
5. Joining a fixed exchange rate may cause inflationary expectations
to be lower
Fixed
rate
Fixed
rate
To maintain
the ER
• supply
foreign
currency
(from
reserves)
• Restrict the
demand for
foreign
currency
• What problems might result from using
the interest rate to manage the
exchange rate?
Black Wednesday
• A run on the currency (ERM)
• Speculators thought the £ was
overvalued against the DM
• Sold £ and buy back once £ had fallen
in value
• BoE would have to support £ to maintain
its value
• http://www.youtube.com/watch?v=oD1n
Gruqnyw
Price of £ in DM
2.95
Demand & supply of sterling
Disadvantage of Fixed Exchange
Rates
1. Conflict with other objectives. To maintain a fixed
level of the exchange rate may conflict with other
macroeconomic objectives.
–
–
–
If a currency is falling below its band the government will
have to intervene. It can do this by buying sterling but this
is only a short term measure.
The most effective way to increase the value of a currency
is to raise interest rates. This will increase hot money flows
and also reduce inflationary pressures.
However higher interest rates will cause lower AD and
economic growth, if the economy is growing slowly this may
cause a recession and rising unemployment
Disadvantage of Fixed Exchange
Rates
1. Less Flexibility. It is difficult to respond to
temporary shocks. For example an oil importer may
face a balance of payments deficit if oil price
increases, but in a fixed exchange rate there is
little chance to devalue.
2. Join at the Wrong Rate. It is difficult to know the
right rate to join at. If the rate is too high, it will
make exports uncompetitive. If it is too low, it
could cause inflation.
3. Current Account Imbalances. Fixed exchange rates
can lead to current account imbalances. For
example, an overvalued exchange rate could cause a
current account deficit
Semi-fixed system
‘managed float’
• ER is allowed to ‘float’ between
undisclosed levels
• Price ceilings and price floors are used
• ERM
Semi-fixed exchange rate
£/€
D
S
Ceiling
Floor
Q
• ‘dirty’ float
• Governments manipulate their currency
to give an advantage over trading
partners
• Examples of a fixed exchange rate
system
– Denmark is fixed against the Euro
– Bulgaria, the Euro
– Saudi Arabia, Qatar, fixed against $
Economic Integration
• What is economic integration?
– Economic integration refers to trade unification between
different states by the partial or full abolishing of customs
tariffs on trade taking place within the borders of each
state.
• What is a trade agreement?
– A trade agreement is a contract/agreement/pact between two or
more nations that outlines how they will work together to ensure
mutual benefit in the field of trade and investment.
– Trade agreements are often regional, involving only a relatively small
number of countries.
– Trade agreements are either bilateral, involving only two countries,
or multilateral, involving more than two countries
Economic Integration
• What is a trade bloc?
– A trade bloc is a type of intergovernmental agreement,
where regional barriers to trade, (tariffs and non-tariff
barriers) are reduced or eliminated among the participating
states.
• What is a Free Trade Area (FTA)
– A free-trade area is a trade bloc whose member countries
have signed a free-trade agreement (FTA), which eliminates
tariffs, import quotas, and preferences on most (if not all)
goods and services traded between them.
Economic Integration
• What is a Customs Union?
– An agreement among countries to have free trade among
themselves and to adopt common external barriers against
any other country interested in exporting to these countries
• What is a Common Market?
– A type of custom union where there are common policies on
product regulation, and free movement of goods and
services, capital and labour.
• What is an Economic & Monetary Union?
– A common market with common currency, where more than
two countries use the same currency.
Economic Integration
• What is Complete Economic Integration?
– Individual countries have no control of economic policy, full
monetary union and complete harmonization of fiscal policy
Free trade agreements
• https://youtu.be/UKqXbSLYOm8
Trade creation
• takes place when domestic consumers in
member countries import more goods
from other members as import prices
fall due to a removal of tariff and
quotas; production will shift to lower
cost producer.
Trade creation
Trade Diversion
• When a customs union is created and
tariffs differentials between members
and non-member result in trade flows
being diverted toward higher cost
producers.
Essay (June 2011)
An economy which is enjoying rapid economic growth
experiences a significant rise in the external value of
its currency within a floating exchange rate system.
1 1 Explain the factors which may lead to a rise in the
exchange rate of a currency within a floating exchange
rate system. (15 marks)
1 2 Evaluate the possible macroeconomic consequences
for an economy of a rise in the exchange rate of its
currency. (25 marks)