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Exchange Rates Countries choose their exch. rate system: 1. 2. 3. 4. Free - Floating Managed - Floating Fixed (may be rigidly fixed or somewhat flexible – eg. adjustable peg) Monetary Union with other countries Floating Exchange Rates Value of currency determined solely by mkyt forces No target set by gov’t – no intervention Sterling has floated freely on foreign exchange markets since the UK crashed out of the ERM, Sept. 1992 Managed Floating Exchange Rate Currency usually determined by mkt forces Some intervention (demand-management policies) Interest rates may also used No specific long-term target for currency Fixed Rates Some pegged at one level, others have target bands (crawling peg) Central banks buy or sell currency to keep it at desired level Revaluations may occur, though seen as undesirable The Case for Floating Exchange Rates Less need for foreign currency reserves for use in intervention – gov’t not involved Useful tool for automatic macroeconomic adjustment (eg. High trade deficit can lead to drop in currency, helping correct) May be less vulnerable to currency speculators (those who sell a currency if they believe it is about to be devalued) The Case for Fixed Exchange Rates • Currency stability improves trade • Some flexibility (occasional ‘realignments’) mean gov’t can adjust the economy • Domestic producers can improve int’l competitiveness through costs Explaining the High £ Since mid-90’s £ has been above its purchasing power parity rate – why? Independent monetary policy boosted market confidence in low inflation (key in currency mkts) UK economy relatively strong with recessions elsewhere, esp Europe Escaped uncertainties of the Eurozon The J Curve In the short term, a devaluation is likely to lead to a deterioration in the current account position before it starts to improve Due to the inelasticity of imports… people take a while to change their buying and the immediate effect is to increase the total spent on imports and decrease the total spent on exports Marshall-Lerner Condition Devaluation will lead to an improvement in the current account so long as the combined price elasticities of exports and imports are greater than 1 Eg. If PEDimports = 0.3 and PEDexports = 0.5, then, although exports are going to rise, they will not rise significantly enough to counter the decrease in price – the same holds true here for imports… no improvement If If PEDimports = 0.9 and PEDexports = 0.7, then the net change will improve the trade deficit