Download Forex Systems 3 - IBECON

Section 4.6
Exchange Rate Systems
Exchange rates
►
The exchange rate is determined in the
foreign exchange market by supply and
•The demand for the
demand.
Price of LE in
terms of $
S
E
D
Quantity of LE
domestic currency
stems from the
demand for
domestic goods
and services.
•The supply of the
currency stems
from the demand
for foreign goods
and services.
Advantages of Fixed
exchange rates
►
Reduced Risk
 The increased stability of exchange
rates will encourage international
trade as traders do not fear that the
value of the currency would change by
the time their contracts are due for
settlements. Moreover, FDI will
increase as MNCs will be able to
accurately project their profits.
► Discipline
in Economic Management
 Governments have an incentive to avoid
inflation as it would undermine the
competitiveness of their exports.
►
Elimination of Destabilizing Speculation
 A fixed exchange rate will reduce the
possibility of destabilizing speculation. The
elimination of speculative pressures will
prevent the currency from being overvalued
or undervalued, thus preventing a
misallocation of resources.
Disadvantages of Fixed
exchange rates
► Maintaining
a fixed rate might force the government
to increase interest rates in order to increase
demand for the currency. This will cause a
deflationary gap, lowering aggregate demand and
increasing unemployment. Thus jeopardizing a
macro economic goal.
► High levels of foreign reserves must be set aside in
order to maintain the fixed rate.
► Finding the right level to fix the rate at is not an
easy task.
 A high exchange rate will reduce export competitiveness.
 A artificially low level will be seen as an unfair trade
advantage and cause economic disputes and retaliation.
Advantages of floating
exchange rates
►
Automatic BOP adjustment
 A BOP deficit results in a depreciation
of the domestic currency. The
depreciation makes exports more
competitive and imports more
expensive. The depreciation brings the
BOP current account to balance
without any government intervention.
(this is provided that the MarshallLerner condition is satisfied)
►There
will be no need to hold
high levels of foreign reserves.
►Domestic
Inflation does not
negatively affect exports
 Under a floating exchange rate,
domestic inflation results in a
depreciation of the currency,
compensates for the increased
export prices and prevents them
from becoming less competitive
abroad.
► Freedom
of Choice of Domestic Policy
 A fixed exchange rate system calls for
constant intervention in the foreign exchange
market to keep the value of the currency at
its pegged value. For example, the central
bank may have to raise interest rates to push
the value of the currency upward. This
deflationary monetary policy will increase the
level of unemployment in the domestic
economy.
 A floating exchange rate enables the central
bank to use monetary policy to fine-tune the
economy as opposed to keeping the
exchange rate at its predetermined pegged
value.
Disadvantages of floating
exchange rates
►Exchange
rate instability
 Floating exchange rates are often
unstable due to speculative pressures.
This instability could reduce the
volume of international trade as
traders are unsure about the
exchange rate that will prevail when
their contracts are settled. The
uncertainty could also reduce FDI as
potential MNCs will not be able to
make accurate profit projections.
►Higher
Inflation
 When domestic inflation does not
negatively impact export
competitiveness, governments
have less of an incentive to fight it.
 When the domestic currency
depreciates, the price of imported
raw materials increases causing
cost-push inflation.
►In
reality, floating exchange rates are
affected by factors other than supply
and demand, such as government
intervention, world events and
speculations. Therefore, they don't
necessarily self adjust and correct
current account deficit.
Would a devaluation always lead
to an improvement in the BOP?
►
The automatic stabilization in the BOP
presupposes that the demand for
exports and the demand for imports is
elastic.
 Deficit depreciation of currency
exports are cheaper export revenues
increase deficit shrinks.
 Deficit depreciation of currency
imports are more expensive  import
payments fall deficit shrinks.
The Marshal-Lerner Condition
The sum of the elasticities of demand
for exports and imports should be
greater than one in order for a
currency devaluation to result in an
improvement in the BOP’s current
account.
PEDexports + PEDimports > 1
 Remember that demand become more
elastic over time so more countries would
meet the Marshall – Lerner condition in
the long run.
Does the M-L condition hold for
LDCs?
► The
demand for exports tends to be
inelastic because LDCs export primary
sector goods.
► The demand for imports tends to be
inelastic as LDCs often import raw
materials and semi-finished goods.
► The Marshal-Lerner condition does not
hold for most LDCs.
The J Curve
Even if the Marshal-Lerner condition
were met, the depreciation of the
currency would not immediately bring
about an improvement in the BOP.
 It will take time for consumers to shift from foreign
goods to domestic goods and for suppliers to
produce import substitutes.
 The elasticities of demand and supply for domestic
goods is low at first and then it increases as
consumers and suppliers have had time to adjust
to price changes.
 Similarly, it will take time for other countries to
realize that your exports’ prices fell. They might
The J Curve
BOP current
balance
+
0
-
Time
Following a
depreciation,
the BOP
deteriorates
first before it
starts improving
Expenditure switching vs.
Expenditure reduction
►A
country facing a BOP deficit could devalue its
currency so that expenditure switching from
imports to exports helps restore the balance. This
policy would be effective if the Marshal-Lerner
condition is met.
► Expenditure
reduction is another option where
the country adopts policies aimed at reducing
aggregate demand. In this case imports would be
reduced due to the reduction in income. This option
would be more effective if the marginal propensity
to import is high.
The Adoption of a Unified
Currency—EURO
►
Countries that choose to adopt a unified
currency enjoy
 reduced foreign exchange risk, more business
confidence and hence greater FDI.
 increased efficiency in trade transactions (no
transaction costs). Countries do not have to keep
changing currencies and paying exchange
commissions.
 it makes it easier to compare prices between different
countries.
Disadvantages
►A
country adopting the euro abandons
its monetary policy to the ECB, and no
longer has the option of using
monetary policy to respond to local
conditions.
► Adopting the euro eliminates one
possible option for adjustment
between countries. Free floating
exchange rates allow for automatic
BOP adjustments.
Purchasing Power Parity
(PPP)
► The
PPP theory argues that in the long-run:
 exchange rates should move towards levels
that would equalize the prices of an identical
basket of goods in two countries.
 it equates the exchange rates with the relative
inflation rate in each country.
 Exchange rates will be in equilibrium when
people can buy the same basket of goods with
an equal amount of money.
 Ex: if the exchange rate between UK & US is £1 = $1.8 and
the same basket of goods can be bought for £100 in the UK
and for $180 in the US then, the actual exchange rate and
the PPP rate equal.
What happens in case of inflation?
►
If prices go up by 10% in the UK and 2% in the US, the
same basket of goods will be bought for £110 and $183.6.
Thus the PPP exchange rate would now be £1 = $1.67
►
The PPP theory claims that the actual exchange rate
should move towards the PPP exchange rate over time
since UK goods and services became relatively more
expensive. Consequently,
 the demand for US imports in the UK will increase increasing the
supply for pounds in the foreign exchange market.
 the demand for UK goods in the US will fall decreasing the demand
on pounds.
 Thus, the value of the UK pounds relative to the US dollar should
start to depreciate.
► ex:
if inflation rises by 5% the value of the currency should fall by 5%,
ceteris paribus.
Evaluation
► Although,
PPP theory is very useful in
making comparisons between countries, it is
a little simplistic.
► In reality, however, the value of a currency
is not only affected by the demand for
goods and services. Speculations,
government interest rate manipulation,
business confidence and world events may
prevent the long run from ever materializing
because of short run fluctuations.
The End