economics - theme 4 exchange rates summary

what are international currencies

essentially products that can be bought and sold on the foreign exchange market (forex)

what controls the exchange rate system

• the central bank of a country

• determines the value of a nation’s currency

3 exchange rate systems

• floating exchange rate

• fixed exchange rate

• managed exchange rate

floating exchange rate definition

a system in which demand and supply determines the rate at which one currency exchanges for another

fixed exchange rate definition

system in which a country’s central bank intervenes in the currency market to fix the exchange rate in relation to another currency

managed exchange rate definition

system in which the free market determines the value of a currency but also where the central banks will intervene from time to time so as to keep the currency value within desired range

floating exchange rate system explained

• if there’s an excess demand for the currency on the forex market, then prices rises

• the currency is now worth more

• called an appreciation

• if there’s an excess supply of the currency on the forex market, then prices fall

• currency is now worth less

• called a depreciation

fixed exchange rate system explained

• central bank negotiates with the International Monetary Fund (IMF) to fix (peg) their currency to another one

• sometimes the peg is at parity (1=1)

• often the pen is not at parity

• revaluation : occurs if the central bank decides to change the peg and increase the strength of its currency

• devaluation : occurs if the central bank decides to change the peg and decrease the strength of its currency

managed exchange rate system explanation

• combination of fixed and floating

• central bank determines the preferred currency value and when the currency is free to fluctuate within a certain range of this value

• if it goes above this range, central bank will intervene by selling its own currency in forex markets so as to increase supply

• increased supply of currency → decrease value of currency → brings it back within the range

• if it goes below the range, central bank intervenes by buying its own currency in the forex market using its foreign reserves

• increased demand for currency → increases value of currency → brings it back within the range

• interest rates can also be used to intervene

6 factors influencing floating exchange rates

• relative interest rates

• relative inflation rates

• net investment

• current account

• speculation

• quantitative easing

relative interest rates explanation

• influence the flow of hot money between countries

• if the uk increases its interest rate, then demand for £ by foreign investors increases and the £ appreciates

• if the uk decreases its interest rate, then supply of £ increases as investors sell their £’s in favour of other currencies and £ appreciates

relative inflation rates explanation

• as inflation in the uk rises relative to other countries, its exports become more expensive

• therefore less demand of uk products by foreigners

• means there is less demand for £ and so depreciation

net investment explanation

• foreign direct investment (FDI) into the uk creates a demand for the £

• leads to the £ appreciating

• FDI by uk firms abroad creates a supply of £’s which leads to the £ depreciating

current account explanation

• uk exports have to be paid for in £

• uk imports have to be paid for in local currencies which requires £’s to be supplies to the forex market

• due to this, an increasing trade surplus will result in an appreciation of the £

• an increasing deficit will result in a depreciation of the £

speculation explanation

• vast majorly of currency trades are speculative

• speculation occurs when traders buy a currency in the expectation that it will be worth more in the future

• at which point they will then sell it for profit

quantitative easing

• involves increasing the money supply and much of the new supply is used to buy back gilts

• many of these gilts are owned by foreigners who then exchange the £s received for their own currency

• the increase in supply depreciated the £

2 ways to intervene in a market

• changing interest rates

• buying and selling currency in the forex market

changing interest rates explanation

• if the central bank wants to appreciate the currency, it would raise interest rates

• thereby making it more attractive for foreigners to move more money into the country’s banks

• decreasing interest rates has the opposite effect and causes a depreciation

buying and selling currency in the forex market explanation

• central bank can change the demand or supply for their currency using their reserves

• if they want to appreciate the currency then they buy it on the forex market using foreign currencies

• if they want to depreciate the currency then they sell their own currency and buy foreign currencies

one positive of devaluation / depreciation

• makes the country’s exports cheaper

• if demand for their exports is price elastic, then the country is likely to experience higher export volumes and higher export revenues

4 consequences of international devaluation / depreciation

• anticompetitive and upsets international competitors

• larger countries usually have more financial resources to manipulate markets and so gain unfair advantages over smaller countries

• other countries may respond by also lowering the value of their currencies resulting in very little change to market share

• raises the cost of imports used in production and with little change to value of exports so profits decrease

5 impacts of change in exchange rates on an economy

• current account balance

• economic growth

• inflation (price stability)

• unemployment

• living standards

current account balance explanation

• depreciation of £ causes exports to be cheaper and imports to be dearer

• extent to which this improves the current account balance depends on Marshall-Lerner condition - when a currency depreciates the current account balance will only improve if the sum of the PED’s for exports and imports is elastic (greater than 1)

• follows the revenue rule - states that in order to increase revenue, firms should lower prices for products that re price elastic in demand

• if the combined elasticity of exports / imports is less than 1 (inelastic) a depreciation will actually worsen the current account balance

• also is a time lag involved

• this is explained by the j-curve effect

economic growth explanation

• net exports are a component of aggregate demand

• a depreciation that results in an increase in net exports will lead to economic growth

inflation explanation

• cost push inflation is likely to occur as the price of imported raw materials increases with currency depreciation

• net exports are a component of AD

• a depreciation that results in an increase in net exports will lead to an increase in AD

• this may lead to an increase in demand pull inflation

• an appreciation would have the opposite effect

unemployment explanation

• if depreciation leads to an increase in exports, unemployment is likely to fall as more workers are required to produce the additional products demanded

• an appreciation of the currency will have to opposite effects

living standards explanation

• impact of a depreciation on living standards can be muted

• as imports are more expensive, households face higher prices and less choice, which detracts from living standards

• rising exports can decrease unemployment and increase wages / incomes which means an improved standard of living for some households

• impact of appreciation will be the opposite