10.4: exchange rate systems

an exchange rate is

the weight of one currency relative to another

in a floating exchange rate system

the value of exchange rate is determined by the forces of demand and supply

the demand of a currency is

equal to exports plus capital inflows

the supply of a currency is equal to

imports plus capital outflow

a fixed exchange rate is

an exchange rate that is fixed at a certain level by the countries central bank and maintained by intervention in the foreign exchange market

ways central banks manage fixed exchange rates are

exchange equalisation, interest rates, quantitative easing

exchange equalisation is

central bank buying and selling its own currency on foreign exchange market, if want to reduce it they will sell to offset excess demand, if going too low create artificial demand by buying

governments can manipulate interest rates to control exchange rate as

an increase in interest rates relative to other countries makes it more attractive to invest funds into the country because rate of return of investment is higher, increasing demand for currency, causing appreciation, known as hot money flows

quantitative easing can be used by banks to manipulate exchange rates as

it can help stimulate the economy when standard monetary policy is no longer effect, it has inflationary effects as increases money supply and can reduce the value of the currency. usually used when inflation is low and not possible to lower interest rates further

managed exchange rates

combine the characteristics of fixed and floating exchange rate systems so the currency fluctuates but doesn’t float fully freely due to ceilings and floors

examples of managed exchange rate systems are

the indian rupee, the Japanese central bank has attempted to make exports cheaper by manipulating the Yen

the two types of managed exchange rates are

adjustable peg exchange rate, managed floating

adjustable peg exchange rates is

closer to a fixed exchange rate but a central bank may change the central peg by devaluing or revaluing to prevent over or underevaluation

managed floating exchange rates are

when the currency is officially free floating but the central bank buys and sells currency to maintain certain rates

advantages of floating exchange rates are

balance of payments equilibrium, resource allocation, domestic macro policy objectives, inflation, independent monetary policy, auto adjusts to shocks

disadvantages of floating exchange rate system

speculation and capital flows, international trading uncertainty, cost-push inflation, demand pull inflation

floating exchange rate is good for balance of payments equilibrium because

the exchange rate should automatically correct a payments imbalance since a currency should never be over or undervalued affecting competitiveness of exports

floating exchange rate is beneficial for resource allocation because

exchange rates need to be correctly valued in order for efficient allocation between competing uses, market price must accurately represent shifts in demand and changes in competitive and comparative advantage as results from technical progress and events such as discoveries of new resrouces.

floating exchange rate is beneficial for domestic macro policy objectives because

it can be argued that when exchange rate is free floating, bop are no longer a policy problem and therefore can peruse other objectives such as full employment and growth as market forces look after BOP

floating exchange rates benefit inflation because

floating exchange rates insulate the country against importing inflation from the rest of the world,

floating exchange rates benefit monetary policy as

monetary policy is solely used to achieve domestic policy objectives so is independant

speculation and capital flows is a disadvantage of free floating exchange rate system because

in the short run, exchange rates are extremely vulnerable to speculative capital/ hot money flows but arguably so are fixed

international trading uncertainty is a disadvantage of floating exchange rates because

volatility and instability caused by floating exchange rate systems can slow and destroy international trade as the uncertainty can deter businesses from international trade and stick to domestic supply and demand. by inhibiting trade, resources may be misallocated, however in reality hedging prevents this

hedging is

the purchase or sale of a currency in the forward market, reducing trading uncertainties

floating exchange rates can cause cost push inflation because

if a country has higher inflation rate than trading partners, trading competitiveness and bop both worsen, causing exchange rate to fall in order to restore competitiveness. can trigger a cumalitve downward spiral of faster inflation and exchange rate depreciation

a cumulative downwards spiral of faster inflation and exchange rate depreciation can be cause by floating exchange rates as

the initial fall in exchange rate increases import prices, raising cost push inflation, workers react by demanding pay rises to restore real wages. increases domestic inflation causes a loss of export competitiveness that the fall in exchange rate gave contributing to downwards spiral as cycle repeats

floating exchange rates can cause demand pull inflation as

if there is simultaneous increase in demand it can lead to excess demand on a worldwide scale fuelling global inflation, as there is no need to deflate domestic economy to deal with bop deficit on current account which prevents this in fixed ER system

advantages of fixed exchange rates are

certainty and stability, anti-inflationary discipline it imposes on domestic economic management/ gives monetary policy a focused target to work towards, allows firms to plan investment because no harsh fluctuations,

disadvantages of fixed exchange rates

gov and central bank don’t necessarily know better than the market where the currency should be, bop doesn’t automatically adjust to economic shocks, can be costly and difficult to hold large reserves of foreign currencies, continued over and undervaluation of currency leading to misallocation of resources

a currency union is

an agreement between a group of countries to share a common currency, and usually to have a single monetary and foreign exchange rate policy

example of a currency union is

the eurozone

in currency unions, a

common central monetary policy is established, they use the same interest rates, member nations are required to control their government finances

the convergence criteria to join the euro is

budget deficit not exceeding 3%, gross national debt below 6% of gdp, inflation below 1.5% of three lowest inflation countries, avg gov bond yield below 2% of yield of the countries with the lowest interest rates ensuring exchange rate stability

an optimal currency zone is created when

countries achieve real convergence, member countries respond similarly to external shocks and policy changes, there is flexibility in produce markets and labour markets to deal with shocks (through geographical and occupational mobility of labour and wage and price flexibility in labour markets), fiscal transfers to even out regional economic imbalances

advantages of currency unions are

the participating countries have more currency stability, fewer admin fees and less red tape when travelling abroad, benefits trade between member states, german monetary credibility

having more currency stability is an advantage of a currency union as

the currency is less prone to speculative shocks therefore the future markets have more certainty and more potential for investments and growth

being in a currency union means that firms benefit from easier trade with member states as

there is no exchange of currency, meaning there is less uncertainty and barrier, which is especially beneficial to small firms who benefit from the time and money savings

the german monetary credibility is an advantage of the eurozone currency union as

all member states may have a lower interest rate as a result, therefore could encourage more investment and spending and create more jobs

disadvantages of currency unions are

labour mobility across europe is still limited, inflexible exchange rate, loss of sovereignty, cost of joining

labour mobility being limited across currency unions is a disadvantage as

the union is meant to make labour mobility easy and relies on this to disperse regional disparities, however there are still barriers to this such as language

joining a currency union means that member nations loose sovereignty

when there is a common monetary unions meaning that countries with a strong economy have to cooperate with countries with weaker economies and cannot adapt their policy to meet individual requirements

the one off cost of joining a currency union is a disadvantage as

changing labels and prices can be significant and cost a lot