4.5 Exchange Rates

(HL)

Exchange rate

Value of one currency expressed in terms of another.

Exchange Rate System: Fixed Exchange Rate

Value of one currency is fixed or pegged to the value of another currency.

Revaluation

Government increased the value of a fixed exchange rate.

Devaluation

Government decreases value of the currency.

Maintaining exchange rates

1. Increased supply of dollars (buying more imports causes the value of the currency to decrease, as it is less scarce)

2. Government buys up excess currency using foreign currency reserves to maintain the fixed exchange rate.

Advantages of Fixed Exchange Rate

Reduces economic uncertainty

Governments mitigate inflation

Reduces speculation on the Forex Market

Disadvantages of Fixed Exchange Rates

• Government may be forced to increase interest rates, causing deflation

• Need to maintain high levels of foreign currency reserves

• Artificially low exchange rate → more competitive exports which may cause international disagreements

Floating exchange rate (hypothetical)

Value of currency determined by demand and supply on the Forex Market + lack of government intervention

Advantages of Floating Exchange Rate

Flexibility with Exchange Rates

Floating rate adjusts to keep current account balanced

No need to maintain high levels of foreign currency reserves

Disadvantages of Floating Exchange Rate

Uncertainty on international markets

Sensitive to government intervention and speculation

May make inflation worse due to increase in demand

Why governments, firms, and consumers buy or sell foreign currency

Buy export goods or travel to another country

Invest in another country

Save money in the bank of a foreign currency

Make money on speculating on a foreign currency

Factors that shift demand curve for a currency

• Low inflation rates + cheaper goods and services

• Increased foreign incomes

• Change in foreign tastes in favor of domestic products

• Investment prospects improve

• Interest rates increase, making investments more attractive

• Speculators think the value of currency will rise, so they buy now.

Factors that shift the supply curve fro a currency

• More demand for foreign goods and services

• Higher inflation rates, expensive products, and foreign goods may be cheaper

• Increase in incomes of domestic consumers

• Change in tastes and preferences

• Improvement of foreign investment prospects

• Increase in foreign interest rates and more return

• Speculators believe that the currency will fall, so they sell the currency.

Managed Exchange Rates

• Type of floating exchange rate

• Fluctuations force the government to intervene in order to reduce uncertainty

• Government set lower and upper exchange rates, allowing the rate to float freely as long as it does not move outside of the range.

• Gov. intervenes to stabilize exchange rates by changing interests rates or buying/sell using foreign currency reserves.

Advantages of Appreciation

• Downward pressure on inflation (lower cost for imported goods and greater purchasing power)

• More imports (visible and invisible such as travel)

• Domestic producers improve efficiency

Disadvantages of Appreciation

• Damage to export industries due to high prices and unemployment

• Damage to domestic industries

Advantages of Depreciation

More employment in domestic and export industries + cheaper domestic goods

Disadvantages of Depreciation

Inflation (expensive imports, higher costs of production, and expensive domestically produced products due to cost push inflation)

Effects of Changes in Exchange Rates

• Appreciation (imports increase, while exports decrease)

• Depreciation (imports decrease, while exports increase)

• Depreciation causes inflation, exports are cheaper

• Cost-push inflation if materials are imported

• Depreciation leads to increased exports and increased GDP

• negative effect on living standards

• Depreciation lowers unemployment and leads to increased exports

• Appreciation causes lower exports and AD, increasing unemployment rates.