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