Exchange rates, terms of trade, competitiveness, monetary union - booklet 5

Appreciation

A rise in the value of the currency due to market forces

Depreciation

A fall in the value of the currency due to market forces

Revaluation

A rise in the value of the currency due to deliberate government policy

Devaluation

A fall in the value of the currency due to a deliberate government policy

Effective exchange rate

An index number of the value of a country’s currency relative to a weighted basket of other currencies

Floating exchange rate

Market supply and demand of the currency are the sole determinants of its value

Semi fixed exchange rate

The currency has a floor and ceiling but can move between permitted bands of fluctuation

Fixed exchange rate

An exchange rate which doesn’t change and is permanently fixed

Managed exchange rate

The government will intervene to influence the market demand and supply of the currency (dirty exchange rate)

Why would governments manipulate the exchange rate?

To boost trade, to improve the balance of payments, to create economic stability

What are some benefits of floating exchange rate systems?

• Freedom for domestic monetary policy

• Useful investment for macroeconomic adjustment

• Partial automatic correction for a trade deficit

• Reduced risk of currency speculation

What are some disadvantages of floating exchange rate systems?

• Volatile so there’s no certainty for trade an investment

• Self correction of trade deficits is unlikely

• A dirty floating exchange rate means you still have to keep some currency reserves for emergencies

Gold standard

An example of a fixed exchange rate system

What are the benefits of a currency board fixed exchange rate?

• Interest rates are automatically adjusted

• It’s predictable and rule-based which promotes investment

What are some potential disadvantages of a currency board fixed exchange rate?

• Prevents governments from selling their interest rates so that if their inflation is high it’ll be even higher than the country it’s pegged to

• Disequilibrium

Benefits of fixed exchange rate systems

• Stable

• Some flexibility permitted

• Reduces cost of trade by reducing uncertainty

• Encourages FDI, increased confidence in the market which raises animal spirits

Drawbacks of fixed exchange rate systems

• The most expensive type of system, large currency reserves are needed

• Independent monetary policy isn’t possible if interest rates are used to determine the value of the currency

• No partial correction of a balance of payments deficit as with a floating system

Ways the government plays a part in determining the exchange rate

• Buying and selling currency using the gold and foreign currency reserves

• Raising or lowering interests, influencing free market demand and supply

• Borrowing from the International Monetary Fund (IMF) which can be used to buy domestic currency and hold up the exchange rate. This is a last resort.

Adjustable peg system

An exchange rate system where currencies are fixed in value in the short term but can be devalued/revalued in the long term. This is done if economic circumstances change, Bretton Woods

The Bretton Woods agreement

Established in 1944, created a system of international monetary management, setting up institutions like the IMF and World Bank to promote economic stability and reconstruction after World War II until the early 1970s.

Why did the pound devalue in 1967?

Persistent balance of payments crisis, high inflation, and a weakening economy, which led to a loss of confidence in the pound and pressure on the British government to take action to stabilize the currency. This culminated in Prime Minister Harold Wilson's decision to devalue the pound by 14.3%

Benefits of a managed exchange rate

• Attempts to have the benefits of both fixed and floating exchange rate systems and minimise both of their disadvantages

• Cheaper than a fixed rate system

• More stable than a floating system

• Allows for a limited reduction in BoP when the currency depreciates within ceiling and floor

Disadvantages of managed exchange rate systems

• May still have disadvantages of fixed and floating systems

• More expensive than a floating exchange rate system but not as stable as a fixed rate system

• Currency may head to the floor in the LR, causing pressure for realignment

• Imperfect information means the currency may initially be set at the wrong value

• Open target for speculators who can force down the value of the currency causing it to devalued or ejected from the semi fixed system (UK out of ERM black wednesday 1992)

Index of terms of trade formulae

(Index of export prices / index of import prices) x 100

Terms of trade

The ratio of export prices to import prices

When will there be an improvement in terms of trade

• If export prices rise relative to import prices

• If export prices fall by relatively less than import prices

When will there be a deterioration in the terms of trade

If import prices rise significantly that export prices or if import prices fall by relatively less than export prices.

Factors which lead to an improvement in the terms of trade

• An increase in the exchange rate

• High relative inflation rate

• Increase in global demand for a commodity in which the country specialises

Factors which lead to a depreciation in the terms of trade

• Increase in global supply of a commodity in which the country specialises

• Improved relative productivity rate

• Falling prices of a good a country sells

International competitiveness

A country’s sustained ability to sell it’s goods and services in domestic and international markets profitably, at a price and quality that is attractive in those markets

Why is competitiveness important?

It is the key to economic growth, which leads to a lower unemployment rate

Measures of price competitiveness

• Relative unit labour costs (measurement of labour costs in one country relative to those in another), the figures are converted into a single currency and shown as an index number

• Relative export prices

Measures of non-price competitiveness

Quality of goods and services (design, reliability, performance, marketing, branding ect.

Factors influencing international competitiveness

• Wage and non-wage labour costs

• Productivity

• The exchange rate

• Inflation

• Regulation (implementing more costs to business which could reduce competitiveness)

• R&D

• Quality

• Taxation

Monetary/currency union

A group of countries which share a common currency, e.g the euro

Fiscal union

A group of countries where a central body has some powers over gov borrowing, spending and setting uniform rates of tax across all member countries

Benefits of Monetary union

• Reduced transaction costs

• No exchange rate fluctuations

• Increased price transparency

• Increased trade between eurozone nations

Drawbacks of monetary union or joining the euro

• Currency fluctuations can still be a problem when trade with the rest of the world

• Transition costs

• Loss of monetary independence

• No exchange rate adjustment possible

• Constraints on fiscal policy

Optimum currency area

A group of countries where efficiency would be maximised by sharing a common currency

Features needed to achieve the optimal currency zone

• Member countries must have sufficient structural economic convergence (similar trade patterns, business cycles, housing markets)

• Sufficient labour market flexibility to absorb unexpected economic events

• Fiscal union