4.2.6.4 - Exchange rate systems

Effective Exchange Rate =

Weighted average of a currency's value relative to a basket of major foreign trading partners

Floating Exchange Rate =

Exchange rate is determined solely by the forces of demand and supply of the currency, without any government intervention.

Country Examples with Floating Exchange Rate

UK, US, Australia

Factors influencing/determining a Floating Exchange Rate

any factors that affect supply or demand for the currency

Demand-side:

• Interest rates increase higher than other countries → Hot money inflows → ↑D for £ → D shifts right → ↑P of £

• New popular tourist attraction

• Inward FDI

• Speculation

Supply-Side:

• Increase in imports, decrease in exports - ↑S of £

• Speculation

• Capital Outflows - outward FDI, outward portfolio investments

Diagrams showing shifts in demand & supply for currency in a Floating Exchange System

Fixed Exchange Rate =

When the government fixes/pegs the value of its currency against another currency. The central bank must actively intervene in forex markets to maintain this value.

Ways the Central Bank manages a Fixed Exchange Rate

Direct buying/selling on Forex Market:

• If ER too high, central bank sells domestic currency and buys foreign currency.

• If ER too low, central bank buys back domestic currency using foreign reserves

• Central bank must hold sufficient foreign exchange reserves in order to intervene

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Monetary Policy:

• Change interest rates → Movement of hot money → Appreciation/depreciation

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Capital Controls:

• Gov restricts flow of capital into and out of a country

• Taxation of foreign deposits in banks to cut profit from hot money flows

Country Examples with Fixed Exchange Rate

• Hong Kong Dollar (HKD) pegged to USD

• Danish Krone (DKK) pegged to Euro

Advantages of Floating Exchange Rates

Freedom of Monetary Policy:

• In fixed ER system, central bank needs to manage the ER - one way they do that is through interest rates.

• However, IR affects macroeconomic policy objectives - Inflation, EG, u/e, X-M

• In floating ER, interest rates can be solely focused on these domestic issues of policy objectives without worrying about the ER → IR can be better used to achieve macroeconomic stability

• APP: In response to 2007/8 GFC, BoE slashed IR from 5% to 0.5% - UK able to do that because floating ER

• IDO: Quality of a country’s Central bank → still requires good use of monetary policy to achieve macroeconomic objs

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Reduced need to hold large amounts of currency reserves

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Automatic correction of balance of trade:

• If country has CAD - Imports>Exports

• High imports → ↑S of £ → Depreciation → Exports cheaper, imports more expensive → Naturally, demand for imports now fall, and ↑Exports → Current account position improves → Fixes CAD automatically

• APP: Japan 2012 following Fukushima nuclear accident had a CAD → Yen depreciated → Exports became cheaper, like Toyota cars → ↑Exports → Japan’s trade improved again

• IDO: Marshall-Lerner Condition - Depreciation only improves CAD if PED of exports + PED of Imports > 1

Disadvantages of Floating Exchange Rates

Volatile:

• Unpredictable fluctuations of ER

• Uncertainty for businesses engaged in international trade and investment → ↓Business confidence → ↓Inward & domestic investment → AD left + LRAS left → Reduced SREG & LREG

• APP: UK pound during brexit voting & negotiations was very volatile → Led to high uncertainty for business planning so investment delays

Advantages of Fixed Exchange Rates

Gives certainty:

• Fixed ER → certainty of currency value → less speculation

• Increased stability for businesses → more confidence about planning → ↑Confidence for inward & domestic investment → AD and LRAS right

• APP: Hong Kong Dollar pegged to USD has helped attract FDI → became major financial hub

• IDO: Whether country can maintain enough forex reserves

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Stability forces businesses to keep costs down as cannot rely on appreciations to reduce costs

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Reduced currency hedging costs for firms

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Lower borrowing costs (lower bond yields) as don’t need to compensate for ER risk

Disadvantages of Fixed Exchange Rates

opposite of advantages for floating

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• Reduced freedom of monetary policy

• Increased need to hold large amounts of currency reserves - developing countries not able to hold sufficient amount

• Speculation that gov cannot maintain that ‘fix’ → large speculative flows → Forced revaluation

Currency Union (+example) =

An agreement between a group of countries to share a common currency, and usually have a single monetary & forex policy.

• e.g. Eurozone

Advantages of joining a Currency Union

Trade Creation:

• Sharing a currency eliminates ER fluctuation risks → Lowers uncertainty in trade

• +Reduced transaction costs as no need for currency conversion

• ↑Exports → ↑AD → ↑Emp → ↓U/E

• +Trade creation diagram - World supply shifts downwards → Price falls

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Access to fiscal transfers:

• If in financial difficulties w/ high national debt, can get cheaper loans or emergency grants from other member countries

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Increased Investment:

• Less uncertainty → Firms can predict cost of imported raw materials so can adequately plan price of exports → ↑Business confidence → ↑Investment → ↑AD + ↑LRAS

Disadvantages of joining a Currency Union

Loss of independent monetary policy:

• Share a single monetary policy with currency union, so individual countries cannot use monetary policy to achieve their own macroeconomic objectives

• → Risk of Asymmetric shocks - Countries have different needs - currency union cannot adjust IR just for one country’s needs because it affects all the other countries in the union too

• If an economic shock affects one country more than others, can be difficult to manage the risk.

• APP: Greece sovereign debt crisis - Greece couldn’t reduce IR to support falling GDP and high u/e

• IDO: How aligned the economic cycles of the countries are - If economic shocks affect all countries together, then currency union is able to change IR in response

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Loss of exchange rate as a policy tool:

• Cannot devalue currency to improve competitiveness & fix balance of payments deficits

• IDO: How aligned the economic cycles of the countries are - If economic shocks affect all countries together, then currency union is able to change IR in response

Factors affecting whether a Currency Union is Optimal

• Flexbility/mobility of labour market (language barriers, flexibility of employment contracts, flexibility of wages)

• Whether member nations are willing to make fiscal transfers between each other to help members experiencing difficult times

• Alignment of economic cycles of the countries - whether economic shocks impact countries in a similar way

• Amount of trade done with each other