15.1 - Exchange rate systems

What are exchange rates?

The external price of a currency measures against another currency

What are the two different types of exchange rate systems?

Floating and Fixed

Floating exchange rate system shown on a diagram?

(PMT)

In a floating exchange rate system, the market equilibrium price is at P1. When demand increases from D1 to D2, the exchange rate appreciates to P2.

The demand for a currency is equal to exports plus capital inflows. The supply of a currency is equal to imports plus capital outflows.

What are the advantages of floating exchange rate systems?

- Automatically adjusts to economic shocks

- Gives the monetary policy more freedom to focus on other macroeconomic objectives

- Improves resource allocation

-Freedom to achieve domestic policy objectives

- Easier to control inflation

- Ability to pursue an independent monetary policy

How do floating exchange rates improve resource allocation?

For efficient resource allocation in a constantly changing world, market prices must accurately reflect shifts in demand and change in competitive and comparative advantage that result from technical progress. In principle, a floating exchange rate should respond and adjust to these changes.

How do floating exchange rates give the freedom to achieve domestic policy objectives?

It is sometimes argued that when the exchange rate is freely floating, balance of payments surpluses and deficits cease to be a policy problem for the government, as it is then free to pursue the domestic economic objectives of full employment and growth. Market forces 'look after' the current account of the balance of payments, leaving governments. free to concentrate on domestic economic policy.

How do floating exchange rates make it easier to control inflation?

A government should benefit from a floating exchange rate because the exchange rate insulates the country against 'importing inflation' from the rest of the world. A floating exchange rate appreciates, which lowers the prices of imports, insulating the economy against importing inflation.

How do floating exchange rates give the ability to pursue an independent monetary policy?

Monetary policy can used solely to achieve domestic policy objectives such as controlling inflation. This is called an independent monetary policy.

What are the disadvantages of floating exchange rates?

- It could make the exchange rate vulnerable to speculative shocks

- It can also affect the exports and imports of a country, which could cause a lot of unemployment if an industry is affected in particular

- The fluctuations in the price of the exchange rate can be unpredictable, which can make investment planning difficult

How may floating exchange rates cause costs push inflation?

- Trade competitiveness and balance of payments worsen, causing exchange rate to fall to restore competitiveness

- Falling exchange rate increases import prices, which raise the rate of domestic cost push inflation

- Workers react by demanding pay rises

- Increased inflation erodes the export competitiveness

- This triggers a further fall in exchange rate to recover the lost advantage

How many floating exchange rates cause demand pull inflation?

If a large number of countries with floating exchange rates simultaneously increase aggregate demand, this can lead to excessive demand on a worldwide scale, which fuels global inflation.

What are floating exchange rates?

The value of the exchange rate in a floating system is determined by the forces of supply and demand

What are fixed exchange rates?

An exchange rate fixed at a certain level by a country's central bank and maintained by the central bank's intervention in the foreign exchange market.

Fixed exchange rate on a diagram?

(PMT)

In a fixed exchange rate system, the supply of the currency can be manipulated by the central bank, which can buy or sell the currency to change to price to where they want. In the diagram, the supply has been increased from S1 to S2 by selling the currency so more is on the market from Q1 to Q3. The currency depreciated as a result from P2 to P3 which makes exports more expensive.

What are the advantages of a fixed exchange rate system?

- Allows for firms to plan investment, because they know that they will not be affected by harsh fluctuations in the exchange rate

- It gives the monetary policy a focused target to work towards

- Attempt to achieve certainty and stability in foreign exchange markets

What are the disadvantages of a fixed exchange rate?

- The bank does not necessarily know better than the bank where the currency should be

- The balance of payments does not automatically adjust to economic shocks

- It can be costly and difficult for the government to hold large reserves of foreign currency

- An independent monetary policy cannot be implemented

- Both overvaluation and undervaluation can lead to a misallocation of resources

What are managed exchange rates?

Systems that combine the characteristics of fixed and fully floating exchange rate systems

What do interest rates do for a currency?

An increase in interest rates, relative to other countries, makes it more attractive to invest funds in the country because the rate of return on investment is higher. This increases demand for tee currency, causing an appreciation. This is known as hot money

What does quantitative easing do for an economy?

This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective. This has inflationary effects since it increases the money supply and it can reduce the value of the currency. QE is usually used where inflation is low and it is not possible to lower interest rates further.

What is a currency union?

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

What is the importance of a common fiscal policy?

It allows wealth to be transferred by a centralised fiscal authority from the richer to the poorer parts of the union. Transfers of wealth are essential to counter the fact that the poorer parts of the union cannot achieve competitive advantage by devaluing their national currencies. Fiscal transfers can help to reduce inequality but can also be used to try to improve the competitiveness of the poorer regions

What can a lack of fiscal policy coordination lead to?

Can lead to some eurozone countries having high levels of government debt.

What are the advantages for a country joining a currency union?

- Participating countries have more currency stability, and the currency is less prone to speculative shocks. This gives future markets more certainty, so there is more investment and growth potential

- There are fewer admin fees and less red tape when travelling abroad or exchanging money

- This also benefits firms which trade with different member states. It is especially beneficial to small firms, who benefit from the time and money saving of a common currency

- The German monetary credibility might result in all member states having a lower interest rate. This might encourage more investment and spending, which might create more jobs

What are the disadvantages of joining a currency union?

- Labour mobility is limited across Europe due to language barriers.

- Differences in economic performance between member countries means a common monetary policy might not be effective

- The exchange rate is not flexible to meet each country's need, such as if they need a boost in exports

- Member nations lose sovereignty when there is a common monetary union. This means that countries with a strong economy have to cooperate with countries that have weaker economies

- The one off cost of joining a currency union of changing labels and prices can be significant