IB Economics - Exchange Rates

floating exchange rates

when a currency's value against other currencies is determined solely by the market demand for and supply of it in the other countries' forex market. Neither governments nor central banks make any effort to manipulate the value of the currency

managed exchange rates

when a currency's value against one or more other currencies is allowed to fluctuate between a certain range by the country's government or central bank. If the exchange rate gets below a certain level or above a certain level, then the government or central bank will intervene to bring it back within the desired range.

the exchange rate

the value of one currency expressed in terms of another currency

appreciation

when one currency gets stronger relative to another (its exchange rate increases)

depreciation

when one currency gets weaker relative to another (its exchange rate deceases)

Forex market

the market for currency

supply of currency

the quantity at a range of prices at which individuals or organizations are willing to sell currency

demand of currency

the quantity at a range of prices at which individuals or organizations are willing to buy currency

quantity demanded equation

Q(d) = a - bx
where a and b are constants and x is the exchange rate

quantity supplied equation

Q(s) = a + bx
where a and b are constants and x is the exchange rate

fixed exchange rates

when a currency's value against one or more other currencies is set by the government or central bank in order to promote particular macroeconomic objectives. Exchange rate fixing requires governments or central banks to intervene in the forex market to manipulate the demand for or supply of the currency

determinants of floating exchange rates

1. taste and preferences
2. relative interest rates
3. relative price levels (inflation)
4. speculation
5. relative incomes

results of appreciation

1. inflation rates lower
2. growth slows
3. unemployment likely to rise
4. balance of payments have more deficit

results of depreciation

1. inflation rates go up
2. growth increases
3. unemployment falls
4. balance of payments move towards surplus

ways of managing the forex market

1. interest rates
2. currency reserves
3. exchange controls

advantages of floating exchange rates

1. monetary policy freedom
2. automatic adjustment
3. no need for foreign reserves

advantages of fixed / managed exchange rates

1. reduced risk of speculation
2. inflation control
3. competitive trade advantage
4. investor confidence