Exchange Rates and Systems Notation

Exchange Rate Systems Overview

  • There are three types of exchange rate systems:

    • Floating Exchange Rates: Rates fluctuate based on supply and demand.

    • Fixed Exchange Rates: Set by the central bank and require government intervention.

    • Managed Exchange Rates: Mostly free to float, but governments intervene occasionally to stabilize.

Fixed Exchange Rate System

  • Defined as a system where exchange rates are set by the central bank and do not vary with supply and demand.

  • Government intervention is constant:

    • Selling currency to address upward pressure (excess demand).

    • Buying currency to address downward pressure (excess supply).

Countries with Fixed Exchange Rates (2017)

  • Key currencies that anchor fixed exchange rates include:

    • US dollar

    • Euro

    • South African rand

    • Indian rupee

    • Composite currencies.

Mechanism of Fixed Exchange Rates

  • Excess Demand:

    • Causes upward pressure, leading the government to sell currency.

  • Excess Supply:

    • Causes downward pressure, leading the government to buy currency.

  • Caution: Prolonged downward pressure can deplete central bank reserves, risking inability to control the currency.

Strategies to Address Downward Pressure on Currency

  • Increasing Interest Rates: Slows economic growth but encourages foreign investment.

  • Borrowing from Abroad: Increases national debt.

  • Limiting Imports: Promotes local goods but may result in welfare loss; can include tariffs and quotas.

  • Implementing Exchange Controls: Prevents currency outflow, potentially leading to welfare loss.

Currency Demand and Supply Shifts Example

  1. Demand Shift:

    • A fall in demand for exports decreases the demand for currency.

    • Central bank could buy excess currency, increasing its demand.

  2. Supply Shift:

    • Reduced imports lead to decreased supply of domestic currency in the market.

Diagram Explanation for Partner Work

  • Partner 1: Draws a diagram to show depreciation (currency value falls).

  • Partner 2: Draws a diagram for government intervention to counter depreciation.

  • Examples:

    • China: RMB is fixed to $; responds to increased tourism by selling Yuan.

    • Brazil: $ is fixed to R$; responds to investments by raising interest rates.

Devaluation and Revaluation Terminology

  • Devaluation: Deliberately lowering a fixed exchange rate.

  • Revaluation: Raising a fixed exchange rate.

Overvalued and Undervalued Currencies

  • Overvalued Currency: Value exceeds that determined by supply and demand; can hinder exports but makes imports cheaper.

  • Undervalued Currency: Value below market level; aids export growth but makes imports expensive; viewed as an unfair trading advantage.

Managed Exchange Rate System

  • Exchange rates float freely but are occasionally stabilized by government intervention.

  • Aim: Prevent rapid fluctuations in currency value.

Exchange Rate Calculations

  • Formula for converting prices between currencies:
    extPriceinothercurrency=extPriceimes(1/Y)ext{Price in other currency} = ext{Price} imes (1/Y) where Y is the exchange rate.

Example of Price Conversion

  • If the exchange rate is 16 pesos: 1 dollar and an item's price is 400 pesos:
    400imes(1/16)=25400 imes (1/16) = 25

  • Thus, the item costs $25.

Economic Data for Bangladesh (Table Comparison)

  • 2010 Stats:

    • GNI per capita: $844

    • Population: 147.6 million

    • Exports: $18.5 billion

  • 2019 Stats:

    • GNI per capita: $1348

    • Population: 163 million

    • Exports: $46.4 billion

  • Shirt Calculation:

    • 2010: Price = BDT400 = $5.75

    • 2019 Exchange Rate: 64.9 BDT/$

    • Price in 2019 = 400imes(1/64.9)<br>ightarrow6.16400 imes (1/64.9) <br>ightarrow 6.16

    • Conclusion: The Bangladeshi exchange rate depreciated from 2010 to 2019 due to an increase in BDT needed per $1.