T4 - Exchange Rates

THE PRICE OF ONE CURRENCY IN ANOTHER CURRENCY

FLOATING EXHANGE RATE CHANGES:

Determined via the forces of demand and supply - there is a market for a currency

Appriciation - an increase in the exchange rate

Depreciation - decrease in the exchange rate

Demand for £ increased - high price formed - pound has got stronger - pound can buy more of another currency

Demand for the pound may appriciate becuase:

• Increase in relative (to the rest of the world) interest rates

• Speculators anticipate a rise in the £ - people move their money to £

• Increase in FDI

• Rise in incomes abroad - foreigners may demand more UK exports

• Increase in international competitiveness - may increase D for UK exports

Demand for pound may depreciate - people want to swap their £ for different currency

Demand for pound may decrease because: INCREASE IN SUPPLY OF £

• Fall in relative interest rates - investors moving money to get better returns

• Speculators anticipate fall in £

• Firms moving away from UK

• Increase in incomes domestically - higher demand for imports

Why is a floating exhange rate good?

• Natural market forces determine currency value - helps correct CA deficits

• Less risk of currency being incorrectly over/undervalued

• Reduced need for central bank to hold currency reserves

Impacts of chanes in floating floating ER

• Impact on trade balance - J curve/Marshall-Lerener

• Inflation

• Economic growth

• Unemployment

• FDI

MARSHALL-LERNER CONDITION

States devaluation/depriciation only improves the current account if the combined elasticities of demand for exports and imports are greater than 1. If they are less than 1, depreciation/devaluation worsens the CA balance

J CURVE EFFECT - SR vs LR

Effect of depreciation on trade difict depends on price of PED for exports and imports. J-curve effect says in the SR export volumes will remain constant and import spending will rise - worsening CA. Only in the LR will the CA start to improve

Fixed Exchange Rates

Government/central bank needs to hold large amount of domestic and foreign currency reserves

REVALUATION - fixes new higher exchange rate

DEVALUATION - fixes new lower exhange rate

If the pound is underpressure and needs to fall in value, then increase the supply of it - sell £ currency reserves

If the pound is under falling pressure and needs to rise, use foreign currency to buy up the £ - increasing demand for £

EXHANGE RATE CHANGES AND THEIR IMPACTS

If currency APPRICIATES - SPICEE (Strong currency, imports cheap, exports expensive)

more issues that benefits

• Lower growth - potential current account deficit

• Higher unemployment in exporting industries as exports are more expensive

• Higher unemployment in domestic industries

• Lower inflation - demand-pull and cost-push

• Cheaper imports - increase living standards

• Potential efficiency gains for domestic producers

If a currency DEPRECIATES - WIDEC (weak currency imports dear exports cheaper)

Should increase AD - increase in growth in the economy

• Higher employment in exporting industries - increase in demand for industries, need to produce more

• Higher employment in domestic industries generally

• Higher inflation - demand-push and cost-pull

MANAGED FLOATING EXCHANGE RATES: systems that combine the characteristics of fixed and floating exhange rate systems, where currency floats but the govt will intervene in foreign exchange markets

HOW CAN GOVT INTERVENE

1. Foreign Currency Transactions - open-market operations, involves buying and selling currency using foreign currency reserves held by the govt

2. Interest Rate Changes - influence demand from foreign investors for better returns, placing money in eg UK bank to get better IR, Hot money flows