Exchange Rates
Floating, Calculating, Fixed, Managed
Text Reference: 392-399
Foreign Exchange
- International transactions involve the use of different national currencies,
known as foreign exchange.
- National currencies are traded for each other in the foreign exchange market.
If you travel from Canada to Britain you need to exchange your CAD for GBP
- You sell your CAD and buy GBP in the foreign exchange market
Foreign Exchange
Foreign exchange market is made up of demand and supply of currencies
In the previous example you demand GBP and supply CAD to the market.
Likewise, British consumers import goods from Canada they buy CAD to pay
Canadian exporters - thereby demanding CAD in the foreign exchange market.
To get those CAD British consumers sell or supply their GBP to get the CAD they
need.
Exchange Rates
- This is the mechanism that establishes the ‘value’ of each currency in the foreign
exchange market.
- Exchange rates express the value of one currency in terms of another. Eg
1 pound = 1.5 USD
0.67 pound =1 USD
Determining exchange rates occurs in two ‘pure’ ways
Floating exchange rate system
Fixed exchange rate system
Most countries ultimately use a managed (float) exchange rate system
Floating
Exchange
Rates 1
-
Floating
Exchange
Rates 2
Exchange Rate changes: Appreciation
Exchange Rate changes: Depreciation
Causes of changes
in Exchange Rates
Fixed Exchange Rates
- Exchange rate is fixed by the government or central bank at a particular level
(or narrow range) and not permitted to change in response to supply and
demand.
- Demand and supply of the currency are manipulated to arrive at the desired
equilibrium exchange rate.
- Requires constant intervention in the form of buying and selling reserve
currencies.
Fixed Exchange Rates - Shifting Demand
A = Fixed Exchange Rate
$2 USD = ￡1 GBP
① Falling demand for British
exports causes shift in
demand for GBP. Floating
value declines to $1.50
②Central Bank buys surplus
to restore demand to
equilibrium
Fixed Exchange Rates - Shifting Supply
A = Fixed Exchange Rate
$2 USD = ￡1 GBP
① Falling demand for
British exports causes shift
in demand for GBP. Floating
value declines to $1.50
②Government intervenes to
restrict imports thereby
reducing supply and
returning to fixed rate.
Interventions to maintain fixed exchange rates
Using official reserves to maintain exchange rates
- Buying excess supply by selling foreign currency reserves
- Reducing excess demand by buying dollars.
Increases in interest rates
- Attract investment from abroad
Efforts to limit imports
- Reduces supply of domestic currency in foreign exchange market
Devaluation and Revaluation
- If currency value is higher than what can be maintained through government
intervention the government may change it to a new, lower value -
Devaluation
Makes exports cheaper and imports more expensive
- If currency value is lower than what can be maintained it may be changed to a
new, higher value - Revaluation
Makes exports more expensive and imports cheaper
Fixed Exchange Rates
Historically, fixed exchange rates used until 1973.
1879 -1934 exchange rates were fixed relative to the value of gold - gold standard
1944-1973 Bretton Woods system removed ties to gold standard and allowed for
periodic devaluations and revaluations.
Today, pegged exchange rates are the closest to fixed - currency is fixed against
another currency - eg. pegged to the USD
Pegged Currency
Allows fluctuation within a narrow range.
Central bank intervenes when currency reaches upper or lower limit.
Stabilizes exchange rate relative to currency to which it is pegged and supports
trade flows.
Pegging to US dollar is relatively common.
Pegged Currency
Shifting of demand to limits D₂ or
D₃ triggers Central Bank to buy
or sell currency reserves to bring
Exchange Rate back towards D₁
Consequences of over or undervalued currency
Overvalued - value is too high relative to equilibrium in a free market (floating)
- Imports become cheaper - developing countries may seek to import capital
goods to drive industrialization
- Exports become more expensive - harms exporters
- Can lead to current account deficit as imports exceed exports
Undervalued - value is too low relative to equilibrium in a free market (floating)
Consequences of over or undervalued currency
Undervalued - value is too low relative to equilibrium in a free market (floating)
- Exports cheaper to foreign buyers
- Imports more expensive to domestic consumers
Sometimes used to expand exports industries, economies and grow employment.
Seen to be an unfair way to gain a competitive advantage compared to countries
that do not undervalue their currencies - which subsequently suffer increased
imports and decreased exports.
Calculations using exchange rates