EXCHANGE RATE –

EXCHANGE RATES
 The rate of exchange is the price of one currency in terms of another

 Rate of exchange is determined by demand and supply

How the value of currency may rise:

 More demand abroad for home produced goods

 More payment received from abroad for home produced goods

 Supply of foreign currency increases

 Demand for your currency increases

How the value of currency may fall:

 Local demand for foreign goods increases

 More money paid for foreign goods

 Supply of home currency increases

 Demand for foreign currency increases

Reasons for Demand of Currency

 To pay for imports

 To save money in foreign financial institutions

 To invest in foreign firms

Exchange Rate & Prices

 When the currency of a country depreciates, the overseas prices of its exports fall and the

home price of its imports rise

 When the currency of a country appreciates, the overseas prices of its exports rises and the

home price of its imports falls

Reasons for Currency Fluctuations

 Changes in balance of payments on current account (X-M)

 Inflation

 Interest rates

 Price of Oil

 Speculation
How Exchange Rates are Set

 Floating Exchange Rate: determined freely by the forces of demand and supply without

government intervention

 Fixed Exchange Rate: governments intervening in exchange markets by buying and selling

their reserves to fix their own currency’s value so that:

1. Depreciation of currency doesn’t lead to inflation

2. Appreciation of currency doesn’t cause exporting firms to close down

3. The uncertainty caused by floating exchange rates does not cause traders to trade less

 Devaluation: government abandoning the existing fixed exchange rate and adopting a lower

one to make exports cheaper and imports dearer

 Revaluation: government abandoning the existing fixed exchange rate and adopting a higher

one to make exports dearer and imports cheaper

 Dirty Floating: the rate of currency is allowed to move slightly but with government

intervention (managed flexibility)

Factors which influence the exchange rate

An exchange rate is determined by supply and demand factors. These are the various factors
which determine the demand and supply of a currency.
1. Inflation
If inflation in the UK is lower than elsewhere, then UK exports will become more competitive and
there will be an increase in demand for £s. Also foreign goods will be less competitive and
so UK citizens will supply less £s to buy foreign goods.
Therefore the rate of £ will tend to increase.
2. Interest Rates
If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in
the UK, Therefore demand for Sterling will rise. This is known as “hot money flows” and is an
important short run determinant of the value of a currency.
3. Speculation
If speculators believe the sterling will rise in the future, they will demand more now to be able to
make a profit. This increase in demand will cause the value to rise.
Therefore movements in the exchange rate do not always reflect economic fundamentals, but
are often driven by the sentiments of the financial markets.
For example, if markets see news which makes an interest rate increase more likely, the value
of the Pound will probably rise in anticipation.
4. Change in competitiveness
If British goods become more attractive and competitive this will also cause the value of the
Exchange Rate to rise. This is important for determining the long run value of the Pound.
5. Relative strength of other currencies
Between 1999 and 2001 the £ appreciated because the Euro was seen as a weak currency.
 6. Balance of Payments
A large deficit on the current account means that the value of imports is greater than the value
of exports. If this is financed by a suplus on the financial / capital account then this is OK. But a
country who struggles to attract enough capital inflows will see a depreciation in the currency.
(For example current account deficit in US of 7% of GDP was one reason for depreciation of
dollar in 2006-07)

Economic Effects of an Appreciation

An appreciation means an increase in the value of a currency. It means a currency is worth more
in terms of foreign currency.
e.g. If £1 = €1 An appreciation of Pound could mean £1 =€1.2
Effects of an Appreciation
 Exports more expensive, therefore less UK exports will be demanded
 Imports are cheaper, therefore more imports will be bought.
 A fall in AD, causing lower growth.
 Lower inflation because:
 import prices are cheaper
 Lower AD and less demand pull inflation
 More incentives to cut costs

Economic Effect of a Devaluation of the Currency

A devaluation occurs in a fixed exchange rate. A depreciation occurs in a floating exchange rate
system. Both mean a fall in the value of the currency.
Economic Revision Notes on Devaluation
1. A devaluation of the exchange rate will make exports more competitive and appear cheaper
to foreigners. This will increase demand for exports
2. A devaluation means imports will become more expensive. This will reduce demand for
imports.
3. Higher economic growth. Part of AD is X-M Therefore higher exports and lower imports will
increase AD. Higher AD is likely to cause higher Real GDP and inflation.
4. Inflation is likely to occur because:
 i) Imports are more expensive causing cost push inflation.
 ii) AD is increasing causing demand pull inflation
 iii) With exports becoming cheaper manufacturers may have less incentive to cut
costs and become more efficient. Therefore over time costs may increase.
Evaluation:
The effect on inflation will depend on other factors such as:
 iv) Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to cause
inflation
 v) Do firms pass increased import costs onto consumers? Firms may reduce their profit
margins, at least in the short run.
 vi) Import prices are not the only determinant of inflation. Other factors affecting inflation such
as wage increases may be important
5. There is likely to be an improvement in the current account balance of payments.
This is because exports are increasing and imports are falling
 Government Intervention in the Foreign Exchange
market
Under certain circumstances, the government might want to intervene in the foreign exchange
markets to influence the level of the exchange rate.
Methods to Influence the Exchange Rate
1. Reserves and Borrowing. If the value of an exchange rate is falling and the government
wants to maintain its original value it can use its foreign exchange reserves - e.g. selling its
dollars reserves and purchase pounds. This purchase of Pound sterling should increase its
value.
2. Borrow The government can also borrow foreign currency from abroad to be able to buy
sterling.
3. Changing interest rates (In UK this is now done by the MPC) higher interest rates will cause hot
money flows and increase demand for sterling. Higher interest rates make it relatively more
attractive to save in the UK.
4. Reduce Inflation
 Through either tight fiscal or Monetary policy Aggregate Demand and hence inflation can be
reduced.
 By decreasing AD consumers will spend less and purchase less imports and so will supply less
pounds. This will increase the value of the ER
 Lower inflation rate will also help because British goods will become more competitive. Thus the
demand for Sterling will rise.

However this policy has an obvious side effect because lower AD will cause lower growth and
higher unemployment
5. Supply side measure to increase the competitiveness of the economy. This will take along
time to have an effect.

Fixed Exchange Rates

Definition of a Fixed Exchange Rate: This occurs when the government seeks to keep the
value of a currency fixed against another currency. e.g. the value of the Pound is fixed at £1 =
€1.1
Semi Fixed Exchange Rate. This occurs when the government seeks to keep the value of a
currency between a band of exchange rate. In other words, the exchange rate can fluctuate
within a narrow band.
E.g. the Pound Sterling could fluctuate between a target exchange rate of £1 = €1.1 and £1 =
€1.2
Definition of a Floating Exchange Rate: this is when the govt does not intervene in the foreign
exchange market but allowss market forces to determine the level of a currency.
· Exchange Rate Mechanism ERM. This was a semi fixed exchange rate where EU countries
sought to keep their currencies fixed within certain bands against the D-Mark. The ERM was the
forerunner of the Euro
Advantages of Fixed Exchange Rate
1. If the value of currencies fluctuate significantly this can cause problems for firms engaged in
Trade.
 For example if a firm is exporting to the US, a rapid appreciation in sterling would make its
exports uncompetitive and therefore may go out of business.
 If a firm relied on imported raw materials a devaluation would increase the costs of imports and
would reduce profitability
2. The uncertainty of exchange rate fluctuations can therefore reduce the incentive for firms to
invest in export capacity. Some Japanese firms have said that the UK's reluctance to join the
Euro and provide a stable exchange rates maker the UK a less desirable place to invest.
3. Governments who allow their exchange rate to devalue may cause inflationary pressures to
occur. This is because AD increases, import prices increase and firms have less incentive to cut
costs.
4. A rapid appreciation in the exchange rate will badly effect manufacturing firms who export,
this may also cause a worsening of the current account.
5. Joining a fixed exchange rate may cause inflationary expectations to be lower

Disadvantage of Fixed Exchange Rates

1. To maintain a fixed level of the exchange rate may conflict with other macroeconomic
objectives.
· If a currency is falling below its band the govt will have to intervene. It can do this by buying
sterling but this is only a short term measure.
· The most effective way to increase the value of a currency is to raise interest rates. This will
increase hot money flows and also reduce inflationary pressures.
· However higher interest rates will cause lower AD and economic growth, if the economy is
growing slowly this may cause a recession and rising unemployment
2. It is difficult to respond to temporary shocks. For example an oil importer may face a balance
of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to
devalue

The advantages of a fixed exchange rate system

Stability
Some economists would argue that this is the most significant advantage. If exchange rates are stable over a given period of time,
exporting firms will be able to plan ahead without worrying about huge swings in the value of the pound eliminating their profit
margin. This will encourage more investment and trade between countries, both of which are important if economies are to grow in
the long term.
Discipline
If a country is part of an exchange rate system, they cannot devalue their currency at the first sign of trouble (i.e. a large current
account deficit). They have to try and cure the fundamental problem by, for example, improving the competitiveness of their
exporters through increased productivity and improved quality.
One can also argue that fixed exchange rate systems discipline countries into keeping inflation down. Again, there is no option to
devalue if increasing inflation leads to reduced competitiveness.
Avoid speculation?
Theoretically, fixed exchange rates should eliminate speculation because there is no point buying and selling currencies that will not
change in value. In the real world, this is not always the case.
Speculators believed the politicians when they said that these rates were forever, and so did not see the point in buying or selling
the currencies involved.
The disadvantages of a fixed exchange rate system
The loss of monetary policy
A commitment to a fixed exchange rate means that you lose control over all other instruments of monetary policy. Although the
government pretended that UK interest rate decisions we still their own (and technically they were) any movement of the German
interest rate was usually quickly followed by a similar change in the UK. Today the Monetary Policy Committee (MPC) can set
interest rates at whatever level they want, but they cannot control the value of the pound at the same time. Controlling one of these
two instruments means a loss of control of the other.
The need for a large pool of reserves
To maintain the pound's value within the ERM, the government had to have a large pool of foreign reserves with which to buy the
pound when it fell to the floor of the bottom band. Apart from being expensive in itself, some countries may find it hard to get their
hands on sufficient stocks of reserves to support their currency. One of the main jobs of the IMF in the Bretton Woods system was
to help poor countries in times of trouble and lend them reserves when they were short.
Problems of uncompetitiveness
With a freely floating currency, a deteriorating trade situation should automatically cause the pound to fall (speculators permitting!),
which, in turn, would improve the competitiveness of British exporters and improve the trade balance.
Economies stuck in a fixed exchange rate system with a deteriorating trade balance may feel that they joined the system at too high
an exchange rate. Although they may be allowed to devalue eventually, the exchange rate may be at the wrong rate for significant
periods of time. This can cause permanent job losses and recession. Some economists feel that the recession of 1990-92 in the UK
was prolonged due to membership of the ERM.

Advantages of a floating exchange rate system

Theoretical elimination of trade imbalances
As we have stated before, floating exchange rates should adjust automatically to trade imbalances, which, in turn, will eliminate the
trade imbalance. Of course, it has also been noted that this does not always work in the real world because so few currency
transactions that take place are for trade.
No need for reserves?
On the whole, foreign reserves are used to help maintain a currency's position within a fixed exchange rate. If a currency is freely
floating, then there is no need to use reserves to affect its value. In the real world, governments will always have some reserves, in
case of a crisis in the balance of payments, or if they feel that their currency is getting a bit too high or too low.
More freedom over domestic policy
As was stated above, if the government is not controlling their exchange rate, then they can control their rate of interest. The
evidence of the past five years suggests that, although exporters suffer with a strong pound, the economy as a whole is best served
when the authorities can control domestic monetary policy.
The disadvantages of a floating exchange rate system
Speculation
Again, there are two ways of looking at this. You could argue that with floating exchange rates, speculation is less likely because an
exchange rate can move freely up or down, so it is more likely to be at its true level. But the very fact that it does move up and down
easily means it can move a long way if speculators think that it is at the wrong level. The quick rise in the value of the pound in the
second half of 1996 showed that big swings in currencies do not just happen when speculators force them out of fixed exchange
rate systems.
Uncertainty
The biggest advantage of fixed exchange rate systems was their stability and certainty. This tended to increase investment and
trade, both good things. The biggest disadvantage of floating exchange rate systems is their uncertainty, reducing the rate at which
investment and trade increase. Firms often use the currency markets to hedge against large fluctuations in the exchange rate, which
helps to a certain extent, but there is still felt to be too much uncertainty.