Key Terms
Exchange rate: The price of one currency in terms of another. It is determined by the demand and supply of currencies on the foreign exchange market (FOREX).
Exchange controls: Restrictions on the ability to trade foreign currencies by a country’s central bank.
Exchange controls: Restrictions on the ability to trade foreign currencies by a country’s central bank.
Theory
Types of Exchange Rate Systems
1) Freely floating exchange rate system (U.K, U.S, Germany and Sweden)
2) Fixed exchange rate system (Bulgarian Lev)
Factors Causing Exchange Rate Appreciation
1) Higher interest rates (relative to other countries)
Higher interest rates make deposits in the UK more attractive (“hot money flows”), this increases demand for pounds and causes an appreciation.
2) Low Inflation
Countries with lower inflation rates see exports increase thus demand for pounds increases and an appreciation in the value of their currency occurs.
3) Foreign direct investment (FDI)
If another country wishes to invest in the U.K. they must aquire pounds. This causes an increase in demand for pounds and therefore an appreciation of the pound.
4) Positive speculator expectations
If speculators believe the sterling will rise they demand more pounds to make profit in future, this increases demand for pounds and causes appreciation.
5) Rise in incomes abroad
If households in foreign countries become richer they will consumer more goods and services. Foreign consumption may leak into U.K. goods and servies thus increasing demand for £ to purchase british goods causing appreciation.
6) Increase in competitiveness
An increase in competitiveness could arise due to an increase in productivity which results in a better quality products. A better quality product will result in an increase in demand for U.K. goods. Pounds are demanded to aquire these goods, thus causing an appreciation of the pound.
Factors Causing Exchange Rate Depreciation
If domestic incomes increase, then households have a greater propensity to spend. Some of this spending leaks on imports. In order to purchase imports, households must sell pounds and buy foreign currencies. This increase the supply of pounds and causes depreciation.
Floating Exchange Rates System
Floating Exchange Rate System
Advantages of Floating Exchange Rates System
1) Automatic Adjustment
Floating ER automatically adjusts without need for government intervention. If M > X = Supply of £ > Demand for £ = Price of £ Depreciates = ER ↓
In theory a floating exchange rate will therefore never stay undervalued or overvalued for long.
2) Flexibility
Floating ER gives the government / or monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands.
3) Resource allocation
For the world's resources to be efficiently allocated between competing economies, the exchange rate must be valued correctly. According to theory a floating exchange rate should allow efficient resource allocation as the market price accurately reflects shifts in demand and changes in competitive and comparative advantage.
Floating ER automatically adjusts without need for government intervention. If M > X = Supply of £ > Demand for £ = Price of £ Depreciates = ER ↓
In theory a floating exchange rate will therefore never stay undervalued or overvalued for long.
2) Flexibility
Floating ER gives the government / or monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands.
3) Resource allocation
For the world's resources to be efficiently allocated between competing economies, the exchange rate must be valued correctly. According to theory a floating exchange rate should allow efficient resource allocation as the market price accurately reflects shifts in demand and changes in competitive and comparative advantage.
Disadvantages of Floating Exchange Rates System
1) Vulnerability
A floating exchange rate is vulnerable to de-stabilising speculative flows of ‘hot money. Market speculation undermines the ability for a floating currency to automatically adjust.
2) Uncertainty / Disruption to business planning
Uncertainty over the exchange rates will affect business planning. If businesses cannot properly monitor their spending, there will be a fall in businesses confidence. This will most likely result in a reduction in foreign investment.
3) Dual inflationary effects
In a floating exchange rate system the economy is vulnerable to dual infltionary effects. If a currency is weak, exports will increase, thus shifting out the aggregate demand curve causing demand-pull inflation.
A weak currency also makes imports more expensive, therefore firms that import raw materials from abroad will see an increase in production costs. Higher production costs will passed on to the consumer in the form of higher prices thus causing cost-push inflation.
A floating exchange rate is vulnerable to de-stabilising speculative flows of ‘hot money. Market speculation undermines the ability for a floating currency to automatically adjust.
2) Uncertainty / Disruption to business planning
Uncertainty over the exchange rates will affect business planning. If businesses cannot properly monitor their spending, there will be a fall in businesses confidence. This will most likely result in a reduction in foreign investment.
3) Dual inflationary effects
In a floating exchange rate system the economy is vulnerable to dual infltionary effects. If a currency is weak, exports will increase, thus shifting out the aggregate demand curve causing demand-pull inflation.
A weak currency also makes imports more expensive, therefore firms that import raw materials from abroad will see an increase in production costs. Higher production costs will passed on to the consumer in the form of higher prices thus causing cost-push inflation.
Fixed Exchange Rates System
Fixed Exchange Rate System
Advantages of Fixed Exchange Rates System
1) Stability
In a fixed exchange rate system exporting firms prices are more stable, as are importing firms costs. This is the main reason the Chinese Yuan was fixed against the US Dollar for nearly 20 years, creating a very stable framework for Chinese manufacturing.
2) Confidence / Investment (Domestic + Foreign)
Fixed prices mean that firms can plan their spending and are likely to invest more. Confidence is necessary for investment. This leads to an increase in productivity on a national-scale and causes an increase in the productivity capacity of the economy.
The stability associated with a fixed exchange rate may encourage mutli-national firms to locate to fixed ER countries thus increasing FDI.
3) Discipline
Policy makers cannot easily devalue the currency in an attempt to hide inflation or a balance of payments deficit. "There is clearly the idea beginning to circulate that (floating) currencies can be used as a policy weapon”, Strauss-Kahn (IMF).
Fixed ER is therefore a good measure of how successfully the government is pursuing macro-economic objectives.
4) Reduced destabilising speculation
The incentive to speculate with a fixed currency is very small due to lack of potential profit on the FOREX.
In a fixed exchange rate system exporting firms prices are more stable, as are importing firms costs. This is the main reason the Chinese Yuan was fixed against the US Dollar for nearly 20 years, creating a very stable framework for Chinese manufacturing.
2) Confidence / Investment (Domestic + Foreign)
Fixed prices mean that firms can plan their spending and are likely to invest more. Confidence is necessary for investment. This leads to an increase in productivity on a national-scale and causes an increase in the productivity capacity of the economy.
The stability associated with a fixed exchange rate may encourage mutli-national firms to locate to fixed ER countries thus increasing FDI.
3) Discipline
Policy makers cannot easily devalue the currency in an attempt to hide inflation or a balance of payments deficit. "There is clearly the idea beginning to circulate that (floating) currencies can be used as a policy weapon”, Strauss-Kahn (IMF).
Fixed ER is therefore a good measure of how successfully the government is pursuing macro-economic objectives.
4) Reduced destabilising speculation
The incentive to speculate with a fixed currency is very small due to lack of potential profit on the FOREX.
Disadvantages of Fixed Exchange Rates System
1) Stability / confidence likely to collapse in the long run
Economies do not grow in line with each other, so fixing one currency against another is difficult. Occasionally economies will be forced to revalue the exchange rate. China is recent country to have revaluated its currency, pegging to a basket of world currencies rather than the us dollar.
Once revaluation takes place, stability and confidence collapses under uncertainty resulting in less investment and spending.
2) Loss of Monetary Policy
In Fixed ER the interest rate often needs to be used in order to stay in line with the target or within the ceiling / floor. Therefore interest rates can no longer be used to achieve other domestic objectives.
Russia recently had this problem. The Russian Ruble had depreciated greatly due to political uncertainty after the ‘invasion’ of Crimea. As a result they raised interest rates to 7% thus hurting all forms of lending to businesses and homeowners.
3) Large holdings of foreign exchange reserves required
Fixed exchange rates require a government to hold large scale reserves of foreign currency to maintain the fixed rate. Such reserves have an opportunity cost, they could be used more efficiently elsewhere.
4) Speculator Attacks
Speculators may attack fixed ER (if they consider it unrealistic) E.g. The sterling was forced out of the ERM in 1992 when it became clear that Sterling’s fixed rate was too high.
Chancellor Norman Lamont raised interest rates from 10% to 12%, then to 15%,and authorised the spending of billions of pounds to buy up the sterling being frantically sold on the currency markets.
Economies do not grow in line with each other, so fixing one currency against another is difficult. Occasionally economies will be forced to revalue the exchange rate. China is recent country to have revaluated its currency, pegging to a basket of world currencies rather than the us dollar.
Once revaluation takes place, stability and confidence collapses under uncertainty resulting in less investment and spending.
2) Loss of Monetary Policy
In Fixed ER the interest rate often needs to be used in order to stay in line with the target or within the ceiling / floor. Therefore interest rates can no longer be used to achieve other domestic objectives.
Russia recently had this problem. The Russian Ruble had depreciated greatly due to political uncertainty after the ‘invasion’ of Crimea. As a result they raised interest rates to 7% thus hurting all forms of lending to businesses and homeowners.
3) Large holdings of foreign exchange reserves required
Fixed exchange rates require a government to hold large scale reserves of foreign currency to maintain the fixed rate. Such reserves have an opportunity cost, they could be used more efficiently elsewhere.
4) Speculator Attacks
Speculators may attack fixed ER (if they consider it unrealistic) E.g. The sterling was forced out of the ERM in 1992 when it became clear that Sterling’s fixed rate was too high.
Chancellor Norman Lamont raised interest rates from 10% to 12%, then to 15%,and authorised the spending of billions of pounds to buy up the sterling being frantically sold on the currency markets.