Transcript Exchange Rate Systems

Exchange Rate Systems
A2 Economics
What are exchange rates?
The rate at which one currency can be
converted (bought or sold) into another
currency is known as the exchange rate.
 Normally expressed in the terms of one single currency
against another.
Exchange rate systems
Freely floating exchange rate
= a system whereby the price of one currency is
determined by the forces of supply and demand
Fixed exchange rate
= an exchange rate system in which the value of one
currency has a fixed value against another countries
Semi-fixed exchange rate
= an exchange rate system that allows a currency’s value
to fluctuate within a permitted band of fluctuation.
Freely floating exchange rate
 The value of the pound is determined purely by market
demand and supply of the currency
 Both trade flows and capital flows affect the exchange
rate under a floating system
 No target for the exchange rate is set by the Government
 There is no need for official intervention in the currency
market by the central bank
Sterling has floated freely on the
foreign exchange markets since
the UK suspended membership
of the ERM in September 1992
Demand and Supply
 There are 3 main reasons why foreign
exchange is bought and sold:
1. International trade
2. Short-term capital flows
3. Long-term capital movements
Demand and supply of Dollars
Price of
$ in £’s
S of $ (US)
50p
D for$ (UK)
0
D & S of $
Price of the $ is 50p - $1 will exchange for 50p
$1 spent in the US will purchase 50p's worth of UK exports
50p, spent in the UK will buy $1's worth of US imports
Increased demand for $’s
Price of
$ in £’s
S of $ (US)
1
50p
D1
D for$ (UK)
0
D & S of $
Demand for the $ ↑ - D - D1 - price of the $ ↑ from 50p to £1
$ is now worth more, it has appreciated in relation to the £
£ has depreciated - worth less in terms of the $
Changes the prices of imports and exports:
Now $1 will buy £1 of UK exports – previously it only purchased 50p
Price of UK goods in the US has fallen
When a currency appreciates exports ↑increase in price, imports ↓ in price
When a currency depreciates exports ↓decrease in price, imports ↑ in price
Advantages of a freely floating
system
 Reduced need for currency reserves
 Freedom for domestic monetary policy
 Useful instrument for macroeconomic
adjustment – controlling AD and inflation
 Partial automatic correction of a trade deficit
Disadvantages
Uncertainty
Lack of investment
The floating exchange rate can be
inflationary if price stability not prioritised.
Does a floating rate automatically remedy
a trade deficit?
Evaluation
The extent to which a floating system is
advantageous for a country depends upon
the price elasticity of imports and exports.
Marshall-Lerner Condition – BoP will only
improve if imports/exports are price
responsive.
Fixed exchange rate
 The government makes a commitment to a fixed
exchange rate
 The exchange rate is pegged against another
currency
 There are no fluctuations from the central rate
 System achieves exchange rate stability through
the buying selling of its own currency and
changes in interest rates.
 However this may be at the expense of domestic
stability
Advantages of a fixed exchange rate
Encourages trade and investment as less
risk of fluctuations
Reduces the need for hedging and so the
cost of international trade
Disciplines on domestic producers
Disadvantages
Large holdings of foreign exchange
reserves needed
Loss of freedom in your internal policy
International retaliation
Semi-fixed/semi-floating exchange
rates
 The exchange rate is given a specific target
 The currency can move between permitted
bands of fluctuation on a day-to-day basis
 Exchange rate becomes an target of economic
policy-making (interest rates are set to meet the
exchange rate target)
 The Bank of England might have to intervene to
maintain the value of the currency within the set
targets if it moves outside the agreed range
 Re-valuations are seen as a last resort
Examples of semi-fixed systems
Adjustable peg systems – short term: currencies
are fixed and do not change in value, long term: the
value of the currency can change if economic
circumstances dictate.
Crawling peg systems – exchange rate is fixed
however mechanism allows the band to rise and fall
regularly over time.
Exchange rate band systems – exchange rate
floats freely within a permitted band of fluctuation.
Causes of fluctuations
Consequences of fluctuations