Exchange Rates

• Exchange rate is the external price of a currency, usually measured against another currency
• Spot rate is the value of one currency against another at any given point in time
• Index rate uses index numbers to measure the relative changes in the value of one currency against a group of other currencies over time
• Freely floating exchange rate are exchange rates that are determined purely based upon demand for, and supply of, a currency
• Fixed exchange rate is where exchange rates are fixed (pegged) by a country's central bank and maintained by intervention in the foreign exchange market
• Currency holdings are holdings of foreign currencies to pay for future goods and services in the future
• Currency hedging is intentionally holding foreign currencies in anticipation of future changes in exchange rates
• Currency over-evaluation leads to over priced exports and under-priced imports; therefore a deficit on BoP current account
• Currency under-evaluation leads to under priced exports and over-priced imports; therefore a surplus on BoP current account
• The Dollar Standard is where in 1945, the universally accepted standard by which the external values of other currencies were measured became the US Dollar
• A free-floating currency is where the external value of a currency depends wholly on market force of supply and demand
• A managed-floating currency is when the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives
• A fixed exchange rate system is where a currency peg either as part of a currency board system or membership of the EMR II for countries intending to join the Euro
• Strong Pound, Imports Cheaper, Exports Dearer (SPICED)
• Bilateral means the rate of one currency in terms of another
• Effective is the ER for a country relative to a weighted average of currencies in its trading partner
• Real Exchange Rate: Index of the domestic price level / Index of weighted foreign price levels x 100
• The Central Bank/Government can intervene in markets to manage a fixed exchange rate through buying or selling its own currency on the foreign exchange market or lowering the bank rate to keep the pounds exchange rate between the ceiling and floor rate
• Managing floating exchange rates can be done by changes in monetary policy interest rates, quantitative easing, direct buying/selling of the currency and taxation of overseas currency deposits
• For Fixed exchange rates, the external value is pegged to one or more currencies (anchor currency) and the central bank must hold sufficient foreign exchange reserves to intervene in case, sometimes the peg can be realigned
• Bretton Woods established a fixed ER system using the Dollar Standard and this was in place until the 1970s where changes in the ER were permitted
• Floating versus Fixed Exchange Rates:

  
• A hybrid system is a mixture of free and floating and some systems include: managed floating, semi-fixed and semi-floating and pegged
• Managed Floating Exchange Rates have the currency set by market forces and the Central Bank/Government may intervene occasionally
• A currency appreciation makes exports more expensive and is likely to lead to an inward shift of AD
• A currency appreciation makes imports cheaper and likely to cause an outward shift of AS
• Consequences of Exchange rate fluctuations:

  • Economic growth
  • Interest rates
  • Inflation
  • Trade
  • Foreign Investment
• Evaluation points on the effects of ER changes:

  • Counter-balancing use of fiscal and monetary policy
  • Time lags
  • Low price elasticity of demand
  • Business response to the challenge of a high exchange rate using methods like: cutting their export prices, outsourcing, seeking productivity / efficiency gains and investing extra resources in new product lines
• Competitive devaluations occur when a country deliberately intervenes to drive down the value of their currency to provide a competitive raise to demand and jobs in their export industries
• An example of competitive devaluations would be China
• The J-Curve effect shows the time lags between a falling currency and an improved trade balance:

  
• The Marshall-Lerner condition states that a depreciation/devaluation of the ER will eventually lead to a net improvement in the trade balance provided that the sum of the price elasticity of demand for exports and imports is greater than 1
• Reasons for depreciation of ER:

  • Fall in the world's price of a country's major export
  • Trade deficit
  • Central bank reducing monetary policy interest rates
  • Intervention from Central Bank
  • Currency trading speculations change
• Purchasing Power Parity is the comparison of GDP which is done by building a basket of comparable goods and services and looking at the prices, the main way this is done is using McDonald's Big Mac prices