4.1.8 Exchange rates

• Exchange rate


  The weight of one currency relative to another
• Floating exchange rate


  • The value of the exchange rate is determined by the forces of supply and demand
• Fixed exchange rate


  • The value is determined by the government compared to other currencies
• Managed exchange rate system

  • The currency fluctuates, but the central bank buys and sells currencies to influence the exchange rate
• Examples of managed exchange rate systems

  • Japanese central bank manipulating the Yen
  • Indian rupee fluctuating but central bank intervening when it falls outside a set range
• Revaluation


  When the currency's value is adjusted relative to a baseline, such as the price of gold, another currency or wage rates
• Appreciation


  When the value of a currency increases. Each pound will buy more dollars, for example.
• Devaluation


  When the value of a currency is officially lowered in a fixed exchange rate system
• Depreciation


  When the value of a currency falls relative to another currency, in a floating exchange rate system
• Factors influencing floating exchange rates

  • Inflation
  • Speculation
  • Other currencies
  • Government finances
  • Balance of payments
  • International competitiveness
• Inflation


  • A lower inflation rate means exports are relatively more competitive, increasing demand for the currency and causing it to appreciate
• Speculation


  • If speculators think a currency will appreciate, demand increases in the present, causing an increase in the value of the currency
• Other currencies


  • If markets are concerned about major economies, the currency might rise, as happened with the Swiss Franc in 2010
• Government finances


  • A government with high debt is at risk of defaulting, which could cause the currency to depreciate as investors lose confidence
• Balance of payments


  • When the value of imports exceeds exports, there is a current account deficit, causing the currency to depreciate
• International competitiveness


  • An increase in competitiveness increases demand for exports, increasing demand for the currency and causing an appreciation
• Government intervention in currency markets

  • Foreign currency transactions
  • Use of interest rates
• Interest rates


  • An increase in interest rates, relative to other countries, makes it more attractive to invest funds in the country, increasing demand for the currency and causing an appreciation
• Quantitative easing


  • This can reduce the value of the currency due to inflationary effects from increasing the money supply
• Foreign currency transactions


  • Buying and selling foreign currency to manipulate the domestic currency, as done by China to undervalue the Yuan
• Competitive devaluation/depreciation


  When a country deliberately devalues or depreciates its currency to make exports cheaper and imports more expensive, in order to improve the current account
• Devalued currency


  Makes exports cheaper and imports more expensive, which can increase economic growth but also increase inflation
• Devalued currency


  Improves the current account as there are fewer imports and more exports
• Devaluing the currency allows firms to plan investment as they know they will not be affected by harsh fluctuations in the exchange rate
• The government and central bank do not necessarily know better than the market where the currency should be, and the balance of payments would not automatically adjust to economic shocks
• It can be costly and difficult for the government to hold large reserves of foreign currencies to maintain a devalued currency
• Devaluation is unlikely to affect exports if the main trading partners are in a recession and demand for exports is low
• Reduction in the exchange rate

  Causes exports to become cheaper, increasing exports, and imports to become more expensive, improving the current account
• Marshall-Lerner condition


  A devaluation in a currency only improves the balance of trade if the absolute sum of long run export and import demand elasticities is greater than or equal to 1
• 1. curve effect


  When a currency is devalued, the total value of imports initially increases, worsening the deficit, before eventually decreasing as the value of exports decreases
• There may be a time lag in changing the volume of exports and imports when the currency is devalued, due to trade contracts and price inelasticity of demand for imports in the short run</b>
• Exchange rate appreciation


  Likely to reduce AD as imports become cheaper and exports more expensive, causing households to switch to imports
• Weaker exchange rate


  Likely to increase exports, allowing domestic firms to increase sales and profits, potentially creating jobs
• Depreciation in exchange rate

  Likely to be inflationary due to increase in price of imported raw materials, causing cost-push inflation
• Foreign direct investment (FDI)

  The flow of capital from one country to another, in order to gain a lasting interest in an enterprise in the foreign country
• Currency depreciation


  Makes the country more internationally competitive, likely attracting more FDI
• The effects of exchange rates on imports can be remebered by using the acronym SPICED


  Strong Pound Imports Cheap Exports Dear