😮Exchange rates

• Exchange rate


  The value of one currency for the purpose of conversion to another
• Currency appreciation

  An increase in the value of one currency in relation to another currency
• Factors determining a currency's value


  • Portfolio investment
  • Trade balance
  • FDI
  • Currency demand + TXR
  • Speculation
  • Interest rate differentials
  • Relative inflation rate
• Factors leading to currency appreciation


  1. Increasing portfolio investment (in stocks and bonds)

  2. Increasing interest rates
• Revaluation


  An increase in the value of a fixed exchange rate
• Devaluation


  A decrease in the value of a fixed exchange rate
• SPICED impacts:

  • ↓CP inflation
  • Worsened trade balance
  • ↓econ growth
  • ↓X and ↑M may increase AS
  • Boost to labour market →↓export profits
• 🌏UK current exchange rate examples (22 Jan 2024):

  • Euro: €1.1687
  • US dollar: $1.2721
  • Chinese Yuan: ¥9.1598
• EVALUATION of SPICED impacts:

  • PED for M and X
  • Size of change (appreciation/depreciation)
  • Any trade restrictions?
  • Ceteris paribus
  • Depends on incomes abroad
• Main currency systems:

  1. Free floating XR
  2. Managed floating XR
  3. Semi-fixed currency (crawling peg)
  4. Fully-fixed XR (hard peg)
  5. Currency board system (hard peg)
• J curve effect:

  = Shows the time lag between a fall in exchange rate change and the improvement in the trade balance

  
• Floating XR:

  =where the exchange rate depends wholly on market forces of supply and demand with no central bank intervention

  🌏E.g., UK, USA, Japan, Canada, Australia, Chile

  + :

  • ↓need for currency reserves
  • ↓BOP deficit
  • Shock absorption
  • Monetary policy autonomy
  • ↓speculative attacks

  -:

  • XR volatility (makes business planning difficult)
  • ↓XR → inflationary pressures
  • Loss of XR as policy tool
  • Currency risk
  • Speculation strengthens XR → ↓competitiveness
• SPICED & WPIDEC diagrams:

  
• Currency diagrams:

  
• Marshall-Lerner condition:

  a depreciation/devaluation of the exchange rate will only improve the trade balance if the sum of the price elasticity of demand for imports and exports exceeds 1

  
• Fixed XR:

  =Where the government/central bank set the exchange rate (normally at a target rate)

  🌏Examples:

  • Hong Kong dollar (pegged to US dollar)
  • Bulgarian Lev (pegged to euro)

  +:

  • ↓speculation
  • Competitive pressures on firms (→ forces lower costs, R&D, ↑productivity)
  • Creates certainty → encourages investment (incl FDI)

  -:

  • If speculators feel a fixed XR isn't sustainable, may take advantage of this by selling the currency
  • Lost control over interest rates
  • Difficult to maintain fixed XR
• 🌏Examples of Managed XR:

  • Brazilian Real
  • Swiss Franc
  • Japanese Yen
  • Ghanian Cedi
• How can government intervene to influence the XR?

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