Presentation on theme: "Economics – A Course Companion Blink & Dorton, P"— Presentation transcript:
1Economics – A Course Companion Blink & Dorton, P274-288 EXCHANGE RATESEconomics – A Course CompanionBlink & Dorton, P
2EXCHANGE RATES What is an exchange rate? An exchange rate is the value of one currency expressed in terms of another currency.Currencies are exchanged (traded) on the foreign exchange market. This is the largest market in the world in terms of cash movements.The market includes the trading of foreign currencies between governments, central banks, private commercial banks, MNCs and other financial institutions.
3EXCHANGE RATE SYSTEMThere are a number of exchange systems operating in the world.The way that a country manages its exchange rate is known as its exchange rate regime.There are three main type:Fixed Exchange RateFloating Exchange RateManaged Exchange Rate
4Fixed Exchange Rate A fixed exchange rate is an exchange rate regime where the value of the currency is:fixed ORpegged to the value of another currency ORPegged to the average value of a selection of currencies ORdetermined by the value of some other commodity, such as gold.
5Fixed Exchange RateAs the value of the variable that the currency is pegged to changes, then so does the value of the currency.Deciding upon, and the maintaining, the fixed value of the currency is usually carried out by the government or the central bank.
6Fixed Exchange Rate Revaluation of Currency If the value of a currency in a fixed exchange rate regime is raised, then we say that this is a revaluation of the currency.Devaluation of the CurrencyIf the value is lowed, then we say that there is a devaluation of the currency.
7Floating Exchange Rate A floating exchange rate is an exchange rate regime where the value of the currency is allowed to be determined solely by the demand for and supply of, the currency on the foreign exchange market.There is generally no government intervention to influence the value of the currency.
8Floating Exchange Rate Appreciation of the CurrencyIf the value of the currency in a floating exchange rate regime rises, then we say that this is an appreciation of the value of the currency.Depreciation of the CurrencyIf the value falls, then we say that there has been a depreciation of the value of the currency.
9Understanding Exchange Rates Examples 20th Jan: $1AUS = 79 US cents ($AUS 190 million)20th Nov: $1AUS = 95 US cents. ($AUS 158 million)What does this mean?The Australian dollar has appreciated against theUS dollar.Application - ExerciseIf Qantas (The Australian Airline) were to purchase an aircraft from Boeing for $US150 million, how much would it save by buying the aircraft in November, rather than January??
10Qantas – Foreign Exchange Case Study (1/.79)-(1/.95)=0.213 [exchange rate differential] *150 million = 32.0 million
11What will cause the US dollar to rise or fall? The demand for the US dollar will rise if:US Investment prospects improveUS interest rates increase, making it more attractive to save there, than in other countries.Speculators believe the US dollar will rise in the futureThere is an increase in incomes in other countries, which increases demand for all things including imports from the US.A change in consumer tastes in favor of US products.
12What will cause the US dollar to rise or fall? The demand for the US dollar will fall if:US Investment prospects become negative.US interest rates decrease, making it less attractive to invest there, than in other countries.Speculators believe the US dollar will rise in the futureThere is an increase in incomes in other countries, which increases demand for all things including imports from the US.A change in consumer tastes in favor of US products.
14Managed Exchange RateIn realty there is no currency in the world that is allowed to be completely freely floating.Even when governments try to be as non-interventionist as possible, there will comes times when the currency is subject to extreme fluctuations and the government or central bank will feel they must interveneIn the same way frequent changes in the exchange rate, if completely free floating may cause uncertainty for businesses, which is not desirable for trade, so governments will be forced to intervene in order to stabilize the exchange rate.
15Managed Exchange RateMost exchange rate systems in the world are managed exchanged rates.Theses are exchange rate regimes where the currency is allowed to float, but with some element of interference from the government.
16Managed Exchange Rate Upper & Lower Exchange Rate Value The most common systems are where a central bank will set an upper and lower exchange rate value and then allow the currency to float freely, so long as it does not move out of the band.If the exchange starts to get close to the upper or lower level, then the central bank will intervene in the foreign exchange market for its currency.Central banks do not make the upper and lower level values public, for fear of speculation, but they do exist.
17Possible Advantages & Disadvantages of High & Low Exchange Rates The actual level of the exchange rate will have marked economic effects upon a country and we need to understand fully why governments intervene to influence the value of the exchange rate.
18POSSIBLE ADVANTAGES OF A HIGH EXCHANGE RATE Three possible advantages of a high exchangerate are:Downward pressure on inflationMore imports can be broughtA High Value of a currency forces domestic producers to improve their efficiency.
19POSSIBLE ADVANTAGES OF A HIGH EXCHANGE RATE Downward Pressure on InflationIf the value of the exchange rate is high, then the price of finished imported goods will be relatively low.In addition, the price of imported raw materials and components will reduce the costs of production for firms, which could lead to lower prices for consumers.The lower prices of imported goods also puts pressure on domestic producers to be competitive by keeping prices low.
20POSSIBLE ADVANTAGES OF A HIGH EXCHANGE RATE More Imports can be broughtIf the value of the exchange rate is high, then each unit of the currency will more buy more foreign currencies and so more foreign goods and services.This would include both visible imports, such as technology, and invisible imports such as foreign travel.
21POSSIBLE ADVANTAGES OF A HIGH EXCHANGE RATE A high value of a currency forces domesticproducers to improve their efficiencyA high exchange rate will threaten their international competitiveness so they will be forced to lower costs and become more efficient in order to maintain competitiveness.While this might result in laying off workers, there are other means of increasing efficiency that will result in greater economic productivity for the country.
22POSSIBLE DISADVANTAGES OF A HIGH EXCHANGE RATE Some possible disadvantages of a high exchangerate include:Damage to export industriesDamage to domestic industries
23POSSIBLE DISADVANTAGES OF A HIGH EXCHANGE RATE Damage to Export IndustriesIf the value of the exchange rate is high, then export industries may find it difficult to sell their goods and services abroad, because of the relatively high prices.This could lead to unemployment in these industries.
24POSSIBLE DISADVANTAGES OF A HIGH EXCHANGE RATE Damage to Domestic IndustriesWith greater levels of imports being purchased because imports are now relatively less expensive, domestic producers may find the increased competition causes a fall in the demand for their goods and services.This may lead to a further increase in the level of unemployment as firms cut back.
25POSSIBLE ADVANTAGES OF LOW EXCHANGE RATES Two main advantages of low exchange ratescould be:Greater employment in export industries.Greater employment in domestic industries.
26POSSIBLE ADVANTAGES OF LOW EXCHANGE RATES Greater Employment In Export IndustriesIf the value of the exchange rate is low, then exports from the country will be relatively less expensive and so more competitive.This in turn may lead to more employment in the export industries.
27POSSIBLE ADVANTAGES OF LOW EXCHANGE RATES Greater Employment in Domestic IndustriesThe low exchange rate will make imports more expensive than they were.This will encourage domestic consumers to buy domestically produced goods, instead of imports, and this may also raise employment.
28POSSIBLE DISADVANTAGE OF A LOW EXCHANGE RATE InflationA low value of the currency will make imported final goods and services, imported raw materials and imported components more expensive.The raw materials and components are needed by firms and are costs of production that will rise, possibly leading to higher prices in the economy.Final goods and services will have higher prices.Thus there is a serious likelihood of inflation.
29SUMMARY – HIGH & LOW EXCHANGE RATES A high value of a currency may be good to fight inflation, but it may create unemployment problems.A low value of a currency may be good for solving unemployment problems, but it may create inflationary pressure.
30GOVERNMENT MEASURES TO INTERVENE IN THE FOREIGN EXCHANGE MARKET Governments might interfere in the FOREX market to:Lower the exchange rate in order to increase employmentRaise the exchange rate in order to fight inflation.Maintain a fixed exchange rateAvoid Large fluctuations in floating exchange rateAchieve relative exchange rate stability in order to improve business confidenceImprove a current account deficit, (where spending on imported goods is greater than the revenue received from exported goods and services)
31Government Intervention in the Foreign Exchange Market There are two main methods of governmentinterference:Using their reserves of foreign currencies to buy or sell foreign currencies.By Changing Interest Rates.
321. Using Reserves of Foreign Currencies to buy or sell foreign currencies Government Wishes to Increase Value ofCurrencyIf the government wishes to increase the value of the currency then it can use its reserves of foreign currencies to buy its own currency on the foreign exchange market.This will increase demand for its currency and so force up the exchange rate.
331. Using Reserves of Foreign Currencies to buy or sell foreign currencies Government wishes to lower value of itsCurrencyIf the government wishes to lower the value of its currency, then it simply buys foreign currencies on the foreign exchange market, increasing its foreign exchange reserves.To buy foreign currencies, the government uses its own currency on the foreign exchange market and so lowers its exchange rate.
342. Changing Interest Rates Governments wants to INCREASE the value ofthe currencyIf the government wishes to increase the value of the currency, then they may raise the level of interest rates in the country.This may make the domestic interest rates relatively higher than those abroad and should attract financial investment from abroad.In order to put money into the country, the investors will have to buy the country’s currency, thus increasing demand for it and so its exchange rate.
352. Changing Interest Rates Government wants to LOWER the Value of theCurrencyIf the government wishes to lower the value of its currency, then they may lower the level of interest rates in the country.This will make the domestic interest rates relatively lower than those abroad and should financial investment abroad more attractive.In order to invest abroad, the investors will have to buy foreign currencies, thus exchanging their own currency and increasing the supply of it on the financial exchange market.This should lower its exchange rate.
36ADVANTAGES OF A FIXED EXCHANGE RATE A fixed exchange rate should reduce uncertainty for all economic agents in the country. Businesses will be able to plan ahead in the knowledge that their predicted costs and prices for international trading agreements will not change.
37ADVANTAGES OF A FIXED EXCHANGE RATE If the exchange rate is fixed, then inflation may have very harmful effect on the demand for exports and imports. Due to this, the government is forced to take measures to ensure that inflation is as low as possible, in order to keep businesses competitive on foreign markets Thus fixed exchange rates ensure sensible government policies on inflation.
38ADVANTAGES OF A FIXED EXCHANGE RATE 3. In theory, the existence of a fixed exchange rate should reduce speculation in the foreign exchange market. However, in reality, this has not always been the case and there are often attempts to destabilize fixed exchange rate systems in order to make speculative gains.
39DISADVANTAGES OF FIXED EXCHANGE RATE The government is compelled to keep the exchange rate fixed. The main way of doing this is through the manipulation of interest rates. However, if the exchange rate is in danger of falling, then the government will have raise the