Purchasing power parity, effective exchange rates and types of exchange rate

Purchasing power parity theory of exchange rates Is €1.45/£ a long term equilibrium rate? What if a basket of goods which cost £100 in the UK, cost €130 in Europe? The measurement of the difference in the cost of living is done by calculating purchasing power parities, and gives in this case a real exchange rate of €1.30/£ Can €1.45/£ therefore be a long term equilibrium rate? If UK goods are too expensive at this rate, which they should be, then we will have a deficit with the Eurozone (which we do have) This would mean M>X, which means S>D for a currency (since we supply pounds to buy euros to pay for imports…), so it will tend to fall in value This makes exports more competitive and imports less competitive, so S will fall because imports fall, and D will increase since exports rise At €1.30/£, our goods will be priced correctly and there will be no deficit or surplus

Purchasing power parity The general assumption behind floating exchange rates is that a country’s current or trade account deficit will be corrected in the long run through a change in exchange rates So in the long run, the equilibrium exchange rate would be €1.30/£ What happens if UK inflation is lower than in Europe? This means the cost of a basket of goods in the UK rises more slowly than in Europe For example, 0 inflation in the UK, and 5% in Europe What would the purchasing power parity be in a year? £100:€136.5 or €1.365/£ The purchasing power theory of exchange rates therefore states that exchange rates in the long run change in line with relative inflation

Effective exchange rates So far we have discussed bilateral exchange rates, ie the value of one currency against another Question - is the pound weak or strong? Answer – how can we measure this? Answer 2 – by weighting the exchange rate according to our trading patterns. Called trade weighted index Index 100weightchangeWeighted change $/£30%10%3.0% €/£50%-5%-2.5% Y/£20%2%0.4% Overall100%0.9%

Types of exchange rate systems Fixed exchange rates Best known was gold standard. Each currency was convertible into a set quantity of gold (eg a pound into ounces in 1914), so there was therefore a fixed rate at which 1 currency converted into another Gold standard no longer exists, but have currency board systems where a currency is fixed to another (eg $ or €) Search how many currencies are fixed Not technically fixed, but some countries do not have a currency but use another country’s (remember the Scottish referendum debate)

Types of exchange rate systems Managed exchange rate systems Adjustable peg system Currencies fixed in the short run (can also be classified as fixed exchange rate system in reality), but currencies can be devalued Bretton Woods system post WW2 an example of this (eg pound was fixed at various rates, eg $2.80/£ Managed floating Exchange rate mostly left to market forces, but governments/central banks may intervene Buying and selling currency to: smooth fluctuations move the rate (eg lower to help exporters) Change interest rates, eg lower to help lower the value of the currency Use currency controls to manage demand/supply for a currency

Types of exchange rate systems Floating exchange rate When an exchange rate is left entirely to market forces Is the £ a floating or managed floating exchange rate?