Exchange Rate Policy

Exchange Rates  The value of currencies are determined by the foreign currency markets.  With no government intervention – free market so to speak – this is called the  free or Floating Exchange Rate

Who decides on the Exchange Rate Policy?  ECB – Frankfurt  Bank of England – London  Federal Reserve – Washington  These central banks have developed a reputation of having a hands off or laissez faire approach.

In contrast  Bank of Japan  People‘s Bank of China  These central banks have the reputation of manipulating/influencing the value of their currencies.

Influencing the exchange rate  Central banks that have exchange rate policies can influence their currencies in two main ways.

Interest Rates  By increasing an interest rate a country can encourage people to invest in their banks.  This will increase the demand for that currency which will increase the value of that currency.

Gold and Currency Reserves  Central banks have traditionally held gold and foreign currency reserves.  If the Bank of England wanted to increase the value of the pound, it would sell some of it`s currency reserves in exchange for pounds.

Effects on the Economy  A rise or appreciation of the exchange rate will make exports more expensive to foreigners but make imports cheaper to domestic customers.  A fall or depreciation in the exchange rate will have the opposite affect.

However  Exporting firms can choose to lock the price of the goods that they are exporting to a specific price in the buyers country. 1 Pound = 1 Dollar Now: 1 Pound= 2 Dollars What does the British exporter do to keep exporting the same amount?

Macroeconomic impact of changes in exchange rates  Inflation  A rise in exchange rates is likely to moderate inflation.  A rise in exchange rates leads to a fall in import prices, which can lead to a fall in domestic prices.  A rise in exchange rate will lead to a fall in aggregate demand. (X-M)

 However:  What about the price elasticity of demand for imports and exports?  The opposite happens when there is a depreciation in exchange rates.

Economic Growth  A higher exchange rate will discourage exports and encourage imports.  This may lead to lower domestic investment.

Unemployment  A rise in exchange rates will tend to increase unemployment.  Because this will lower aggregate demand and equilibrium output.  However: There will be more unemployment in sectors of the economy that rely heavily on exporting.

Current Balance  Someone explain this to the class.