Exchange Rates IB Chapter 23

Floating Exchange rates  The exchange rate between two currencies is the price of one in terms of the other  The first diagram shows the market for dollars  The demand for dollars comes from the UK which offers pounds in exchange  The supply of dollars come from the US to buy the pound  Both countries demand each other’s currency to  Purchase each other’s goods  To purchase each other’s services  To invest in each other’s firms  To speculate  To put funds in each others banks when the rate of interest increases  Equilibrium price is 50p ($1 exchanged for 50p)

Floating Exchange rates  Demand for US goods and services increases which increases the demand for the dollar  D shifts to D1  The dollar is now worth more (£1) – it has appreciated  The sterling has depreciated against the dollar – it is worth less in terms of the dollar  Weak pound exports cheap (WIDEC)  Assuming that exports are elastic the BoP will improve  If exports improve the UK will have to supply more sterling (when the US demands it in exchange for the dollar)  S shifts to S1  The price of the pound (in terms of the dollar) goes down wXz7ZXwU Greek guy – BoP and exchange rates

Floating Exchange rates  Things that increase the demand for the £ from the US  Increase in interest rates relative to the US causes a flow of hot money (dollars coming to the UK)  A rise in demand for UK exports by the US  If speculators think the value of the sterling will fall and the dollar to increase they will buy sterling  A floating exchange rate is one that is dictated by the market

Advantages of a Floating Exchange rate  Automatic adjustment mean that a country with a large balance of payments will see their exchange rate depreciating which means the price of exports will fall and become more competitive leading to an improvement in the BoP  Reduced speculative pressure – if there are fixed exchange rates speculators will sell and then repurchase when the price has fallen  If there is a large amount of speculation this may force governments to reduce the value of the currency  Speculators will gain by selling it at one price and buying back at a lower price  Under floating exchange rates countries cannot be forced to devalue and speculators have no idea how far a central bank will allow its currency to fall  The currency is more stable  If government does not have to maintain the level of a fixed exchange rate it will not have to hold such large foreign exchange reserves

Advantages of a Floating Exchange rate  If government does not have to maintain the level of a fixed exchange rate it will not have to hold such large foreign exchange reserves  Freedom (autonomy) for domestic monetary policy: This is arguably the most important advantage of having a floating exchange rate  absence of an exchange rate target allows short term interest rates to be set to meet domestic economic objectives such as controlling inflation or stabilising the economic cycle

Disadvantages of a Floating Exchange rate  No guarantee to solve BoP problem – depends on the PEDs for exports and imports  Effect on domestic inflation – when the currency depreciates imports increase in price  Raw materials more expensive and firm’s costs go up  Pass on to consumer with higher prices  Demand for higher wages  Uncertainty – since the removal of exchange controls massive capital flows can occur leading to large changes in a currency’s price  Rapid increases lead to unemployment  Falls lead to increasing inflation  Foreign currency reserves have not really become redundant because most governments buy and sell their currency to maintain what they think should be an optimal value Exchange controls: restrictions on the ability to trade foreign currencies by a country’s central bank

Trade weighted index  The sterling Exchange Rate Index (ERI) is the same as the Effective Exchange Rate Index (EER)  a weighted index of sterling's value against a basket of currencies the weights used calculated by the importance of trade between the UK and each country.  used by economies to compare their exchange rate against those of their major trading partners

Factors affecting exchange rates  Relative interest rates  An increase in the relative rate of interest in the UK should lead to an increase in the demand for sterling  Hot money – enormous pool of money owned by companies and rich individuals that moves around the world seeking the highest interest rate (return) with least risk  This will increase the demand for sterling making it appreciate in value  Imports cheaper  Exports more expensive  If imports/exports are elastic BoP will be affected  May lead to rise in unemployment

Factors affecting exchange rates  Inflation has led to the depreciation of sterling (when inflation is rising faster than the US)  Less revenue from exports  To maintain export earning the UK must increase exports  In the UK foreign demand (exports) tends to be price elastic so this should benefit the BoP  Imports appear to be inelastic so more is spent on imports  Overall depreciation benefits UK – Marshall- Lerner condition holds  All depends on the PEDs  Depreciation leads to increasing inflation possibly leading to inflationary spiral  If more exports are required there may be a need for more capacity – government may need to take steps to ensure that the goods are not consumed domestically (with imports being more expensive)

Evaluation

Factors affecting exchange rates  Foreign Direct Investment (FDI) Less revenue from exports  FDI = flows of capital (long term investment opposed to short term hot money)  Usually to set up a factory or purchase shares in a foreign business  Increase in FDI increases demand leading to appreciating currency  Increasing inflows of FDI into Asia leads to an appreciation of the Asian currencies  Trade and current account deficits  Importing more increases the supply of their currency which depreciates the value  If the deficits are persistent or a large percentage of GDP speculators may feel the value will fall and sell  Causes uncertainty

Fixed exchange rates  Fixed exchange rates have fallen out of fashion with the increased supply-side emphasis on markets  The UK’s exchange rate was fixed between 1944 and 1972  Then again in 1990 to 91 when the UK joined the ERM (Exchange Rate Mechanism)  The major problem – when rates were fixed they were realistic but changes in the market meant they were very different from the market rate  This was due to  Difference in inflation rates between countries causing the £ to depreciate  Difference in growth rates – high growth rates (long term) reduces prices of goods causing the currency to appreciate  Fixed exchange rates vulnerable to speculation

Fixed exchange rates  If the government fixes the exchange rate at 50p to the dollar as seen in the diagram  Initial equilibrium where B dollars are demanded  An increase in the demand for dollars to D1 creates a disequilibrium situation because supply is fixed at B  If the dollar was would have appreciated to 60p with a floating exchange rate  The central bank would sell AB dollars out of its foreign currency reserves to stop the dollar appreciating to 60p  It may also have regulations in place to restrict exchanges between sterling and other currencies Fig 18.4 P212

Fixed exchange rates  If the imbalance were maintained there would be a continuous drain on reserves  The authorities could  Abandon the fixed rate allowing sterling to find its own level with market forces  Take steps to restrict the demand for dollars by following a deflationary domestic policy  Could be an increase in taxation  More likely to be an increase in interest rates  Notice that if you use fixed exchange rates you would need to use monetary policy which you need to control inflation  Variations of the totally fixed rate could be used  Adjustable peg – currencies could be changed to new fixed values  Crawling peg – could change values weekly or monthly

Fixed exchange rates – a run on the currency  A further problem with fixed rates was speculation where hot money flows would virtually determine whether the currency was revalued or devalued  The diagram shows fixed rates in terms of Pounds and Deutschmarks (as was the case with the ERM)  2.95 DMs to the pound is the fixed rate  If speculators thought the pound was overvalued and only maintained by high interest rates they would sell (S to S1) and buy back later at the devalued price  If UK authorities wanted to support the sterling they would buy AB sterling  If the market still thought devaluation was going to happen more banks and financial institutions will sell pound shifting the supply to S2 Revalued: when the authorities increase the value of their currency against others Devalued: when the authorities decrease the value of their currency against others

Fixed exchange rates – a run on the currency  The authorities could  Raise interest rates to increase demand for the currency  Investors may still be reluctant to buy a currency that they think is overvalued  They could raise a loan to borrow foreign currency in order to purchase sterling and maintain its value  Governments don’t like official loans  If they borrow money from the IMF for example there are normally conditions that regard future economic policy  The UK chancellor had to borrow DMs from the Bundesbank but the speculative flows were too large and the UK was forced to leave the ERM Fig 18.5 P213 IMF: International Monetary Fund – a multinational institution set up in 1947 to operate the adjustable peg exchange rate system

Fig 18.5 P213

The case for a fixed exchange rate  Reinforcing comparative advantage Read ‘Fixed or Flexible?’ on P214

A managed float  A fixed rate make it impossible to concentrate the use of the rate of interest on inflation targeting  A free floating exchange rate can lead to large changes in the price of imports and exports  A managed float where sterling is free to fluctuate between levels is the alternative  In the diagram assume that the UK government sets an upper limit (a ceiling price) of 2 Euros to the £  The lower limit (floor price) is 1 Euro to the £  If the price were any lower it would make imports into the UK too expensive and bring inflationary pressure  The exchange rate can be seen as a trade off between too much inflationary pressure from import prices and competitive export prices to improve the balance of payments Fig 18.6 P215 Dirty float: manipulation of a floating rate to gain advantages over trading partners

A managed float  The authorities will try to manage the exchange rate by buying and selling pounds  When the pound rises near to two Euros the authorities will sell  As it falls lower to 1 euro it will buy  Should they manipulate the currency in order to gain advantage over their trading partners this is known as dirty float  The upper and lower levels are not publicised by the authorities so it is difficult to speculate  By using the managed float the authorities can obtain the advantages of both floating and fixed exchange rates Fig 18.6 P215 Dirty float: manipulation of a floating rate to gain advantages over trading partners P290 Student Workpoint

Key Terms Depreciation = A decrease in the value of a country’s currency in a floating exchange rate system. Appreciation = An increase in the value of a country’s currency in a floating exchange rate system. Devaluation = A decrease in the value of a country’s currency in a fixed exchange rate system. Revaluation = An increase in the value of a country’s currency in a fixed exchange rate system.

Videos Mjmfoodie Work through all of the student workpoints in the Exchange rate chapter (to hand in) HL work through the two HL assessment advices (to hand in) Next week: During each lesson there will be some kind of assessment on international economics Revise for homework (revise for homework)