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at the end of the lesson u should be able to: explain ER determination in a fixed ER system revaluation and devaluation

at the end of the lesson u should be able to: explain ER determination in a fixed ER system revaluation and devaluation government intervention by buying and selling the currency. Fixed ER System. The ER of a country is fixed in terms of another anchor currency.

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at the end of the lesson u should be able to: explain ER determination in a fixed ER system revaluation and devaluation

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  1. at the end of the lesson u should be able to: • explain ER determination in a fixed ER system • revaluation and devaluation • government intervention by buying and selling the currency

  2. Fixed ER System • The ER of a country is fixed in terms of another anchor currency. • This is known as peggingthe ER where a rate is fixed & then guaranteed by the govt. • e.g. pegging of Ringgit against US$. from 1998 - 2005

  3. Fixed ER System • A fixed ER is maintained by intervention through central banks (in UK through Bank of England [BOE] via the Exchange Equalization A/C), which holds they country's reserves of foreign currencies. • When the govt states that the official price or ER for its currency, they will buy or sell that currency as required in order to maintain the ER @ the official level. • Assume that official ER between RM & US$ is at RM 1 = US$0.26

  4. setting rate above equlibrium D 1 $US/RM s D Fixed rate 0.26 D 1 0.24 D s 2 10 12 Qty of $RM

  5. Setting rate above equilibrium • Govt. wishes to set the rate at US$0.26 = RM 1 i.e. above the equlibrium • At this price, SS > DD by 10 m(12 - 2) • if it is left to the free market forces, it will tend to fall towards the equilibrium • Therefore if govt. wishes to maintain this rate, it will have to buy up 10m and this will shift DD to D1D1.where SS = DD.

  6. Setting rate below equilibrium Setting rate below equilibrium: S $US/$RM D S 1 0.28 Fixed rate 0.26 S D S 1 Qty of $RM 18 20 22

  7. Setting rate below equilibrium • Govt. wishes to fix the ER at price US$0.26 = RM1 i.e. below the equilibrium • At that price DD > SS by 4m (22-18) and this will push the price up to US$0.28. • Therefore in order to maintain the price at US$0.26, govt. have to sell 4m and this will shift SS to S1S1

  8. Revaluation • an increase in the value of a nation’s currency • b4, £1 = US$2 • now £1 = US$3 • deliberate action by the govt Devaluation • a decrease in the value of a nation’s currency • b4, £1 = US$2 • now £1 = US$1.50 • deliberate action by the govt

  9. Managed Float • Central Bank sells and buys currency in the foreign exchange market. • Limit currency depreciation by buying the currency. • Prevent excessive appreciation of currency by selling.

  10. Setting rate below equilbrium S D1 ER S 1 D Upper Limit P Lower Limit S E D1 D S 1 Quantity of $

  11. Managed Float • OP is the equilibrium or par value with a upper and lower limits. • If there is an increase in SS to S1S1, this will reduce the value of the $ in the free market to below the agreed level (E). • To maintain the currency at the lower limit, central bank must buy $ with the foreign exchange reserves thus pushing DD to D1D1 where SS =DD

  12. Setting rate below equilibrium S E S 1 ER D Upper Limit P Lower Limit D1 S D S 1 Quantity of $

  13. Managed Float • OP is the equilibrium or par value with a upper and lower limits. • If there is an increase in DD to D1, this will increase the value of the $ in the free market to above the agreed level (E). • To maintain the currency at the upperr limit, central bank must sell $ with the foreign exchange reserves thus pushing SS to S1s1 where SS =DD

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