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Exchange Rate Systems. A2 Economics. What are exchange rates?. Normally expressed in the terms of one single currency against another. The rate at which one currency can be converted (bought or sold) into another currency is known as the exchange rate. Exchange rate systems.
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Exchange Rate Systems A2 Economics
What are exchange rates? • Normally expressed in the terms of one single currency against another. The rate at which one currency can be converted (bought or sold) into another currency is known as the exchange rate.
Exchange rate systems • Freely floating exchange rate = a system whereby the price of one currency is determined by the forces of supply and demand • Fixed exchange rate = an exchange rate system in which the value of one currency has a fixed value against another countries • Semi-fixed exchange rate = an exchange rate system that allows a currency’s value to fluctuate within a permitted band of fluctuation.
Freely floating exchange rate • The value of the pound is determined purely by market demand and supply of the currency • Both trade flows and capital flows affect the exchange rate under a floating system • No target for the exchange rate is set by the Government • There is no need for official intervention in the currency market by the central bank Sterling has floated freely on the foreign exchange markets since the UK suspended membership of the ERM in September 1992
Demand and Supply • There are 3 main reasons why foreign exchange is bought and sold: • International trade • Short-term capital flows • Long-term capital movements
Demand and supply of Dollars Price of S of $ (US) $ in £’s 50p D for$ (UK) 0 D & S of $ Price of the $ is 50p - $1 will exchange for 50p $1 spent in the US will purchase 50p's worth of UK exports 50p, spent in the UK will buy $1's worth of US imports
Increased demand for $’s Price of S of $ (US) $ in £’s 1 50p D1 D for$ (UK) 0 D & S of $ • Demand for the $ ↑ - D - D1 - price of the $ ↑ from 50p to £1 • $ is now worth more, it has appreciated in relation to the £ • £ has depreciated - worth less in terms of the $ • Changes the prices of imports and exports: • Now $1 will buy £1 of UK exports – previously it only purchased 50p • Price of UK goods in the US has fallen • When a currency appreciates exports ↑increase in price, imports ↓ in price • When a currency depreciates exports ↓decrease in price, imports ↑ in price
Advantages of a freely floating system • Reduced need for currency reserves • Freedom for domestic monetary policy • Useful instrument for macroeconomic adjustment – controlling AD and inflation • Partial automatic correction of a trade deficit
Disadvantages • Uncertainty • Lack of investment • The floating exchange rate can be inflationary if price stability not prioritised. • Does a floating rate automatically remedy a trade deficit?
Evaluation • The extent to which a floating system is advantageous for a country depends upon the price elasticity of imports and exports. • Marshall-Lerner Condition – BoP will only improve if imports/exports are price responsive.
Fixed exchange rate • The government makes a commitment to a fixed exchange rate • The exchange rate is pegged against another currency • There are no fluctuations from the central rate • System achieves exchange rate stability through the buying selling of its own currency and changes in interest rates. • However this may be at the expense of domestic stability
Advantages of a fixed exchange rate • Encourages trade and investment as less risk of fluctuations • Reduces the need for hedging and so the cost of international trade • Disciplines on domestic producers
Disadvantages • Large holdings of foreign exchange reserves needed • Loss of freedom in your internal policy • International retaliation
Semi-fixed/semi-floating exchange rates • The exchange rate is given a specific target • The currency can move between permitted bands of fluctuation on a day-to-day basis • Exchange rate becomes an target of economic policy-making (interest rates are set to meet the exchange rate target) • The Bank of England might have to intervene to maintain the value of the currency within the set targets if it moves outside the agreed range • Re-valuations are seen as a last resort
Examples of semi-fixed systems • Adjustable peg systems – short term: currencies are fixed and do not change in value, long term: the value of the currency can change if economic circumstances dictate. • Crawling peg systems – exchange rate is fixed however mechanism allows the band to rise and fall regularly over time. • Exchange rate band systems – exchange rate floats freely within a permitted band of fluctuation.
