Notesale: Turn your study into money

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Exchange  Rate  
•Exchange  rate-­‐The  policy  of  that  currency  in  terms  of  another  currency  
 
Types  of  exchange  rate  system  
1)  Fixed  Exchange  Rate  
•Control  the  demand  and  supply  of  currency  by  government  
•Government/Central  Bank  controls  the  exchange  rate  
2)  Floating  Exchange  Rate  
•Exchange  rate  determine  by  the  free  interruption  of  demand  and  supply  of  those  
currencies  
•Demand>Supply  of  the  currencyàExchange  Rate  appreciates  
•Supply>Demand  of  the  currencyàExchange  Rate  depreciates  
 
Factors  influencing  exchange  rates  
•Interest  rates    –  higher  interest  rates  encourage  hot  money  flows  and  demand  for  
currency
...
 
•Inflation  –  higher  inflation  makes  exports  less  competitive  and  reduces  demand  for  
currency
...
 
•Confidence  in  the  economy  
 
Advantages  of  free-­‐floating  exchange  rate  
1
...
 In  
this  way,  balance  of  payments  disequilibrium  are  automatically  and  instantaneously  
corrected  without  the  need  for  specific  government  policies  
2
...
 
Since  there  is  no  government  intervention  in  the  foreign  exchange  market,  there  is  
no  need  to  hold  reserves
...
 Insulation  from  external  economic  events  
•Act  as  cushion  to  prevent  sticks  which  protect  against  world  economic  fluctuations  
and  shocks  
4
...
 Similarly,  the  
central  bank  can  choose  whatever  rate  of  interest  is  necessary  to  meet  domestic  
objectives  such  as  achieving  target  rate  of  inflation
...
 Whereas  a  fall  in  interest  rate  causing  a  depreciation
...
 They  don’t  have  to  always  alert  to  the  exchange  rate  in  order  to  
correct  the  system  by  policy  

 
Disadvantages  of  free-­‐floating  exchange  rate  
1
...
 Speculation  
•Speculation  will  tend  to  be  an  inherent  part  of  a  floating  system  and  it  can  be  
damaging  and  destabilising  for  the  economy,  as  the  speculative  flows  may  often  
differ  from  the  underlying  pattern  of  trade  flows
...
 Uncertainty  for  traders  and  investors  
•The  uncertainty  caused  by  currency  fluctuations  can  discourage  international  trade  
and  investmentàmake  them  difficult  to  plan  
4
...
 They  will  have  adverse  effects  over  the  longer  term  as  the  government  will  at  
some  point  have  to  deflate  the  economy  again,  with  a  resulting  fall  in  output  and  
rise  in  unemployment    
 
Advantages  of  fixed  exchange  rate  
1
...
   Little  or  no  speculation  
•Provided  the  rate  is  absolutely  fixed  and  people  believe  that  it  will  remain  so  there  
is  no  point  in  speculating  
3
...
 Competitive  contractionary  policies  leading  to  world  depression  
•Conflicts  with  other  macroeconomic  objectives  as  government/central  banks  use  
reserves  to  remain  fixed  exchange  rate,  it  will  reduce  government  expenditure  and  
increase  unemployment
...
 Problems  of  international  liquidity  
•Government/Central  Bank  stabilizes  the  currency  by  involving  drawing  from  reserve  
account  in  order  to  cushion  the  effect  of  currency  fluctuationàáwithdrawal  
moneyàliquidity  problem  
3
...
 It  is  difficult  to  respond  to  temporary  shocks
...
 Speculation  
•If  speculators  believe  that  a  fixed  rate  simply  cannot  be  maintained,  speculation  is  
likely  to  be  massive

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