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EXCHANGE RATE SYSTEMS
An exchange rate is the price of one currency expressed in terms of another
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These come in three types
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Fixed - this is an exchange rate system where one currency is fixed in value against
another
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These give certainty but can cost vast sums of foreign exchange
from national reserves
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Floating - this is an exchange rate which accepts that market forces will determine
rates based on how they view a country's trade performance and its economic and
political stability
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This can seriously affect trade performance and
confidence
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Managed or dirty float - which is where the rate is floating but between upper and
lower limits that the domestic government keeps it to
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Floating Exchange Rates
Under a floating rate system, a currency’s exchange rate is simply determined by the free
market forces of demand and supply, without any intervention by the government or its
central bank
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Supply curve of foreign exchange is upward sloping:

Supply curve of foreign exchange slopes upwards due to positive relationship between supply
for foreign exchange and foreign exchange rate, which means that supply of foreign exchange
increases as the exchange rate increases
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At that exchange rate (e1), the equilibrium
quantity of US Dollars is Q1
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The
higher the value of the US Dollar, the more Euros you will be able to purchase with 1 USD
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To understand what determines the equilibrium exchange rate, we need to look at the
factors that create a demand or supply of a currency
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For instance when Jaguar sells cars
in Europe it wants to be paid in £s, so it can pay its workers and suppliers
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K
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Short term capital inflows – currency speculators may buy a currency if they think it is likely
to appreciate in value or if they believe interest rates in the country are likely to rise
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A fall in the exchange rate of the pound, for instance would
make Britain’s exports more competitive, so other countries would want to buy more £s in
order to buy more British goods
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K
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An increase in the value of the pound, by contrast would encourage more selling of sterling,
as imports into Britain would be cheaper
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K firms will be able to afford to buy more assets abroad
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Changes in the value of exports – An increase in a country’s exports will cause an
increase demand for its currency
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2
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3
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4
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It will also lead to a
decrease in its supply as holders of the currency will be less willing to sell
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Speculative activity – If currency speculators believe a currency will appreciate in
value (perhaps because of favourable economic news) this will result in an increase in
its demand and a decrease in supply and vice versa
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An increase in supply is shown by a rightward shift of the supply curve (and vice versa)
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Diagrams showing a depreciation in the floating exchanges rates:

A decrease in demand or increase in supply will push the exchange rate down
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Changes in the imports and exports of the country: An increase in exports of a country
will lead to an increase in demand for the currency and thus the value rises
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Changes in Inflation rate: Higher inflation rate will make the country uncompetitive in the
international market
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Rise in domestic income relative to incomes abroad: currency depreciates
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Speculative sentiments: Individuals and institutions invest in currency markets with the sole
intention to get short term gains
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Whenever a
currency is going strong, people will invest more in an expectation to gain from it
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Global trading patterns: if strong global presence in trade then the currency appreciates
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Especially on what the country in consideration exports and imports
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This might lower aggregate demand and decrease inflation (Keynesian
model) if the economy was at its potential or the bottleneck
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

Imports they now seem cheaper due to appreciation of the currency
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Hence, the price level in the economy should fall (AS shifts down) and
inflation decrease as a result of appreciation in the exchange rate
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Currency depreciation


Exports become more competitive internationally
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Goods/services which have
low PEDs (price elasticity of demand) will not be likely to affect the AD by
much (e
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oil)
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A lot of industries use oil as an input in their production process
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Exchange rate change effect on employment and economic growth
Explain the impact of exchange rate changes on employment and economic growth
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Currency appreciation


Exports become less competitive, lower demand for them, producers might have to
cut production, hence, increasing unemployment and lower economic growth (or even
possibly falling GDP)
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

Imports become cheaper, so if they are used as inputs, producers face lower
production costs and that might encourage to increase the quantities produced
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However, because imports seem cheaper, people might substitute away from
domestic goods to imported ones and that would lead to falling employment and
lower GDP
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As quantity demanded grows,
producers hire more workers and increase production -> employment grows and GDP
increases
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

Imports become more expensive
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However, people might
substitute from imports which now seem more expensive to domestically produced
goods
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Exchange rate change effect on current account balance
Explain the impact of exchange rate changes on current account
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Movements in the exchange rate will have an impact on the current account
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Then that particular country will experience a
fall in the foreign price of its exports
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Assuming demand for exports is relatively elastic then a depreciation will lead to an increase
in the value of exports and therefore improve the current account deficit
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This will lead to a fall in demand for imports and also help to reduce the
current account deficit
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In theory, any imbalance in that
statement automatically changes the exchange rate
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The
country’s exports would become cheaper, resulting in an increase in demand and eventually
attaining equilibrium in the BOP
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Hence, the
reserves can be utilized for promoting economic growth by importing capital goods
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This is due to the fact that member countries are no longer required to keep huge
international reserves
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Trading in
international currencies itself becomes an important economic activity
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However, countries with floating
exchange rates do not face such a problem
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Hence, governments and banks do not need to resort to a
continuous management process
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Exchange rate tends to fluctuate like
price of goods in the commodity market
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It
becomes difficult to draw long period policies of exports and imports
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If the country is
already experiencing economic problems such as higher inflation or unemployment, floating
exchange rates may make the situation worse
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