EXCHANGE RATE - RECENT NOTES

Factors which influence the exchange rate

An exchange rate is determined by supply and demand factors. These are the various factors which determine the demand and supply of a currency.

1. Inflation
If inflation in the UK is lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for £s. Also foreign goods will be less competitive and so UK citizens will supply less £s to buy foreign goods.
Therefore the rate of £ will tend to increase.

2. Interest Rates
If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK, Therefore demand for Sterling will rise. This is known as “hot money flows” and is an important short run determinant of the value of a currency.

3. Speculation
If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise.
Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets.

For example, if markets see news which makes an interest rate increase more likely, the value of the Pound will probably rise in anticipation.

4. Change in competitiveness
If British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the Pound.

5. Relative strength of other currencies
Between 1999 and 2001 the £ appreciated because the Euro was seen as a weak currency.

6. Balance of Payments
A large deficit on the current account means that the value of imports is greater than the value of exports. If this is financed by a suplus on the financial / capital account then this is OK. But a country who struggles to attract enough capital inflows will see a depreciation in the currency. (For example current account deficit in US of 7% of GDP was one reason for depreciation of dollar in 2006-07)

Economic Effects of an Appreciation

An appreciation means an increase in the value of a currency. It means a currency is worth more in terms of foreign currency.

e.g. If £1 = €1 An appreciation of Pound could mean £1 =€1.2

Effects of an Appreciation

·         Exports more expensive, therefore less UK exports will be demanded

·         Imports are cheaper, therefore more imports will be bought.

·         A fall in AD, causing lower growth.

·         Lower inflation because:

·         import prices are cheaper

·         Lower AD and less demand pull inflation

·         More incentives to cut costs

Economic Effect of a Devaluation of the Currency

A devaluation occurs in a fixed exchange rate. A depreciation occurs in a floating exchange rate system. Both mean a fall in the value of the currency.

Economic Revision Notes on Devaluation

1. A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports

2. A devaluation means imports will become more expensive. This will reduce demand for imports.

3. Higher economic growth. Part of AD is X-M Therefore higher exports and lower imports will increase AD. Higher AD is likely to cause higher Real GDP and inflation.

4. Inflation is likely to occur because:

·                      i) Imports are more expensive causing cost push inflation.

·                      ii) AD is increasing causing demand pull inflation

·                      iii) With exports becoming cheaper manufacturers may have less incentive to cut costs and become more efficient. Therefore over time costs may increase.

Evaluation:

The effect on inflation will depend on other factors such as:

·         iv) Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to cause inflation

·         v) Do firms pass increased import costs onto consumers? Firms may reduce their profit margins, at least in the short run.

·         vi) Import prices are not the only determinant of inflation. Other factors affecting inflation such as wage increases may be important

5. There is likely to be an improvement in the current account balance of payments.
This is because exports are increasing and imports are falling

Government Intervention  in the Foreign Exchange market

Under certain circumstances, the government might want to intervene in the foreign exchange markets to influence the level of the exchange rate.

Methods to Influence the Exchange Rate

1.   Reserves and Borrowing. If the value of an exchange rate is falling and the government wants to maintain its original value it can use its foreign exchange reserves - e.g. selling its dollars reserves and purchase pounds. This purchase of Pound sterling should increase its value.

2.   Borrow The government can also borrow foreign currency from abroad to be able to buy sterling.

3.                  Changing interest rates (In UK this is now done by the MPC) higher interest rates will cause hot money flows and increase demand for sterling. Higher interest rates make it relatively more attractive to save in the UK.

4.   Reduce Inflation

·   Through either tight fiscal or Monetary policy Aggregate Demand and hence inflation can be reduced.

·   By decreasing AD consumers will spend less and  purchase less imports and so will supply less pounds. This will increase the value of the ER

·   Lower inflation rate will also help because British goods will become more competitive. Thus the demand for Sterling will rise.

However this policy has an obvious side effect because lower AD will cause lower growth and higher unemployment

5.   Supply side measure to increase the competitiveness of the economy. This will take along time to have an effect.

  

Fixed Exchange Rates

Definition of a Fixed Exchange Rate: This occurs when the government seeks to keep the value of a currency fixed against another currency. e.g. the value of the Pound is fixed at £1 = €1.1

Semi Fixed Exchange Rate. This occurs when the government seeks to keep the value of a currency between a band of exchange rate. In other words, the exchange rate can fluctuate within a narrow band.

E.g. the Pound Sterling could fluctuate between a target exchange rate of £1 = €1.1 and £1 = €1.2

Definition of a Floating Exchange Rate: this is when the govt does not intervene in the foreign exchange market but allowss market forces to determine the level of a currency.

· Exchange Rate Mechanism ERM. This was a semi fixed exchange rate where EU countries sought to keep their currencies fixed within certain bands against the D-Mark. The ERM was the forerunner of the Euro

Advantages of Fixed Exchange Rate

1. If the value of currencies fluctuate significantly this can cause problems for firms engaged in Trade.

·         For example if a firm is exporting to the US, a rapid appreciation in sterling would make its exports uncompetitive and therefore may go out of business.

·         If a firm relied on imported raw materials a devaluation would increase the costs of imports and would reduce profitability

2. The uncertainty of exchange rate fluctuations can therefore reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that the UK's reluctance to join the Euro and provide a stable exchange rates maker the UK a less desirable place to invest.

3. Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. This is because AD increases, import prices increase and firms have less incentive to cut costs.

4. A rapid appreciation in the exchange rate will badly effect manufacturing firms who export, this may also cause a worsening of the current account.

5. Joining a fixed exchange rate may cause inflationary expectations to be lower

Disadvantage of Fixed Exchange Rates

1. To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives.

· If a currency is falling below its band the govt will have to intervene. It can do this by buying sterling but this is only a short term measure.

· The most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures.

· However higher interest rates will cause lower AD and economic growth, if the economy is growing slowly this may cause a recession and rising unemployment

2. It is difficult to respond to temporary shocks. For example an oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue

DETAIL NOTES

Advantages and disadvantages of fixed and floating systems

The advantages of a fixed exchange rate system

Stability

Some economists would argue that this is the most significant advantage. If exchange rates are stable over a given period of time, exporting firms will be able to plan ahead without worrying about huge swings in the value of the pound eliminating their profit margin. This will encourage more investment and trade between countries, both of which are important if economies are to grow in the long term.

Discipline

If a country is part of an exchange rate system, they cannot devalue their currency at the first sign of trouble (i.e. a large current account deficit). They have to try and cure the fundamental problem by, for example, improving the competitiveness of their exporters through increased productivity and improved quality.

One can also argue that fixed exchange rate systems discipline countries into keeping inflation down. Again, there is no option to devalue if increasing inflation leads to reduced competitiveness.

Avoid speculation?

Theoretically, fixed exchange rates should eliminate speculation because there is no point buying and selling currencies that will not change in value. In the real world, this is not always the case.

Speculators believed the politicians when they said that these rates were forever, and so did not see the point in buying or selling the currencies involved.

The disadvantages of a fixed exchange rate system

The loss of monetary policy

A commitment to a fixed exchange rate means that you lose control over all other instruments of monetary policy. Although the government pretended that UK interest rate decisions we still their own (and technically they were) any movement of the German interest rate was usually quickly followed by a similar change in the UK. Today the Monetary Policy Committee (MPC) can set interest rates at whatever level they want, but they cannot control the value of the pound at the same time. Controlling one of these two instruments means a loss of control of the other.

The need for a large pool of reserves

To maintain the pound's value within the ERM, the government had to have a large pool of foreign reserves with which to buy the pound when it fell to the floor of the bottom band. Apart from being expensive in itself, some countries may find it hard to get their hands on sufficient stocks of reserves to support their currency. One of the main jobs of the IMF in the Bretton Woods system was to help poor countries in times of trouble and lend them reserves when they were short.

Problems of uncompetitiveness

With a freely floating currency, a deteriorating trade situation should automatically cause the pound to fall (speculators permitting!), which, in turn, would improve the competitiveness of British exporters and improve the trade balance.

Economies stuck in a fixed exchange rate system with a deteriorating trade balance may feel that they joined the system at too high an exchange rate. Although they may be allowed to devalue eventually, the exchange rate may be at the wrong rate for significant periods of time. This can cause permanent job losses and recession. Some economists feel that the recession of 1990-92 in the UK was prolonged due to membership of the ERM.

Advantages of a floating exchange rate system

Theoretical elimination of trade imbalances

As we have stated before, floating exchange rates should adjust automatically to trade imbalances, which, in turn, will eliminate the trade imbalance. Of course, it has also been noted that this does not always work in the real world because so few currency transactions that take place are for trade.

No need for reserves?

On the whole, foreign reserves are used to help maintain a currency's position within a fixed exchange rate. If a currency is freely floating, then there is no need to use reserves to affect its value. In the real world, governments will always have some reserves, in case of a crisis in the balance of payments, or if they feel that their currency is getting a bit too high or too low.

More freedom over domestic policy

As was stated above, if the government is not controlling their exchange rate, then they can control their rate of interest. The evidence of the past five years suggests that, although exporters suffer with a strong pound, the economy as a whole is best served when the authorities can control domestic monetary policy.

The disadvantages of a floating exchange rate system

Speculation

Again, there are two ways of looking at this. You could argue that with floating exchange rates, speculation is less likely because an exchange rate can move freely up or down, so it is more likely to be at its true level. But the very fact that it does move up and down easily means it can move a long way if speculators think that it is at the wrong level. The quick rise in the value of the pound in the second half of 1996 showed that big swings in currencies do not just happen when speculators force them out of fixed exchange rate systems.

Uncertainty

The biggest advantage of fixed exchange rate systems was their stability and certainty. This tended to increase investment and trade, both good things. The biggest disadvantage of floating exchange rate systems is their uncertainty, reducing the rate at which investment and trade increase. Firms often use the currency markets to hedge against large fluctuations in the exchange rate, which helps to a certain extent, but there is still felt to be too much uncertainty.