Chapter 6 - Exchange Rates Flashcards
What is an exchange rate?
The price of one currency in terms of another
What is a floating exchange rate?
When the price of one currency in terms of another is determined purely by the forces of demand and supply
What is a fixed exchange rate?
When the price of one currency in terms of another is set and maintained by central authorities
What factors can cause an appreciation of a floating exchange rate? 5
What diagram do we use
Diagram = standard supply and demand with demand shift right, on the axis: price of £ / quantity of £
1) A relative rise in UK interest rates
UK rates rise relative to rest of world -> investors looking for best interest rate rate for their money are more likely to save in UK banks -> increasing demand for £ -> appreciating value (hot money inflows)
2) An increase in FDI in Britain
More FDI enters Britain -> higher demand for £ as capital will need to be bought by foreign businesses in GBP -> staff will need to be paid in £
3) Speculators anticipating a rise in the pound
Speculators are currency traders who make trades based on their expectations of exchange rate cahges -> anticipate rise -> go long, buying of currencu -> increase in demand
4) Increase in export demand
Could be due to higher incomes abroad and/or improvements in international competitiveness of domestic exports -> increasing demand for GBP to purhcase exports
5) High investor confidence in economy
If there is high confidence in long term state of UK economy with little economic volatility -> investors see UK as a safe and realiable place to store/invest their money for a good rate of return -> increasing demand for GBP
What are the causes of a depreciation of a floating exchange rate? What diagram?
Diagram = Normal Demand/SUpply diagram with supply shift right, Price and Quantity of £ on the axis
1) Fall in relative interest rates and quantitative easing
Hot money outflows -> investors move money out of UK financial institutions -> increasing supply of GBP. QE directly increases supply of GBP
2) Outward direct investment
Where UK businesses move operations outside of the UK, this will invovle selling the £ in order to buy foreign exchange to invest in target country -> increasing supply
3) Speculators anticipating a fall in the pound
peculators are currency traders who make trades based on their expectations of exchange rate cahges -> they go short, selling GBP against other currencies -> increasing supply
4) Increase in import demand
Could be cuz of a rise in disposable incomes at home -> More GBP being converted into foreign currencies in order to pruchase imports -> increasing supply of imports
5) Low investor confidence in the economynomy with the UK economy seen as volatile and unsafe coutnry for investors to store/invest -> investors will move money out of UK -> selling GBP -> increasing supply
6) A fall in export demand (THE ONLY FACTOR THAT CAN BE EXPLAINED USING A DEMAND SHIFT LEFT INSTEAD OF SUPPLY)
For reasons such as lower incomes abroad -> fall in British export demand -> lower demand for GBP to purchase exports
How can a central bank maintain a fixed exchange rate coming under rising pressure? Diagram
Diagram = simple P£ / Q£ with Demand and Supply curve shifts
1) Manipulate its currency reserves
Selling reserves of domestic currency and buying up foreign currency, adding to foreign currency reserves -> increasing supply of domestic currency from S1 to S2 in FOREX markets and reduce upward pressure back to the fixed rate
2) Lower interest rates
Investors will move their money out of domestic financial institutions in order to chase better rates of return elsewhere -> hot money outflows -> increasing suppy of domestic currency from S1 to S2 in FOREX markets -> reducing upward pressure back to the fixed rate
How can a central bank maintain a fixed exchange rate thats coming under falling pressure? Diagram
SEE FLASHCARD FOR DIAGRAM
1) Manipulate its currency reserves
Selling reserves of foreign currency and buying up domestic currency, adding to domestic currency reserves -> increasing demand of domestic currency from D1 to D2 in FOREX markets -> reducing dowwards pressure back to the fixed rate
2) Increase interest rates
Investors will move money into domestic financial institutions in order to chase better rates of return -> hot money inflows -> increasing demand for domestic currency from D1 to D2 in FOREX markets -> reducing the downward pressure on it back to the fixed rate
What are the PROS of a depreciation of exchange rates? 3
diagram
1) Improve trade balance
WIDEC -> improved trade balance of CA a reducing CA deficit or moving it to a surplus.
2) Increased growth and reduced unemployment
Economic theory suggests that WIDEC will increase (x-m) in AD equation, AD will rise from AD1 to AD2. increasing economic growth and reducing unemployment
3) Increased FDI
Weak exchange rate could motivate foreign firms to push forward with investment plans given that set up costs will be lwoer with a greater potential for revenue from exports once set up -> increases in FDI can boost growth, employment and tax revenue for the country
What are the CONS of a depreciation of exchange rates? 4
diagram
1) Inflation
Demand-pull infaltionary pressure will rise, as AD increases, more pressure put on existing factors of production increasing their price and increasing costs for firms which will feed through to higher prices from P1 to P2.
COST PUSH INFLATION will also rise as it will be more expensive for firms to import raw materials (diagram SRAS shift left) firms will pass costs on in the form of higher prices to consumers
WORSE for a nation that depends heavily on imported commodities and raw materials, significantly dampening economic growth form Y1 to Y2 perhaps even leading to stagflation
2) Lower living standards
Weak exchange rate acn directly increase price of imported goods, reducing affordability and living standards of households -> especially damagin for households in developing countries where imports contribute greatly to a rise in living standards but incomes are not large anough to absorb a rise in import price
3) Domestic producer inefficiency
Domestic producers benefit heavily from weaker exchange rates and gain competitive advnatages that can lead to compacency and inefficiencies in production
-a) Exports are cheaper, increased demand and revenue
-b) Imports are realtively more expensive, reducing demand for imports
As a consequence, when interest rates rise again, firms couild become uncompetitive harming profitability and LR economic growth
4) Increased foreign debt burdens
A weak exhcnage rate makes it ahrder to finance debts that are held in foreign currency, mostly held by governments and firms. This impacts profitability of firms and limits ability of Gov spending AND an ioncreased risk of bankrupcy for both
What are the evaluation points for an exchange rate depreciation? (opposite for appreciation) 6
1) Marhsall Lerner condition
The Marshall-Lerner condition states that for a currency depreciation to improve a coutry’s current account deficit, the PEDx + PEDm > 1
Implying there must be a strong demand response to cheaper exports for export revenue to rise and a strong demand response to more expensive imports for import expenditure to fall enough to imporve a CA deficit.
If not satisfied, there will be a net increase in import expenditure relative to export revenue, worsening the trade balance and CA deficit
1a) Marhsall-Lerner condition will not be met in shor run due to very price inelastic demand for imports and exports -> contactual agreements make it difficult for countries to immediately switch -> consumers and businesses take time to adjust and find substitute goods -> leading to the J curve effect -> where a weakening of exchange rate will intially result in a worsening of CA deficit due to these inelasticities before improving and recording a surplus after economic agents adjust.
2) Depends on severity of trade restrictions imposed by foreign governments
IF foreign governments have strict controls restricting the level of imports entering the country, a fall in exchange rate may do little to increase overall revenue brought in by exports.
HOWEVER work of WTO over recent year has significantly liberalised trade
3) Depends on size of the depreciation
Large depreciation = Signifcant increase in demand for exports thanks to large drop in price, swaying foreing consumers and firms to purhcase HOWEVER can lead to large inflation on demand and supply side through increase in AD close to Yfe and increases in costs of raw materials
4) Depends on incomes overseas
If low due to recession then there will be little change in demand for exportsd
5) Depends on incomes at home
If high due to economic growth then rises in price of iports can be absorbed and may not affect demand
6) Benefits of growth, unemployment and inflation will depend on intial level of economic activity
What are the cons of an appreciation in exchange rate? What diagram? 3
1) Trade balance deterioration
SPICED -> worsening of trade balance of current account -> increasing deficit or worsening a surplus
2) Reduced growth and increaed unemployment
DIAGRAM = Keynesian LRAS with AD shift left
SPICED means a reduction in (x-m), componenet of AD -> AD will decrease -> reducing economic growth from Y1 to Y2 -> labour is derived demand -> plus firms make less revenue therfore need to reduce costs
3) Lower FDI
A strong exchange rate could motivate foreign firms to leave and move to contries where curencies are weaker given the potential negative efect on export revenue -> outward FDI could harm growth, employment and tax revenue for country
What are the pros of an appreication in exchange rate? 4
What diagram?
DIAGRAM = Can use keynesian aswell BUT defo use SRAS shift right
1) Reduced demand pull inflation + cost push inflation
2) Cheaper imports = Higher living standards
Imports are more affordable -> increasing living standards of households -> beneficila for households in developing countries where impotrs contribute largely to rising living standards
3) Drive to increase efficiency
With higher costs of production and lower revenues, domestic firms are forced to be more competitive and efficient to remain ptofitable -> this could include for example training programs to boost staff productivity, exploiting EOS, negotiating better deals and investing in better capital ->if this occurs accross economy then short term and long term growth will increase -> increased in AD and LRAS
4) Reduced foreign debt burdens
Strong exchange rate makes it easier for governments and firms to finance foreign debt burdens -> increasing profitability and for governemnts freeing up more liquidity and imporving ability to losen fiscal policy and reducing risk of bankrupcy
What are the arguments in favour of using a floating exchange rate? 5
1) Reduced need for currency reserves
No exhcnage rate target -> no need for intervention in FOREX markets in order to manipulate rate -> holding such reserves is extremely expensive and carries a large opportunity cost -> forgoing this expense allows for greater expenditure on productive areas of economy -> leading to sustained growth overtime
2) Freedom for domestic monetary policy
Absence of an exchange rate target allows for interest rates to be set whenever needed to meet inflation targets and other macroeconomic objectives
3) Useful instrument of macroeconomic adjustment
Floating exchange rate acts as a useful instrument of macroeconomic adjustment often following the economic cycle ->
In recession -> exchange rate depreciates -> WIDEC boosts export revenue and decreases import expenditure -> boosting AD -> stimulating growth
In boom -> appreciations can be useful in keeping inflation under control
4) Partial automatic correction for a trade imbalance
Floating exhcnage rates offer a degree of adjustment when the balance of payments is in fundamental equilibrium -
A large trade deficit -> puts downwards pressure on exchange rate due to increases suppl of £ to buy imports -> should boost export revenue and reduce import demand -> self rectifying the trade deficit
5) Reduced risk of currency speculation
Absence of an explicit exchange rate target reduces the risk of curency speculation.
Often, currency market speculaters target a fixed exchange rate that they believe tp be fundamentally over/under valued -> but floating rates this risk is minimised as in theory the floating rate shoudl represent PPP -> less likelihood of speculative attack and rate is unliekly to collapse and trigger economic crisis
What are the arguments AGAINST using a floating exchange rate system? 3
1) Can create uncertainty if volatile
Difficult for businesses trying to plan for their future, cant make accurate predictions about costs and revenues.
Harder to asses risk and return on investment
Exporters and imports find it harder to interpret short vs long-term changes
All of this uncertainty reduces volume of trade -?> reduces FDI -> reduced actual and potential growth
2) They dont always self-adjust to elimante trade balances OR reflect PPP as theory suggests
Because there are other more dominating factors other than trade that can affect movemetns in exhcnage rate and stop PPP being relfected
3) Floating exhcnage rate may worsen inflation
If a country has high levels of relative inflation -> this will make exports less competitive and imports less expensive -> exchange rate will then fall given increased supply of GBP to pruchase imports -> this could increase demand pull inflation as (x-m) increases AND cost push inflation as price of imported raw materials rises -> further fueling inflation
What are the arguments IN FAVOUR of a fixed exchange rate system? 4
1) Reduced uncertainty -> increases trade and investment
Easier for businesses trying to plan for their future, can make accurate predictions about costs and revenues.
Easier to asses risk and return on investment
Exporters and imports find it easier to interpret short vs long-term changes
This increased certainty increases volume of trade -?> increases FDI -> increasing actual and potential growth
2) Some flexibility is permited
If exchange rates are set damagingly high or low, then DEVALUATION or REVALUATIONs are permitted if an agreement is reached with other countries -> however countries with fixed echange rates tend to be reluctant to do so as it goes against the reasons for having a fixed rate in the first place
3) Disciplines on domestic producers
Exporters are forced to organically imporve competitiveness of exports without the assitance of exchange rate depreciations, this could include; this could include for example training programs to boost staff productivity, exploiting EOS, negotiating better deals and investing in better capital ->if this occurs accross economy then short term and long term growth will increase -> increased in AD and LRAS
4) Reductions in currency hedging
With floating rates, many businesses hedge against volatility by buying the currency in the future currency markets, which is risky and more expensive than purchasing in SPOT markets -> with fixed rates, businesses have less need to do this as they know the currency will hold its value in the FOREX markets overtime -> enabling money to be used more efficiently
