2.6.4 Y2 Exchange rate systems to help with education.pptx

Exchange rate notes

1. AQA 2.6 The international economy 2.6.4 Exchange rate systems What factors have influenced the £:€ exchange rate?

2. 2.6.4 What you need to know How exchange rates are determined in freely floating exchange rate systems How governments can intervene to influence the exchange rate The advantages and disadvantages of fixed and floating exchange rate systems Advantages and disadvantages for a country of joining a currency union, e.g. the eurozone

3. Exchange Rate Options Exchange rates play a crucial role in international trade and governments have a choice of exchange rate systems they might adopt. These are: Floating Exchange Rate The exchange rate is determined solely by the forces of demand and supply Fixed Exchange Rate This is a system where the government ties its exchange rate to the price of another currency This is usually done within a narrow price band Managed Exchange Rate The exchange rate is primarily determined by demand and supply but the government may intervene on occasion to influence the exchange rate

4. Free Floating Exchange Rates A floating exchange rate is an exchange rate that is set purely by the forces of demand and supply , and free from government intervention These forces include : Demand Supply Exports of goods and services Imports of goods and services Inflows of FDI Outflows of FDI Speculation Speculation Inflows of ‘hot money’ Outflows of ‘hot money’

5. Free Floating Exchange Rates Diagram Price $ per £ S£2 Q2 D£1 Q1 S£1 D£2 $1.50 $1.60 $1.40 Quantity Imagine an exchange rate is in equilibrium at D£1S£1 with £1 able to buy $1.50. If there was an increase in UK interest rates, this would increase the D£ and there would be a shift to D£2. This would cause an appreciation in the exchange rate with £1 now able to buy $1.60. If there was an increase demand for US exports, there would have to be an increase in S£ to pay for them, so there would be a shift to S£2. This would cause a depreciation in the exchange rate with £1 now able to buy $1.40.

6. Advantages & Disadvantages of Floating Exchange Rate Systems Advantages Disadvantages Automatic adjustment of BoP Countries with a large BoP deficit will find their currency weakens as they sell currency to buy imports. The weaker currency, then makes exports more price competitive, which helps to improve BoP deficit. Uncertainty There is no certainty as to the exact price of a currency on a daily basis. Flexibility The government isn’t tied into trying to maintain a particular exchange rate, which can be expensive and constrictive. Speculation With no upper or lower limit on the price of a currency, floating exchange rates might still be subject to speculation by investors. Low requirement to hold large foreign exchange reserves A fixed rate system requires a country to hold large reserves in the event of having to try to maintain value. A floating system negates this requirement. Inflation When an exchange rate weakens, it increases the price of imports, and potentially inflation. This is especially true for countries who rely on the import of primary raw materials. Freedom to pursue other macroeconomic objectives If the government is not using its resources to meet an exchange rate target, it can use its resources to pursue other objectives without constraint. It also means monetary policy can focus solely on inflation management, rather than exchange rate management. Damage to investment Due to the above factors, investment might be discouraged, particularly from abroad.

7. Dataset 1: UK£ v US$ Research the reasons behind the change in the UK£/US$ exchange rate over the 12 month period. What are the implications for the UK of this trend? Should the UK government intervene and move to a more managed exchange rate?

8. Dataset 2: UK£ v € Research the reasons behind the change in the UK£/ € exchange rate over the 12 month period. What are the implications for the UK of this trend? Should the UK government intervene and move to a more managed exchange rate?

9. Fixed Exchange Rates This occurs when a government tries to maintain its exchange rate against that of another currency It is often implemented in order to promote trade and exports , and is typically used by countries with a degree of instability or high and rising levels of inflation The exchange rate is usually fixed to the US$ , and is artificially maintained by the government and central bank It is necessary for the central bank to hold large reserves of foreign currency , which they either buy or release onto foreign exchange markets in order to maintain the fixed rate

10. Fixed Exchange Rates: Diagram 1 Price $ per £ Q2 D£1 Q1 S£1 D£2 $1.50 $1.60 Quantity Imagine the UK wants to maintain a fixed rate of £1:$1.50. Now suppose there is an increase in D£ to D£2 due to an increase in demand for UK exports from the US. In a free market, the rate should rise to £1:$1.60. However, the central bank will have to buy Q1Q2 of US$ from its currency reserves in order to maintain the £1:$1.50 rate. Alternatively, the central bank could lower interest rates, to reduce the D£.

11. Fixed Exchange Rates: Diagram 2 – Chinese Yuan The Chinese Yuan was fixed against the US$ until 2005, principally to keep the Chinese currency low in order to boost exports. China fixed the exchange rate at P*, below its natural free market equilibrium at P, which should rise as demand for Chinese exports increases. In order to maintain this rate, China increases the supply of Yuan on foreign currency exchanges by gap Q*1-Q*2 and buys US$’s. The Chinese were able to do this by utilising the large reserves of currency they had built up through exports. Price of Yuan against US$ Q*1 D Q S P P* Q*2 S* Quantity of Yuan

12. Advantages & Disadvantages of Fixed Exchange Rate Systems Advantages Disadvantages Reduces uncertainty If economic agents know how much a particular currency is worth, this can raise confidence and enhance trade creation. Maintenance A number of fixed exchange rate systems have been difficult to sustain in the long-term, as they are expensive in terms of the requirement to hold large foreign currency reserves. Economic growth With greater certainty comes greater investment, which may boost supply side capacity and improve competitiveness. Speculation If investors know for example that a government might intervene to buy back currency to maintain its level, they might sell extra currency in order to make a short-term profit. Low inflation If the exchange rate is set relatively high, this means exports may become less price competitive and imports will become relatively cheaper which helps to reduce demand-pull and cost-push inflationary pressures. Conflict with other objectives If a currency is depreciating, the central bank may have to raise interest rates to attract hot money flows to increase the exchange rate. This may damage consumption and other components of aggregate demand. As a result, there is loss of control over monetary policy. Discipline of economic management It can be argued that a fixed exchange rate requires sound financial management and a long-term view, rather than have to deal with the problems of exchange rate fluctuations. No automatic adjustment of BoP Under a floating system, there can be an automatic stabiliser effect on the BoP, but if there is a severe deficit, then this can only be rectified by stifling demand or devaluing the currency, which in turn, might invite further speculative pressures.

13. Managed Exchange Rates Given some of the advantages and disadvantages of fixed and floating exchange rate systems, some governments favour the use of a ‘managed’ exchange rate system, which aims to gain the advantages of both floating and fixed systems, whilst minimising the disadvantages This is sometimes called a managed float If this is done deliberately to gain an advantage over trading partners, this is known as a dirty float This typically involves the government and central bank deciding upon an upper and lower limit that they ideally would like the exchange rate to operate between The government and central bank will only intervene in the event that there is a danger of the upper or lower limits being breached It is unlikely they will advertise openly these limits in order to avoid speculation , however it is hoped that some degree of certainty can be achieved without excessive and only occasional intervention Although not specifically in the specification, it is useful to have knowledge of a “3 rd option” as regards exchange rate management.

14. The government might hypothetically set a price ceiling of £1:$2 and a floor of £1:$1. If there is danger that the £ has strengthened significantly towards the upper band, this may damage exports, so the government/central bank might intervene by for example, lowering interest rates or increasing the S£ to buy $. Equally, if the £ has weakened considerably so that imports are more expensive and creating inflationary pressure, intervention to buy £’s or raise interest rates may keep the currency within its permitted bands. Price $ per £ D£1 Q1 S£1 $1.50 $2 $1 The wider the band in the managed float, the less intervention will be required, and vice versa. Quantity Managed exchange rates

15. How Governments Intervene to Influence Exchange Rates If a government wishes to intervene to fix or manage its exchange rate, it has four main options: Change interest rates If the government wishes to strengthen its currency in the UK, it can increase rates. This will increase the demand for sterling via the inflow of ‘hot money’ as currency investors move funds to the UK to take advantage of higher interest rates However, this policy may be inconsistent with domestic macroeconomic conditions Use foreign currency reserves If the UK is faced with a high value of sterling which is damaging export growth, the government can sell £s from its stock of currency reserves on foreign exchange markets to increase their supply and reduce sterling’s value Similarly, if sterling was viewed as too weak, the government can buy sterling on foreign exchange markets from its reserves of other global currencies However, this is difficult to manage and potentially expensive relying on a large pool of reserves which may not be sufficient at certain times

16. How Governments Intervene to Influence Exchange Rates Borrowing If the government does not have sufficient reserves, it can borrow currency on foreign exchange markets. This may i nvolve borrowing its own currency, or others depending upon what the government wants to achieve However, borrowing currency comes at a cost and also involves taking on additional exchange rate risk Inflation If the government is able to successfully reduce inflation, this will make UK exports more price competitive, which will boost the demand for sterling and cause an increase in the exchange rate Similarly, a higher rate of inflation may damage export competitiveness and reduce the demand for sterling However, this type of currency manipulation is indirect and maybe less effective, and also potentially conflicts with other macroeconomic policy objectives

17. Currency Unions A currency union is a group of independent countries that share a single currency This is also known as monetary union Technically, the UK is a currency union, across England, Scotland, Wales and Northern Ireland, but the largest currency union globally is the Eurozone The Eurozone came into existence on 1 st January 2002, and initially had 12 members This has now expanded to a currency union of 19 countries: Austria , Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain

18. Advantages and Disadvantages of Joining a Currency Union Advantages Disadvantages Price Transparency, Competition and Efficiency In a currency union, price comparison is straightforward. This may help firms cut costs, as they will be able to find the cheapest product more easily and s hould encourage greater competition as there is greater transparency in prices. This should help increase efficiency as firms are forced to remain competitive. “One Size Fits All” Monetary Policy A currency union requires a single monetary policy. This means interest rates being set centrally for all Euro countries. E.g. if an individual country is suffering a downturn in economic activity, but the rest are booming the c entral Bank may want to increase interest rates, but that would simply worsen the recession for that country. Inward Investment Members of the currency union should be able to access other members markets and equally the country may attract FDI, releasing the potential for additional economic growth. Loss of National Sovereignty The transfer of money and fiscal competencies from national to community level, means economically strong and stable countries would have to co-operate in the field of economic policy with other, weaker, countries. Elimination of Exchange Rate Uncertainty Joining a currency union should end currency instability and a country should be more secure against currency speculation. Moreover, businesses would not face hedging costs to insure themselves against currency fluctuations. Economic Shocks External economic shocks may have an adverse impact which is exacerbated by constraints on monetary and fiscal policy meaning an individual government may find it difficult to react to economic shocks. Elimination of Currency Conversion Costs Converting between currencies has a cost for individuals and firms. Joining a currency union will remove these costs. Transition Costs Joining a currency union involves short term transition costs which would disappear once the new currency was fully established. For example, new money has to be issued and the old withdrawn, vending machines have to be adapted to take the new coins, and foreign exchange departments may shrink in size in some financial institutions.