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Exchange rates - 3.2 - Coggle Diagram
Exchange rates - 3.2
Free floating eg $ and €
When the exchange rate is determined by market forces (D and S) thus, there is no government intervention.
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D curve = D for $ from eurozone citizens who need $ to carry out transactions in the US, importers buying goods in the US, investors investing in the US or tourists in the US.
S curve = S of $ by US residents giving up $ to buy €, importers from euros zone countries, tourists in the eurozone o investors in the eurozone.
As the price of $ in terms of € increases, the quantity of $ supplied increases.
The value of the $ will appreciate if there is either an increase in the demand for $ (causing a rightward shift) or a decrease in the supply of $ (causing a leftward shift).
The value of the $ will depreciate if there is either an increase in the supply of the $ (causing a rightward shift) or a decrease in the demand for the $ (causing a leftward shift)
When a currency appreciates, it can buy more foreign goods/imports. Imports become cheaper. Accordingly, more of other currencies are needed to purchase the appreciated currency hence, exports decrease due to them being more expensive.
Government intervention
Fixed exchange rates
Fixed by the central bank of the country and are not permitted to change in response to supply and demand. This requires constant intervention and selling currencies to shift demand or supply curves and eliminate disequilibriums.
- Increase IR: attracts financial investments = increase in D for domestic currency = shifts D. May involve contractionary monetary policy which can lead to a recession.
- Limit imports: Policies attempting to reduce the supply of domestic currency eg contractionary policies these lower AD, incomes hence imports. Or trade protection policies like tariffs.
Devaluation: the currency has a higher value than can be maintained hence the government changes the fixed rate to a lower value.
- cheaper exports to foreigners and more expensive imports for domestic
X > M
Revaluation: the currency has a lower value then can be maintained hence the government sets a higher value.
- more expensive exports to foreigners and cheaper imports for domestic. X < M
If a country experiences serious difficulties in maintaining the fixed exchange rate, a different fixed rates can be set.
Managed exchange rates
Usually free-floating over long periods of time however, can be managed periodically by central banks to stabilise them in the short-term.
Intervene to prevent large, abrupt fluctuations in exchange rates, these disrupt the flow of international trade creating uncertainties
Overvalued currencies: value that is too high relative to its equilibrium free market value. Developing countries over value their currency as imports become cheaper. However exports become more expensive has negatively affecting domestic exporters and the current account balance worsens.
Undervalued currencies: the value is too low relative to its equilibrium free market value. Exports become less expensive to foreign buyers or imports become more expensive domestically. Some developing countries have use this method to expand export industries had to expand their economies and increased employment.
Demand for foreign currencies generates a supply of a domestic currency. If travelling abroad, a tourist will supply their home currency to the foreign country.
The value of each currency is determined through the exchange rate. eg the amount of $ needed to purchase €1 is determined by the exchange rate. The price of one currency is determined in that of another
Causes of changes
Domestic D for imports: If US consumers import more Germany cars, they must purchase € to purchase the car. Hence, they supply $ to the market causing a rightward shift of the S curve and a depreciation fo the currency
The higher the rate of interest in the US the more attractive investments become. Hence, foreign investors will invest in the US = increase demand for $ = rightward shift of the D curve and an appreciation of the $ (and vice versa relative to changing IR)
If the US experiences a higher inflation rate than other countries, exports will decrease as foreign countries will find US goods 'too expensive' = D for $ decreases = leftward shift of D curve = deprecation of the $. Accordingly, imports by Americans will increase as goods become cheaper abroad = increase in S of $ to the market = rightward shift of S curve = depreciation of $
Speculation: (the buying and selling of a currency to make a profit from the changes in exchange rates). If currency speculators think the $ will appreciate, they purchase the currency in hopes of selling it later when the exchange rate is higher. however, by purchasing it they are technically causing it to appreciate therefore it is self-fulfilling.
Foreign demand for exports: If there is an increase in foreign D for American watches, the D for US$ will increase = shifts to the right and the $ appreciates.
Effects of changes
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Current account balance: If a country has excess imports the trade deficit (when M>X) is likely to become smaller. If it has excess exports it's trade surplus (M<X) is likely to become larger. An appreciation however will cause imports to increase and exports for dust by having the opposite effect on the current account balance
Cost-push inflation: if domestic producers are dependent on imported FOPs cost of production will increase. Hence the SRAS curve will shift leftwards and cost push inflation will occur. The more inelastic the demand for the imported FOP the greater the cost push inflation
Employment: As a currency depreciates, net exports increase (due to decrease M and increased X) = increase in AD = increase in employment. As a currency appreciates, net exports decrease = AD decreases = recession = increase/cause cyclical unemployment
Demand-pull inflation: Exchange rates changes affect AD due to influences on net exports. A currency depreciation by making exports cheaper and imports more expensive will increase net exports hence AD causing demand-pull inflation. Appreciation will reduce demand-pull inflation due to decreased X-M