Exchange Rate Systems
Freely floating exchange rates
currency value is set purely by market forces
the strength of currency supply and demand drives the external value of a currency in the market
no intervention by the central bank
the central bank allows currency to find its own level
No target for the exchange rate
external value of currency is not an intermediate target of macroeconomic policy
demand comes from:
sale of exports to other countries, leading to an inflow of foreign currency
inflows of financial capital such as FDI
speculative demand for currency inflows of hot money into the banking system (IR)
inflows of remittances
factors causing an appreciation
current account surplus
strong inward investment inflows and portfolio flows
relatively high policy interest rates
speculative currency demand
factors determining currency's value
trade balances (surpluses tend to have appreciating currency)
FDI
portfolio investment
interest rate differentials
examples of floating exchange rates
UK
USA
Mexico
Australia
Impact of currency depreciation
inflation - higher import prices increase cost push
economic growth -lower £ stimulates growth from more X
unemployment - increase domestic production, export multiplier
balance of trade - dependent on PED
business investment - improve profitability
evaluation
time lags
scale of change
long term/ short term change
PED
when the change takes place
type of economy
degree of openness to international trade
Fixed exchange rates
Government/ central bank fixes currency value
external values is pegged to one or more currencies (anchor currency) :
the central bank must hold sufficient foregin exchange reserve in order to intervene in currency markets to maintain the fixed peg
Pegged exchange rate becomes official rate
trade taxes place at this official exchange rate
may be unofficial trades in shadow currency markets
Adjustable peg
occasional realignments may be needed
devaluation or revaluation depending on economic circumstances
If the fixed rate is £1=$1.50 but the current equilibrium is £1=$1.60 (overvalued), the £ needs to be sold ad buy up the $. this increases supply of £ and reduces the price back to $1.50
If its undervalued, foreign currency needs to be used to buy £ to reduce the supply and increase the price
exchange rates can be changed to achieve other objectives
Managed floating exchange rates
currency usually set by market forces - the central bank gives a degree of freedom for market exchange rates
central bank may intervene occasionally (buying to support a currency or selling to weaken a currency), changes in policy interest rates to affect hot money flows
currency becomes a target of monetary policy - higher rate to control inflationary pressures, 'competitive devaluation' to improve competitiveness
tools for managed floating rates
changes in monetary policy interest rates
quantitative easing to increase liquidity causing outflows of money and a depreciating exchange rate
direct buying and selling in the currency market
taxation of overseas currency deposits and capital controls
examples
Brazil
Switzerland
Japan
Ghana
Competitive devaluation
when a country deliberately intervenes to drive down the value of the currency to provide a competitive raise to demand and jobs in export sectors
may be done when faced with deflationary recession or to attract FDI
may be used when there is a persistent trade deficit
could be seen as a form of protectionsim so may invite relatiation
Evaluation
Floating exchange rates
Advantages
reduces the need to hold large amounts of currency reserves
freedom to set monetary policy to meet domestic objectives
may help to prevent imported inflation
insulation for an economy after external shock for export dependent countries
partial automatic correction for CA deficit
less risk of currency being under/over valued
Evaluation
no guarantee of stability
volatility may repel FDI
may not correct BoP deficit
Fixed exchange rates
advantages
certainty of currency gives confidence for inward investment
reduced costs of currency hedging
stability helps control inflation
lead to lower borrowing costs
imposes responsibility on gov macro policies
less speculation if fixed rate is credible
evaluation
reduced freedom for macro objectives
many countries do not have sufficient foregin currency to maintain fixed rate
difficult to use competitive devaluation
devaluation could cause cost push inflation
Currency Union
an intergovernmental agreement involving two or more states sharing the same currency. Also known as a monetary union. Examples include the Euro shared by the majority of countries in the Euro-zone
Advantages
lower transaction costs of changing currencies - could equal 1% of GDP. also increases tourism suggestions say the Euro increased tourism by 6%
price transparency - easier to compare prices. able to source cheaper materials
eliminate exchange rate uncertainty
improved trade
improvement in inflation performance
could argue that there is too much focus on inflation rather than unemployment and growth
low interest rates
inward investment
Disadvantages
interest rates may not be suitable for the whole area
more barriers to movement of factors eg laws and language differences
limits fiscal policy
lack of incentives for responsibility if there is a safety net
no scope for devaluation even if exports become uncompetitive