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Exchange Rates, Floating / flexible exchange system, Managed exchange rate…
Exchange Rates
Exchage Rate (relative value of a currency in terms of another) Systems
Floating exchange rate system
Exchange rates are solely determined by the market forces of demand and supply of currency within the Foreign Exchange market
Managed exchange rate system
exchange rate floats in the foreign exchange market and there will be central bank intervention from time to time to prevent undesirable movements in the exchange rate
Fixed exchange rate system
Value of a currency is pegged or fixed relative to another currency or the average of a few selected currencies (there is some central bank intervention to maintain the fixed exchange rate)
Floating / flexible exchange system
Demand for currency
Arises from foreigners (buy the domestic currency --> increase demand)
Supply for currency
Arises from domestic residents (sell their domestic currency --> increase supply)
Causes for appreciation and depreciation
Relative growth rate
Appreciation: domestic country's relative growth rate is lower --> fall in national income --> fall in purchasing power --> fall in demand for imports / relative rise in the demand for domestic goods --> increase in demand for domestic currency --> appreciation
Depreciation: domestic country's relative growth rate is higher --> national income rises --> purchasing power rises --> increase in demand for imported goods --> rise in the supply of domestic currency / fall in demand for domestic currency --> depreciation
Relative interest rate
Appreciation: domestic country's interest rates have increased relatively --> increase in expected rate of returns of investment
--> short term inflow of capital (portfolio investment and FDIs) --> increase in demand for domestic currency / fall in supply of domestic currency --> appreciation
Depreciation: domestic country's interest rates are lower --> fall in expected rate of return --> short term outflow of capital --> fall in the demand / rise in the supply of the domestic currency --> depreciation
Relative inflation rate
Appreciation: domestic country's relatively lower inflation rate --> exports are relatively cheaper --> increase in the demand for country's exports --> buy more domestic currency to purchase exports --> increase demand for currency --> appreciation
Depreciation: domestic country's relatively higher inflation rate --> exports are more expensive --> lesser demand for exports --> fall in demand for currency --> depreciation
Changes in taste and preference
change in the taste and preference --> affects demands (foreign and domestic) for exports and imports
Political stability and central bank intervention
Appreciation:
stable political environment --> firms have confidence --> inflow of portfolio investments and FDI --> increase in demand for the currency / fall in supply --> appreciation
central bank sells its holdings of foreign exchange / buys more domestic currency --> increase in demand for domestic currency
--> appreciation
Depreciation:
unstable government --> firms have no confidence in economy and high uncertainty of future ROI --> refrain investment (outflow of FDI and portfolio investment) --> rise in supply / fall in demand for the currency --> depreciation
central bank buys more foreign currency / sells domestic currency --> increases supply of domestic currency --> depreciation
Remittances - payments made by foreign workers to individuals in their home country
Appreciation: many remittances into the country (domestic workers work abroad and send money into the country) --> increase in the demand / fall in supply of domestic currency --> appreciation
Depreciation: many remittances out of the country (many foreign workers sending money out of the country) --> fall in demand / increase in supply of domestic currency --> depreciation
Long term investment prospects
influenced by many factor, e.g. stable economic growth
Appreciation: inflow of long term investments (FDI and portfolio investments) due to stable and conducive economic environment --> increase demand for domestic currency
Depreciation: unstable and unconducive environment --> no confidence --> outflow of investment --> rise in the supply of the currency (people will sell their holdings of the domestic currency and buy more foreign exchange)
Speculation and anticipated changes in exchange rate - currency speculation is when currencies are bought or sold in anticipation of a change in exchange rate to make a capital gain
Appreciation: speculate an appreciation --> buy more domestic currency --> fall in supply / rise in demand of domestic currency --> appreciation
Depreciation: speculate a depreciation --> sell more domestic currency --> rise in supply / fall in demand for domestic currency --> depreciation
Consequence of appreciation and depreciation
Living standards
Appreciation:
currency appreciates --> prices of imported goods and imported inputs (FOP) fall --> fall in COP --> fall in prices of goods due to downward pressure on inflation rate (reduction in cost-push and demand-pull inflation: there is a fall in COP and rightward shift of SRAS + fall in export revenue and fall in AD) --> real income rises --> purchasing power rises --> higher material SOL
demand for exports falls --> fall in production --> unemployment rises --> loss of income --> material SOL falls
Current account balance
Appreciation:
rise in prices of the country's exports in foreign currency and fall in the prices of imports in the domestic currency --> demand for exports fall while demand for imports rise --> worsen current account (export revenue falls and import expenditure rises)
Growth and unemployment
Appreciation:
fall in net exports --> fall in AD --> fall in real GDP --> rise in unemployment as production falls due to fall in profits (fall in prices)
fall in imported cost-push inflation due to the fall in the prices of imported inputs --> rise in SRAS --> fall in GPL
Inflation rate
Appreciation:
fall in net exports --> fall in AD --> fall in demand pull inflation + fall in prices of imported goods --> fall in COP --> fall in SRAS --> fall in imported cost push inflation = fall in prices of final goods and services (both imported and domestically produced) --> low and stable inflation rate --> attract investment --> growth and employment due to a rise in AD (inflow of FDIs and portfolio investment improves financial account and BOP)
Managed exchange rate system
governments / central bank can take advantage of the stability of the fixed exchange rate system and the flexibility of the floating exchange rate
adoption of policy to "lean against the wind"
increase in the value (appreciation) --> central bank / government will sell some of the domestic currency --> moderate appreciation only (does not affect the overall trend as there is still mild appreciation)
the larger the stock of assets --> larger the degree of stability of the exchange rate
Dirty floating --> when the central bank / government purposely prevents the exchange rate from appreciating to stimulate the exports
Overvaluation: currency is above the equilibrium exchange rate
Advantages:
imported inputs are relatively cheaper --> fall in the COP --> rise in SRAS --> rise in production --> industrialization is sped up
Disadvantages:
exports are more expensive --> demand for exports fall (plus rise in imports) --> worsening current account
domestic producers may lose competitive edge (prices of goods are higher than foreign producers)
Undervaluation: currency is below the equilibrium wage rate
Advantages:
exports become cheaper --> more competitive in the global market --> increase in AD --> increase in real GDP --> national income and employment
Disadvantages:
dirty floating
Fixed exchange rate system
government / central bank intervention to maintain the fixed exchange rate
e.g. if demand for currency in foreign exchange market increases --> appreciation --> central bank / government will sell their holdings of the domestic currency --> to cause depreciation (maintaining the exchange rate)
Revaluation: increase in the value of a currency (when there is a depreciation of domestic currency) --> can be used to reduce BOP surplus (current account surplus --> appreciation of currency --> rise in prices of exports --> fall in demand of exports --> reduce current account surplus)
Devaluation: fall in the value of a currency (when there is an appreciation of the domestic currency) --> can be used to reduce BOP deficit