3.4.3 The International Economy Exchange Rate Systems AQA ECON4: T HE NATIONAL AND INTERNATIONAL ECONOMY Compare historical exchange rates. How would you describe the relationship between the US Dollar and the Chinese Yuan Renminbi? What are the possible causes and effects of these fluctuations?

E XCHANGE R ATE S YSTEMS  You should understand how exchange rates are determined in both fixed and floating exchange rate systems (whether completely free or managed periodically by the authorities)  You should be able to evaluate these exchange rate systems and have an understanding of their implications for the management of the domestic economy

E XCHANGE R ATE S YSTEM O PTIONS 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

F LOATING E XCHANGE R ATES  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: DemandSupply Exports of goods and servicesImports of goods and services Inflows of FDIOutflows of FDI Speculation Inflows of ‘hot money’Outflows of ‘hot money’ What happens if the forces of supply and demand are manipulated?

F LOATING E XCHANGE R ATES Price $ per £ Quantity S£2 Q2 D£1 Q1 S£1 D£2 $1.50 $1.60 $1.40 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.

A DVANTAGES AND D ISADVANTAGES OF F LOATING E XCHANGE R ATES AdvantagesDisadvantages 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 to 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 it resources to pursue other objectives without constraint. Damage to investment Due to the above factors, investment might be discouraged, particularly from abroad.

F IXED E XCHANGE R ATES  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

F IXED E XCHANGE R ATES (1) Price $ per £ Quantity Q2 D£1 Q1 S£1 D£2 $1.50 $1.60 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£.

F IXED E XCHANGE R ATES (2) – T HE C HINESE Y UAN E XAMPLE Price of Yuan against US$ Quantity of Yuan Q*1 D Q S P P* 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. Q*2 S*

A DVANTAGES AND D ISADVANTAGES OF F IXED E XCHANGE R ATES AdvantagesDisadvantages 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.

M ANAGED E XCHANGE R ATES  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

M ANAGED E XCHANGE R ATES Price $ per £ Q2 D£1 Q1 S£1 $1.50 $2 $1 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. The wider the band in the managed float, the less intervention will be required, and vice versa.

S UMMARY T ASK Consider carefully the various exchange rate systems explained here. What do you think are the implications for an economy of different exchange rate systems? Which system would you advocate for a developed country? Which might you advocate for a developing country?