objectives Explain how ER is determined in floating ER system. Reasons causing fall in ER – depreciation Reasons causing rise in ER - appreciation

Three types of ER systems : Floating Exchange Rate Fixed Exchange Rate Managed Floating

Floating Exchange Rates: – Price determined only by demand and supply of the currency – no government intervention Fixed Exchange Rates: – The value of a currency fixed in relation to an anchor currency – not allowed to fluctuate Dirty Floating or Managed Exchange Rate: – rate influenced by government via central bank around a preferred rate

The ER is allowed to find its own level in the market. Floating ER is determined by equating the forces of dd & ss of that countrys currency. no intervention by govt. Floating ER System

fig $ / £ $ / £ exchange rate and £ exchange rate index:

DD for £ The lower the ER of £, the cheaper the UK goods, the more people buy their goods, therefore the higher the dd for a currency The DD curve for £ is __________ sloping. Floating ER System

fig $ price of £ DD by USA Q of £ Determination of the rate of exchange Downward Sloping from Left to Right -Rate Lower, -Quantity Higher

SS of £ The higher the ER of £, the more UK residents want to sell £ (to buy the cheaper American goods or to invest in US as it is now cheaper) Therefore ss curve is __________ sloping. Floating ER System

fig (price) $=f £ Q of £ Determination of the rate of exchange SS by UK Upward Sloping From left to right -Rates Increase -Quantity Increase

fig $ price of £ S by UK Q of £ Determination of the rate of exchange D by USA Determined by British demand for US goods Determined by US demand for British goods

fig (price) $=f £ QSQS S by UK Q of £ ER disequlibrium D by USA QDQD ba

a)Excess SS of £ If ER = $1.80, there will be an excess ss or surplus of £ of QdQs amount. Banks wishing to make money by exchanging currency, would have to lower the ER in order to encourage a greater dd for £ & reduce the excess ss. They will continue lowering the rate until dd = ss ER disequilibrium

fig QSQS QDQD d (price) $=f £ S by UK Q of £ c D by USA ER disequlibrium

a)Excess dd of £ If ER = $1.40, there will be an excess __ or ________ of £ of _____ amount. Banks wishing to make money by exchanging currency, would have to raise the ER in order to encourage a greater ss of £ & reduce the excess dd. They will continue raising the rate until dd = ss ER disequilibrium

The equilibrium ER will not change unless the conditions of dd or ss changes, thus shifting the dd or ss curve to the left or right. Changes in ER

A fall in exchange rate of one currency in terms of another. means the £ buys less US$ eg US$2 = £1 to US$1 = £1 caused by i) a fall in demand for the £ or ii) an increase in ss of the £ Currency Depreciation

Factors causing ER to change

E.g. if UK's inflation rate is higher than abroad, UK exports will become more expensive, X will __ The dd of £ will __, dd curve shift left. At the same time, imports will become cheaper, M __ The ss of £ will __ - ss curve shifts right. Result - ER i.e. DEPRECIATION 1)Changes in prices of domestic goods vs. foreign goods

fig Floating exchange rates: movement to a new equilibrium $ = £ S1S1 D1D1 Q of £

fig $/ £ S1S1 D1D1 S2S2 D2D2 Q of £ movement to a new equilibrium - depreciation

Changes in IR causes changes in short term capital flows. Funds may be transferred from country to country to secure the highest rate of return. IR inflow of hot money DD for currency ER - APPRECIATION 2) Changes in relative Interest Rates

D D1 S $ = £1 Quantity of £ movement to a new equilibrium - appreciation

CA surplus X - dd for X dd for £ M - dd for M ss of £ _ _ ER CA deficit X - dd for X dd for £ M - dd for M ss of £ _ _ ER 3 ) Changes in Current Account

If investment prospects become higher abroad than UK, perhaps due to better economic conditions overseas or because of impending recession in UK, then DD for £ will __ & SS of £ will __ 4) Changes in relative investment prospects

If UKs AD/NY, DD for M __, ss of £ __ ER___ 5) Changes in relative incomes

If speculators including importers & exporters etc think that the ER is about to fall they will ____ £ now. Therefore ss of £ __ At the same time, people requiring £ will wait until the rate has fallen before they purchase them. Therefore dd for £ __ Result: ___ ER 6)Speculation

Terms of Trade improves SOL improves X is expensive – X M is cheaper - M CA worsens (if dd for X n M r elastic) Terms of Trade deteriorates SOL worsens imported inflation M is expensive - M X is cheaper - X CA improves (if dd for X n M r elastic)