International Economics Topic 3 - Exchange

The exchange rate The exchange rate is the number of units of one nation’s currency that purchases one unit of another nation’s currency. The exchange rate can be expressed: directly (e.g. AUD1 = $NZ1.25) or indirectly (e.g. AUD0.80 = $NZ1). The AUD to USD is often quoted; this shows how many $US can be bought by AUD (or other currency). The Euro is also an exchange regularly quoted

Supply and demand for foreign exchange The demand for local currency is determined by the demand for that economy’s goods, services and assets. Likewise, the supply of local currency is determined by the level of the economy’s purchases of overseas goods, services and assets. The exchange rate represents equilibrium in the FOREX market (floating regime).

Types of exchange rates There are a number of methods that can be used to determine an exchange rate: A flexible or floating exchange rate is where the market forces of supply and demand determine the exchange rate. A fixed exchange rate is where the government determines the exchange rate for a period of time based on the value of another country’s currency such as the US dollar. A managed exchange rate is where the government intervenes in the market to influence the exchange rate or set the rate for short periods such as a day or week.

Floating exchange Under a flexible or floating exchange rate the value of a country’s currency changes frequently, even by the minute. The market rate will depend on the demand for, and supply of, that currency in the foreign exchange (forex) markets. When there is no intervention in the free market operations by a government agency a “clean float” is said to exist.

Advantages and disadvantages of floating exchange Interest rates can be used for Government monetary policy initiatives Might assist in keeping the current account (incl balance of trade) balanced No need for governments to keep reserves (of currency and gold) Uncertainty in investment markets (investors can not be certain of the value of their investment) leading to possible reduced investment May increase domestic inflation (making exports less attractive) No real, totally floating exchange – Governments sometimes intervene

Shifts in supply and demand for foreign exchange Under a floating exchange rate system, most Western nations allow the value of their currencies to fluctuate continuously according to the forces of supply and demand.

Shifts in supply and demand for foreign exchange There are four important causes of such shifts in supply and demand: changes in tastes and preferences for a nation’s output of goods and services changes in relative incomes changes in relative price levels changes in relative real interest rates.

Equilibrium price - Floating exchange

Equilibrium price - Floating The demand curve (DD) indicates the quantity of Australian dollars that buyers (those people who hold US dollars) are willing to purchase at each possible exchange rate. The supply curve (SS) shows the quantity of Australian dollars that will be offered for sale (those people who hold Australian dollars) at each exchange rate. At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity supplied and demanded is Q1 Australian dollars. At an exchange rate above equilibrium, such as $A1.00 = $US0.60, an excess supply of Australian dollars exists and market forces will force the exchange rate down towards equilibrium. If the exchange rate is below equilibrium, such as $A1.00 = $US0.40, an excess demand situation exits and market forces will put upward pressure on the value of the Australian dollar.

Currency appreciation and depreciation - floating A currency might appreciate (i.e increase in value) or depreciate (decrease in value). Currency appreciation usually occurs when more of that currency is demanded on the market, or if supply is reduced - pushing up the equilibrium price of the currency. This might be from: an increase in demand for goods being sold in that currency or increased investment activity or a decrease in the supply of the currency due to a recession or reduced demand for imports.

Appreciation - floating In Figure 2a there has been an increase in demand (DD to D1D1) for Australian dollars. This has led to an increase (appreciation) in value of the Australian dollar from $US0.50 to $US0.60 and the quantity of Australian dollars traded has also increased from 0Q to 0Q1. In Figure 2b there has been a decrease in the supply (SS to S1S1) of Australian dollars. This has led to an increase in the value (appreciation) of the Australian dollar from $US0.50 to $US0.60. However the quantity of Australian dollars traded has decreased from 0Q to 0Q1

Depreciation - floating A depreciation of the currency occurs under a floating exchange regime where either: The demand for the currency decreases. This might occur if there is a decrease in the price of the domestic currency against its trading partner(s) or by a decrease the demand for domestic exports (such as in a slow down in global economic activity), or because of foreign investors lacking confidence in the domestic economy and investing elsewhere. The supply of currency increases. This might occur due to strong domestic economic growth which increases the demand for imports, or from higher overseas interest rates, causing a capital outflow from the domestic economy

Depreciation - floating In Figure 3a there has been a decrease in demand (DD to D1D1) for Australian dollars. This has led to a depreciation in the value of the Australian dollar from $US0.50 to $US0.40. The quantity of Australian dollars traded has also decreased from 0Q to 0Q1. Figure 3b indicates an increase in supply of Australian dollars with the supply curve moving from SS to S1S1. Again the value of the Australian dollar has decreased from $US0.50 to $US0.40 while the quantity of Australian dollars traded has increased from 0Q to 0Q1.

Fixed Exchange rates Under a fixed exchange rate system the value of a country’s currency is fixed by the government to another currency, a number of currencies, or gold for a specific time period A fixed exchange rate system does not mean that the rate will stay at that same level all the time. The government may decide to change the rate because of adverse effects on the economy. For example, if the currency is overvalued exporting industries will become less internationally competitive, affecting international trade and the balance of payments and the government might take action to devalue the exchange rate The currency might be fixed to the “Trade Weighted Index” (TWI)

Trade Weighted Index The TWI is a weighted average of domestic and foreign currencies, usually major trading partners The TWI is then a more comprehensive measure of the purchasing power of the local currency as it takes into account the relative importance (trade weighted) of each major trading partners and the performance of local economy’s balance of payments. If a TWI is high or appreciates, then more can be purchased with that currency. On the other hand if the TWI is low or decreasing then less can be purchased (or more currency is needed to have the same purchasing power The TWI can also be used to compare 2 currencies The TWI also reflects changes in global economic conditions. There is usually a decline in the TWI when an economy’s major trading partners experience a downturn in economic activity. This is because growth in the global economy slows and the demand for imports and exports decreases.

Advantages and disadvantages of fixed exchange Increases certainty for investors Forces governments to have good inflation policies Reduces speculation on the forex market Manipulation of interest rates may have an adverse effect on domestic unemployment and consumer capacity to borrow and consume Needs high levels of foreign reserves Inexact science International conflict (e.g. US and China)

Devaluation and revaluation A devaluation of a currency occurs under a fixed exchange rate system when there is deliberate action taken by a government to decrease its value in the forex market. OR Alternatively a revaluation occurs under a fixed exchange rate system when there is deliberate action taken by the government to increase the value of the currency in the forex market.

Activity! Read “Student thinkpoint 23.7” on page 290 of your textbook and answer the questions at the end. You can discuss this in groups

Managed exchange rates Managed exchange rates is where a government intervenes in the floating exchange system to affect trade This might be by the setting of outer limits (i.e. a rate may be allowed to float within certain limits), before a country will engage in the forex market to bring the currency up or down within the range

Intervention in FOREX Governments intervene in the FOREX market in the following ways: Using reserves of foreign currency to buy or sell its own, or foreign currencies (affecting demand or supply and therefore price of the currency) Changing interest rates to attract (or discourage) foreign investment (and hence currency)

High exchange rate? Advantages Disadvantages May reduce inflation due to downward pressure on cost of imported goods (and consequent pressure on local prices Increased consumer choice for imports Pressure on local producers to become more efficient (in order to compete with higher imports) Reduced exports and consequent damage to export industries and jobs Damage to local industries which compete with imported goods

Low exchange rate? Advantages Disadvantages Growth in export industries and consequent higher employment Growth in local industry (because imports are comparatively more expensive) Increases prices (inflation) due to increase in costs of production

Research Research what exchange rate regime your countries use List the advantages and disadvantages that apply to these countries (you may need to do some additional research to find out what is actually happening in each country (with the different areas of government policy affected etc)

Sources Figures used from NSW HSC website Blink and Dorton text