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EXCHANGE RATES
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Exchange Rate The price of one currency in terms of another
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Sterling against the US Dollar
Source: Trading Economics The UK operates with a floating exchange rate – the external value of the currency is determined purely by market forces of supply and demand for a particular currency The chart shows the last 5 years for sterling against the $
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Sterling against the Euro
The chart shows the monthly average value of the £ against the Euro For example, in March 2018 one Euro bought 88 pence or expressed another way, £1 bought Euro 1.126
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Changes in Exchange Rate
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Factors Affecting Demand & Supply of Currency
Demand for currency comes from a need to purchase the currency of a particular economy in order to buy that country’s goods / services or invest in it. e.g. The French need to demand Sterling to import our goods Supply of currency comes from economic agents needing to demand overseas currency in exchange for their own e.g. A UK importer needs to demand Euro’s to import from France – in order to do this, he supplies Sterling in exchange
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Factors Affecting Demand & Supply of Currency
The main sources of demand are Trade (exports of goods & services) Inflows of short-term capital (ie., hot money volatile & related to relative interest rate) Long-term capital transactions (buying of assets like land, property, production facilities (FDI) or shares in companies (portfolio investment) in the UK Speculative demand The main sources of supply are Trade (imports of goods & services) Outflows of short-term capital Long-term capital transactions abroad Speculative selling
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Currency Demand and Supply
Short-term capital flows Flows of money in and out of a country in the form of bank deposits. Short-term capital flows are highly volatile and exist to take advantage of changes in relative interest rates. Long-term capital transactions Flows of money related to buying and selling of assets such as land or property or production facilities (direct investment) or shares in companies (portfolio investment).
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Factors that could lead to a Depreciation of Sterling
Higher inflation rate in the UK than abroad A rise in UK incomes (relative to those abroad) A fall in UK interest rates Relative investment prospects improving abroad leading to shifts in FDI or hot money Speculation that the rate will fall
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Currency Market Analysis: Higher Interest Rates
Rise in interest rates Currency more attractive for investors Attracts inflows of hot money Causes outward shift in demand Currency appreciates Value of currency Supply P2 P1 Demand Quantity of currency traded
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Currency Market Analysis: Slump in Exports
Recession in trading partner Causes fall in export sales Worsening of trade balance Inward shift of currency demand Currency will depreciate Value of currency Supply P1 P2 D2 Demand Quantity of currency traded
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How a Lower Currency can affect Macro Objectives
Changes in the exchange rate affects demand for exports and imports, real GDP growth, inflation, business profits and jobs Inflation A fall in a currency leads to a rise in import prices Causes a rise in cost-push inflationary pressure Export demand and trade balance Weaker currency makes exports cheaper overseas Rising export sales & a stronger trade balance Real GDP and jobs Rise in exports and fall in imports will increase AD Higher export profits is boost to the labour market
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Economic Effects of a Currency Depreciation
This will have an effect on a number of economic indicators Domestic production Trade deficit Domestic jobs Changes in import and export prices will affect demand Import sales will CONTRACT Export sales will EXPAND When the pound depreciates against the US dollar It makes UK import prices RISE It makes UK export prices FALL
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J-Curve Effect Shows the trend in a country’s balance of trade following a depreciation of the exchange rate. A fall in the exchange rate causes an initial worsening of the balance of trade, as higher import prices raise the value of imports and lower export prices reduce the value of exports due to short-run price inelasticity of demand for imports and exports.
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Will an Exchange Rate Depreciation improve the BoP?
The diagram below shows the “J Curve effect” – it shows the time lags between a falling currency and an improved trade balance Trade surplus Currency depreciation here Trade deficit may grow in initial period after depreciation Time period after depreciation Net improvement in trade provided certain conditions are met Trade deficit
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The Marshall Lerner Condition
The Marshall Lerner condition states that a depreciation / devaluation of the exchange rate will lead to a net improvement in the trade balance provided that the sum of the price elasticity of demand for exports and imports > 1 Ped for exports Ped for imports Sum of price elasticity Will fall in currency improve the trade balance? Country A 0.4 0.3 Country B 1.2 0.7 Country C 0.8 0.2
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The Marshall Lerner Condition
The Marshall Lerner condition states that a depreciation / devaluation of the exchange rate will lead to a net improvement in the trade balance provided that the sum of the price elasticity of demand for exports and imports > 1 Ped for exports Ped for imports Sum of price elasticity Will fall in currency improve the trade balance? Country A 0.4 0.3 0.7 No Country B 1.2 1.9 Yes Country C 0.8 0.2 1.0 Will leave it unchanged
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Evaluating the Effects of a Currency Depreciation
In theory a depreciation of the exchange rate provides a boost to aggregate demand and economic growth ....but this depends on.. The length of time lags as consumers and businesses respond (J-Curve Effect) The scale of any change in the exchange rate i.e. a 5%, 10%, 20% Whether the change in the currency is short-term or long-term – i.e. is a change in the exchange rate temporary or likely to persist How businesses and consumers respond to exchange rate changes – the value of price elasticity of demand is important i.e. will there be a large change in demand for exports & imports? (Marshall-Lerner Condition) The size of any second-round multiplier and accelerator effects When the currency movement takes place – i.e. Which stage of an economic cycle (recession, recovery etc)
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Exchange rate systems
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Exchange Rate Systems Broadly speaking, a government can choose between 3 ER systems: A FREELY FLOATING Exchange Rate Trade liberalisation & the expansion of global trade over the last 50 years has seen a general shift towards these A FIXED Exchange Rate A HYBRID (Semi-fixed / semi-floating)Exchange Rate You need to understand how each works and the pros and cons of each system
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Freely Floating Exchange Rate
Definition A system whereby the price of one currency expressed in terms of another is determined by the forces of demand and supply. The value of the currency is determined by the supply and demand of the currency on FOREX without government intervention
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Fixed and Floating Exchange Rates
Value of currency determined purely by demand and supply No need for intervention by the central bank Fixed exchange Rates Exchange rate is pegged Occasional realignments e.g. usually a devaluation
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Floating Exchange Rates
Currency supply and demand drive external value of a currency Currency value set by market forces Central bank allows currency to find it’s own level No intervention by the central bank External value of currency is not an intermediate target of macroeconomic policy No target for the exchange rate
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Countries with Floating Exchange Rates
Sterling Australian Dollar New Zealand Dollar Polish Zloty
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Key Advantages of a Freely-Floating Exchange Rate
Domestic policy objectives can be prioritised since there is no pressure to maintain a certain exchange rate Monetary policy is more effective in controlling AD and inflation Balance of Payments problems are automatically corrected
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Key Advantages of a Freely-Floating Exchange Rate
Automatic adjustment to external shocks Possibly reduced currency speculation Keeping reserves of gold or other currencies becomes less necessary
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Main Drawbacks of a Freely-Floating Exchange Rate System
A depreciation may lead to a deterioration in the current account of the Balance of Payments in the short term. J-Curve Effect If the MARSHALL-LERNER CONDITION is not satisfied, a depreciation of currency will not balance the current account of the Balance of Payments, even in the long term.
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Main Drawbacks of a Freely-Floating Exchange Rate System
Misguided short-term objectives may be prioritised Volatility in the exchange rate may discourage trade HEDGING: A business strategy that limits the risk that losses are made from changes in the price of currencies or commodities
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Main Drawbacks of a Freely-Floating Exchange Rate System
Lack of inflationary discipline on domestic producers
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FIXED EXCHANGE RATE SYSTEM
An exchange rate system in which the value of one currency has a fixed value against another currency or basket of currencies The other currency / currencies are usually based on trade patterns
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Fixed Exchange Rates External value is pegged to one or more currencies Government / central bank fixes currency value Trade takes place at this rate There might be some unofficial trades in black markets Pegged exchange rate becomes official rate Occasional realignments may be needed E.g. devaluation or revaluation depending on economic circumstances Adjustable peg
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Methods of revaluation / devaluation
Interest rates ↑r → ↑ D £ due to hot money flows → ↑ ER r → ↑S £ due to hot money flows → ER Foreign currency reserves Used to buy Sterling Domestic currency supply Used to increase / decrease supply of Sterling Exchange controls Limits on how much foreign currency domestic businesses can obtain / how much domestic currency can be taken out of the country
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Benefits of a Fixed Exchange Rate
Reduced exchange rate uncertainty Reduced cost of trade FUTURES MARKETS Markets where people and businesses can buy and sell contracts to buy commodities or currencies at a fixed price at a fixed date in the future
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Benefits of a Fixed Exchange Rate
Imposes discipline on domestic firms to be competitive Imposes inflationary discipline on economy
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Drawbacks of a Fixed Exchange Rate
The need to hold large amounts of foreign currency Monetary policy becomes impotent Speculative attacks on currencies perceived as over- under-valued may lead to severe economic crises International political pressures
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Floating versus Fixed Exchange Rates
Floating Currency Freedom to set interest rates Prevents imported inflation Insulation for economy after external shocks Automatic adjustment for a current account deficit Fixed Currency Certainty gives confidence for investment Stability helps to control cost and price inflation Imposes responsibility on government policies Less speculation if the fixed rate is credible
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MANAGED / HYBRID EXCHANGE RATE SYSTEMS
An exchange rate system that allows a currency’s value to fluctuate within a permitted band of fluctuation Main systems include: Adjustable peg systems Managed floating systems Crawling Peg Systems Exchange Rate Band Systems (e.g. ERM)
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Managed Exchange Rates
Central bank gives a degree of freedom for exchange rates on a day-to-day basis Currency usually set by market forces Buying to support a currency Selling to weaken a currency Changes in policy interest rates to affect “hot money flows” Central bank may intervene Higher exchange rate to control inflation Lower exchange rate to boost exports Currency becomes a target of policy
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Countries with Managed Exchange Rate Systems
Brazilian Real Swiss Franc Japanese Yen Norwegian Krone Ghana - Cedi
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Exchange Rate History for the UK
The UK operated a semi-fixed system from October September 1992 when a member of the ERM. Sterling was eventually forced out of the ERM by a wave of speculative selling Sterling has floated since the UK suspended membership of the ERM in 1992 The Bank of England has not intervened to influence the pound’s value since it became independent in 1997
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Black Wednesday – Britain leaves the ERM
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Does China Manipulate its currency? Why?
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PURCHASING POWER PARITY (PPP)
The exchange rate that equalises the price of a basket of identical traded goods and services in two different countries. PPP is an attempt to measure the true value of a currency in terms of the good and services that it will buy. PPP tends to be reflected in the REAL Exchange Rate rather than the quoted NOMINAL exchange rate
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Big Mac Index
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