1. EXCHANGE RATES

2. Exchange Rate
The price of one currency in terms of another

3. 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 $

4. 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

5. Changes in Exchange Rate

6. 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

7. 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

8. 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).

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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.

15. 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

16. 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

17. 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

18. 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)

19. Exchange rate systems

20. 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

21. 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

22. 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

23. 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

24. Countries with Floating Exchange Rates
Sterling
Australian Dollar
New Zealand Dollar
Polish Zloty

25. 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

26. 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

27. 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.

28. 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

29. Main Drawbacks of a Freely-Floating Exchange Rate System
Lack of inflationary discipline on domestic producers

30. 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

31. 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

32. 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

33. 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

34. Benefits of a Fixed Exchange Rate
Imposes discipline on domestic firms to be competitive
Imposes inflationary discipline on economy

35. 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

36. 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

37. 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)

38. 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

39. Countries with Managed Exchange Rate Systems
Brazilian Real
Swiss Franc
Japanese Yen
Norwegian Krone
Ghana - Cedi

40. 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

41. Black Wednesday – Britain leaves the ERM

42. Does China Manipulate its currency? Why?

43. 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

44. Big Mac Index