1. Exchange Rates Countries choose their exch. rate system:
Free - Floating
Managed - Floating
Fixed (may be rigidly fixed or somewhat flexible – eg. adjustable peg)
Monetary Union with other countries

2. Floating Exchange Rates
Value of currency determined solely by mkyt forces
No target set by gov’t – no intervention
Sterling has floated freely on foreign exchange markets since the UK crashed out of the ERM, Sept. 1992

3. Managed Floating Exchange Rate
Currency usually determined by mkt forces
Some intervention (demand-management policies)
Interest rates may also used
No specific long-term target for currency

4. Fixed Rates
Some pegged at one level, others have target bands (crawling peg)
Central banks buy or sell currency to keep it at desired level
Revaluations may occur, though seen as undesirable

5. The Case for Floating Exchange Rates
Less need for foreign currency reserves for use in intervention – gov’t not involved
Useful tool for automatic macroeconomic adjustment (eg. High trade deficit can lead to drop in currency, helping correct)
May be less vulnerable to currency speculators (those who sell a currency if they believe it is about to be devalued)

6. The Case for Fixed Exchange Rates
Currency stability improves trade
Some flexibility (occasional ‘realignments’) mean gov’t can adjust the economy
Domestic producers can improve int’l competitiveness through  costs

7. Explaining the High £
Since mid-90’s £ has been above its purchasing power parity rate – why?
Independent monetary policy boosted market confidence in low inflation (key in currency mkts)
UK economy relatively strong with recessions elsewhere, esp Europe
Escaped uncertainties of the Eurozon

8. The J Curve
In the short term, a devaluation is likely to lead to a deterioration in the current account position before it starts to improve
Due to the inelasticity of imports… people take a while to change their buying and the immediate effect is to increase the total spent on imports and decrease the total spent on exports

9. Marshall-Lerner Condition
Devaluation will lead to an improvement in the current account so long as the combined price elasticities of exports and imports are greater than 1
Eg. If PEDimports = 0.3 and PEDexports = 0.5, then, although exports are going to rise, they will not rise significantly enough to counter the decrease in price – the same holds true here for imports… no improvement
If If PEDimports = 0.9 and PEDexports = 0.7, then the net change will improve the trade deficit