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Edexcel A Level Economics A:復(fù)習(xí)筆記4.1.8 Exchange Rates

Category: A-level課程, 教材筆記, 福利干貨 Date: 2022年9月28日 下午4:28

Exchange Rate Systems

  • An?exchange rate?is the price of one currency in terms of another e.g. ￡1 = €1.18
    • International currencies are essentially?products?that can be bought & sold on the?foreign exchange market?(forex)
  • The Central Bank of a country controls the?exchange rate system?that is used in determining the value of a nation's currency
  • There are three?exchange rate systems
    • A?floating exchange rate
    • A?fixed exchange rate
    • A?managed exchange rate

 

Exchange Rate Systems

Exchange Rate System Explanation
Floating

 

  

  • As with any market, if there is?excess demand?for the currency on the forex market, then prices rise (the currency is worth more)
    • In a floating exchange rate system this is called an?appreciation
  • If there is an?excess?supply?of the currency on the forex market, then prices fall (the currency is worth less)
    • In a floating exchange rate system this is called a?depreciation
Fixed

 

  

  • The?Central Bank?negotiates with the international Monetary Fund (IMF) to?fix (peg)?their currency to another one
    • Sometimes the peg is at?parity?e.g. 1 Brunei Dollar = 1 Singapore Dollar
    • Often the peg is not at parity e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1
  • A?revaluation?occurs if the Central Bank decides to change the peg and increase the strength of its currency
  • A?devaluation?occurs if the Central Bank decides to change the peg and decrease the strength of its currency
Managed

 

  

  • This is a?combination?of the fixed & floating mechanism
  • The Central Bank determines the?preferred currency value?- and then the currency is free to fluctuate within a certain?range?of this value e.g 0.75%
  • If it goes?above?this range then the?Central Bank will intervene?by?selling its own currency?in forex markets so as to increase supply
    • Increased supply of their currency in the forex market?decreases the value?of the currency & brings it back within the range
  • If it goes?below?this value then the Central Bank will intervene by?buying its own currency?in the forex market using its?foreign reserves?(US$, Euros etc.)
    • Increased demand for their currency in the forex market?increases?the value of the currency & brings it back within the range
  • Interest rates?can also be used to intervene
    • Raising interest rates appreciates a currency as returns on investment/savings become?more attractive to foreigners?& they demand local currency
    • Decreasing interest rates depreciates a currency as returns on investment/savings become?less attractive to foreigners?& they sell their local currency & move their money elsewhere

Factors Influencing Floating Exchange Rates

  • Numerous factors influence floating exchange rates, resulting in an?appreciation?or?depreciation?of a currency

 

4-1-8-exchange-rates-influences

Factors influencing floating exchange rates

 

  1. Relative?interest?rates:?influence the flow of?hot money?between countries. If the UK increases its interest rate, then demand for ￡'s by foreign investors increases & the ￡ appreciates. If the UK decreases its interest rate, then the supply of ￡'s increases as investors sell their ￡'s in favour of other currencies & the ￡ depreciates
  2. Relative?inflation?rates:?as inflation in the UK rises?relative?to other countries, its exports become more expensive so there is?less demand?for UK products by foreigners, which means there is less demand for ￡s & so the?￡ depreciates
  3. Net investment:?foreign direct investment (FDI) into the UK creates a?demand for the ￡?which leads to the?￡ appreciating. FDI by UK firms abroad creates a supply of ￡'s which leads to the ￡ depreciating
  4. The current account:?UK exports have to be paid for in ￡'s. UK imports have to be paid for in local currencies, which requires ￡'s to be supplied to the forex market. Due to this, an?increasing trade surplus?will result in an appreciation of the ￡ & an?increasing deficit?will result in a depreciation of the ￡
  5. Speculation:?the vast majority of currency trades are speculative. Speculation occurs when?traders buy a currency?in the expectation that it will be worth more in the short to medium term, at which point they will sell it to?realise a profit
  6. Quantitative easing:?involves increasing the money supply & much of the new supply is used to buy back gilts. Many of these gilts are?owned by foreigners?who then exchange the ￡s received for their own currency. The increase in the supply of ￡'s?depreciates?the ￡

Intervention in Markets Using Forex Transactions & Interest Rates

  • When using a?managed exchange rate?system, Government intervention in currency markets takes place in two ways & is managed by the Central Bank
  1. Changing interest rates:?if the Central Bank wants to?appreciate?the country’s currency, it would?raise interest rates?thereby making it more attractive for foreigners to move money into the country's banks?(hot money).?Decreasing interest rates?has the opposite effect & causes a depreciation
  2. Buying & selling currency in the forex market:?The Central Bank can change the demand or supply for their currency using their?reserves. If they want to appreciate the currency then they buy it on the forex market using foreign currencies e.g. to bolster the value of the ￡, the Central Bank could take US$'s from their reserves & buy ￡'s. If they want to?depreciate?the currency then they?sell?their own currency & buy foreign currencies

The Consequences of Competitive Devaluation/depreciation

  • When a currency is?intentionally devalued/depreciated?by a government, it makes the country's exports cheaper
    • If demand for their exports is price elastic, then the country is likely to experience?higher export volumes?& higher export revenues
    • E.g. for many years China prevented the value of their currency from appreciating & saw a boom in their export sales
  • Intentional devaluation/depreciation?has several consequences
    • It is?anticompetitive?& upsets international competitors
    • Large countries usually have more financial?resources?to manipulate markets & so gain unfair advantages over smaller countries
    • Other countries may respond by also?lowering?the value of their currencies resulting in very little change to market share
    • The devaluation/depreciation raises the cost of imports used in production & with little change to the value of exports - profits decrease

Impacts of Changes in Exchange Rates

  • Changes to exchange rates may have far-reaching impacts on an economy

4-1-8-impact-of-exchange-rate

The impact of changes to exchange rates on an economy

 

Economic Indicator Explanation
 

The Current Account

 

  

  • Depreciation?of the ￡ causes?exports?to be cheaper for foreigners to buy &?imports?to the UK are more expensive
  • The?extent?to which this improves the?current account balance?depends on the?Marshall-Lerner condition
    • This follows the?revenue rule?which states that in order to increase revenue, firms should?lower prices?for products that are price elastic in demand
    • If the?combined elasticity?of exports/imports is less than 1 (inelastic), a depreciation (fall in price) will actually?worsen?the current account balance
  • It is also important to recognise that there is a time lag between the depreciation of the ￡ and any subsequent improvement in the current account balance
    • This is explained by the?J-Curve effect
      • It takes?time?for firms & consumers to respond to changes in price
      • Once it becomes evident that price changes will last for a longer period of time, firms & consumers switch
      • E.g. a firm in the USA has been importing electric scooters from the UK. If the?Euro depreciates, the price of scooters in France becomes relatively cheaper. In the short-term, the USA firm will not switch immediately to purchasing scooters from France as the?exchange rate?may soon bounce back. They also have a good relationship with their UK suppliers. In the?long term?they are likely to switch
 

Economic growth

 

  

  • Net exports are a component of?aggregate demand (AD)
    • A depreciation that results in an?increase in net exports?will lead to economic growth
 

Inflation

 

  

  • Cost push inflation?is likely to occur as the price of?imported raw materials?increases with currency depreciation
  • Net exports are a component of?aggregate demand (AD)
    • A?depreciation?that results in an?increase in net exports?will lead to an increase in aggregate demand
    • This may lead to an increase in?demand pull inflation
  • An?appreciation?of the currency will have the opposite effect
 

Unemployment

 

  

  • If depreciation leads to an increase in exports,?unemployment is likely to fall?as more workers are required to produce the additional products demanded
  • An?appreciation?of the currency will have the opposite effect
 

Living standards

 

  

  • The impact of a?depreciation?on?living standards?can be muted
    • ?As imports are more expensive, households face?higher prices & less choice,?which detracts from living standards
    • Rising exports can decrease unemployment &?increase wages/income?which?means an improved standard of living for some households
  • The impact of an?appreciation?on living standards will be the opposite
 

Foreign direct investment (FDI)

 

  

  • Depreciation of a currency makes it?cheaper for foreign firms?to invest in the country and can increase the FDI
    • The money they have available to invest is?worth more?when the currency has depreciated
  • An appreciation has the opposite effect

 

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