3.
2 Exchange rates
____________________________________________________________
Free or Floating Exchange Rate System where the value of the currency is
determined by the demand for, and the supply of, the currency on the foreign exchange
market
Fixed Exchange Rate System - a rate of exchange between at least two currencies
which is constant over a period of time
Managed or Dirty Float - where the exchange rate is determined by free market forces
but governments intervene from time to time to alter the free market price of a currency
P of US$ in
terms of PhP S of US $
Php 47 Equilibrium point
US $1
D for US $
Q for US $
P of US$ in
terms of PhP S of US $
Php 54
US $1 Equilibrium point
Php 47
US $1
US $ D
appreciates D for US $
or PhP
depreciates
in value
Q for US $
P of US$ in
terms of PhP S of US $
S
Php 47
US $1
Php 40
US $1 D for US $
US $
depreciates
or PhP
appreciates Q for US $
in value
Factors that may cause the value of a currency to change:
1. Demand for a countrys goods and services
- Relative prices (inflation) - if domestic inflation decreases, exports
become relatively cheaper, the exchange rate will appreciate
- Incomes (GDP) - increase in foreign income, the higher the demand for a
countrys exports, exchange rate will appreciate
- Tastes and preference - increase in demand for a countrys goods and
services
2. Relative investment prospects - if investment prospects are good in a
country, its exchange rate will appreciate
3. Relative interest rates - increase in domestic interest rates, saving in the
country will be more attractive to foreigners, the exchange rate will appreciate
4. Speculation - if the value for the currency is expected to rise in the future, the
demand for it will increase and its value will appreciate.
5. Use of foreign reserves - buying and selling of currency by the government
Fixed Exchange Rate System - a rate of exchange between at least two currencies
which is constant over a period of time
Devaluation - when the value of a currency is lowered (i.e. made weaker)
against another country
Revaluation - when the value of a currency is raised (i.e. made stronger) against
another country
How a fixed exchange rate is maintained by the government:
- Buying and selling of currency in the foreign exchange market requires maintaining
foreign reserves.
- Legislation - difficult to enforce
<An increase in the supply of Bds$>
Price of Bds$ in US$
S1 S2
(1)
0.50
(2)
D1 D2
0
Q1 Q2
Q of Bds$
<An increase in the demand of Bds$>
Price of Bds$ in US$
S1 S2
(2)
0.50
(1)
D1 D2
0 Q1 Q2
Q of Bds$
Managed Exchange Rate System (or Dirty Float) - here the exchange rate is
determined by free market forces but governments intervene from time to time to alter
the free market price of a currency
Two methods by which government can intervene and manipulate the
exchange rate:
1. Buying and selling in the foreign exchange market using their reserves
of foreign currencies
2. Changing interest rates
Possible consequences of strong and weak currencies:
Strong currency
Advantages:
Downward pressure on inflation - low import prices; lower price for consumers
More imports can be bought
Domestic producers are forced to improve their efficiency
Disadvantages:
Damage to export industries -> less competitive due to relatively higher prices (OFW
earnings can be exchanged for less domestic currency) -> unemployment
Damage to domestic industries -> due to competition from imports -> unemployment
OFW earning can be exchanged for less domestic currency
Weak currency
Advantages:
Greater employment in export industries
Greater employment in domestic industries
Disadvantages:
Inflation - due to more expensive imports (import-push inflation)
Summary:
A strong currency: decreases inflation, increases unemployment
A weak currency: increases inflation, decreases unemployment
Fixed Exchange Rates
Advantages:
1. Reduces uncertainty for economic agents - improves business confidence
2. Ensures sensible government policies on inflation
3. Reduces speculation
Disadvantages:
1. Use of interest rates may have negative impact on domestic macroeconomic
goal (low unemployment)
2. High levels of foreign reserves need to be maintained to support the system
3. The exchange rate may be set at the wrong level
4. Exchange rate set at an artificially low level may create international
disagreements and disputes
Floating exchange rates
Advantages:
1. Interest rates may be freely used as domestic monetary tools
2. Self-adjusts, in order to keep the current account balanced
3. Keeping high levels of foreign currency reserves are not necessary
Disadvantages:
1. Creates uncertainty among economic agents - lowers business confidence
2. Affected by factors other than S&D, such as world events, government
3. intervention, speculation -> may not self-adjust
4. May worsen existing rates of inflation
