Factors which
influence the exchange rate
An
exchange rate is determined by supply and demand factors. These are the various
factors which determine the demand and supply of a currency.
1.
Inflation
If inflation in the UK
is lower than elsewhere, then UK
exports will become more competitive and there will be an increase in demand
for £s. Also foreign goods will be less competitive and so UK citizens
will supply less £s to buy foreign goods.
Therefore the rate of £ will tend to increase.
2.
Interest Rates
If UK
interest rates rise relative to elsewhere, it will become more attractive to
deposit money in the UK,
Therefore demand for Sterling
will rise. This is known as “hot money flows” and is an important short run
determinant of the value of a currency.
3.
Speculation
If speculators believe the sterling will rise in the future, they will demand
more now to be able to make a profit. This increase in demand will cause the
value to rise.
Therefore movements in the exchange rate do not always reflect economic fundamentals,
but are often driven by the sentiments of the financial markets.
For
example, if markets see news which makes an interest rate increase more likely,
the value of the Pound will probably rise in anticipation.
4.
Change in competitiveness
If British goods become more attractive and competitive this will also cause
the value of the Exchange Rate to rise. This is important for determining the
long run value of the Pound.
5.
Relative strength of other currencies
Between 1999 and 2001 the £ appreciated because the Euro was seen as a weak
currency.
6.
Balance of Payments
A large deficit on the current account means that the value of imports is
greater than the value of exports. If this is financed by a suplus on the
financial / capital account then this is OK. But a country who struggles to
attract enough capital inflows will see a depreciation in the currency. (For
example current account deficit in US of 7% of GDP was one reason for
depreciation of dollar in 2006-07)
Economic
Effects of an Appreciation
An appreciation means an increase in
the value of a currency. It means a currency is worth more in terms of foreign
currency.
e.g. If £1 = €1 An appreciation of
Pound could mean £1 =€1.2
Effects of an Appreciation
·
Exports more expensive, therefore less
UK
exports will be demanded
·
Imports are cheaper, therefore more
imports will be bought.
·
A fall in AD, causing lower growth.
·
Lower inflation because:
·
import prices are cheaper
·
Lower AD and less demand pull
inflation
·
More incentives to cut costs
Economic Effect of
a Devaluation of the Currency
A
devaluation occurs in a fixed exchange rate. A depreciation occurs in a
floating exchange rate system. Both mean a fall in the value of the currency.
Economic Revision
Notes on Devaluation
1.
A devaluation of the exchange rate will make exports more competitive and
appear cheaper to foreigners. This will increase demand for exports
2.
A devaluation means imports will become more expensive. This will reduce demand
for imports.
3.
Higher economic growth. Part of AD is X-M Therefore higher exports and lower
imports will increase AD. Higher AD is likely to cause higher Real GDP and
inflation.
4.
Inflation is likely to occur because:
·
i) Imports are more expensive causing
cost push inflation.
·
ii) AD is increasing causing demand
pull inflation
·
iii) With exports becoming cheaper
manufacturers may have less incentive to cut costs and become more efficient.
Therefore over time costs may increase.
Evaluation:
The
effect on inflation will depend on other factors such as:
·
iv) Spare capacity in the economy.
E.g. in a recession, a devaluation is unlikely to cause inflation
·
v) Do firms pass increased import
costs onto consumers? Firms may reduce their profit margins, at least in the
short run.
·
vi) Import prices are not the only
determinant of inflation. Other factors affecting inflation such as wage
increases may be important
5.
There is likely to be an improvement in the current account balance of
payments.
This is because exports are increasing and imports are falling
Government
Intervention in the Foreign Exchange market
Under
certain circumstances, the government might want to intervene in the foreign
exchange markets to influence the level of the exchange rate.
Methods to
Influence the Exchange Rate
1.
Reserves and
Borrowing. If the value of an exchange rate is falling
and the government wants to maintain its original value it can use its foreign
exchange reserves - e.g. selling its dollars reserves and purchase pounds. This
purchase of Pound sterling should increase its value.
2.
Borrow The
government can also borrow foreign currency from abroad to be able to buy
sterling.
3.
Changing interest
rates (In UK this is now done by the MPC)
higher interest rates will cause hot money flows and increase demand for
sterling. Higher interest rates make it relatively more attractive to save in
the UK.
4.
Reduce Inflation
· Through
either tight fiscal or Monetary policy Aggregate Demand and hence inflation can
be reduced.
· By
decreasing AD consumers will spend less and purchase less imports and so
will supply less pounds. This will increase the value of the ER
· Lower
inflation rate will also help because British goods will become more
competitive. Thus the demand for Sterling
will rise.
However
this policy has an obvious side effect because lower AD will cause lower growth
and higher unemployment
5.
Supply side measure to increase the
competitiveness of the economy. This will take along time to have an effect.
Fixed Exchange
Rates
Definition
of a Fixed Exchange Rate: This occurs when
the government seeks to keep the value of a currency fixed against another
currency. e.g. the value of the Pound is fixed at £1 = €1.1
Semi
Fixed Exchange Rate. This occurs when the government seeks to keep the value of
a currency between a band of exchange rate. In other words, the exchange rate
can fluctuate within a narrow band.
E.g.
the Pound Sterling could fluctuate between a target exchange rate of £1 = €1.1
and £1 = €1.2
Definition
of a Floating Exchange Rate: this is when the
govt does not intervene in the foreign exchange market but allowss market
forces to determine the level of a currency.
·
Exchange Rate Mechanism
ERM. This was a semi fixed exchange rate where EU countries
sought to keep their currencies fixed within certain bands against the D-Mark.
The ERM was the forerunner of the Euro
Advantages of Fixed
Exchange Rate
1.
If the value of currencies fluctuate significantly this can cause problems for
firms engaged in Trade.
·
For example if a firm is exporting to
the US,
a rapid appreciation in sterling would make its exports uncompetitive and
therefore may go out of business.
·
If a firm relied on imported raw
materials a devaluation would increase the costs of imports and would reduce
profitability
2.
The uncertainty of exchange rate fluctuations can therefore reduce the
incentive for firms to invest in export capacity. Some Japanese firms have said
that the UK's reluctance to join the Euro and provide a stable exchange rates
maker the UK a less desirable place to invest.
3.
Governments who allow their exchange rate to devalue may cause inflationary
pressures to occur. This is because AD increases, import prices increase and
firms have less incentive to cut costs.
4.
A rapid appreciation in the exchange rate will badly effect manufacturing firms
who export, this may also cause a worsening of the current account.
5.
Joining a fixed exchange rate may cause inflationary expectations to be lower
Disadvantage of
Fixed Exchange Rates
1.
To maintain a fixed level of the exchange rate may conflict with other
macroeconomic objectives.
·
If a currency is falling below its band the govt will have to intervene. It can
do this by buying sterling but this is only a short term measure.
·
The most effective way to increase the value of a currency is to raise interest
rates. This will increase hot money flows and also reduce inflationary
pressures.
·
However higher interest rates will cause lower AD and economic growth, if the
economy is growing slowly this may cause a recession and rising unemployment
2.
It is difficult to respond to temporary shocks. For example an oil importer may
face a balance of payments deficit if oil price increases, but in a fixed
exchange rate there is little chance to devalue
DETAIL NOTES
Advantages
and disadvantages of fixed and floating systems
The advantages of a fixed exchange rate system
Stability
Some
economists would argue that this is the most significant advantage. If exchange
rates are stable over a given period of time, exporting firms will be able to
plan ahead without worrying about huge swings in the value of the pound
eliminating their profit margin. This will encourage more investment and trade
between countries, both of which are important if economies are to grow in the
long term.
Discipline
If
a country is part of an exchange rate system, they cannot devalue their
currency at the first sign of trouble (i.e. a large current account deficit).
They have to try and cure the fundamental problem by, for example, improving
the competitiveness of their exporters through increased productivity and
improved quality.
One
can also argue that fixed exchange rate systems discipline countries into
keeping inflation down. Again, there is no option to devalue if increasing
inflation leads to reduced competitiveness.
Avoid speculation?
Theoretically,
fixed exchange rates should eliminate speculation because there is no point
buying and selling currencies that will not change in value. In the real world,
this is not always the case.
Speculators
believed the politicians when they said that these rates were forever, and so
did not see the point in buying or selling the currencies involved.
The disadvantages of a fixed exchange rate system
The loss of monetary policy
A
commitment to a fixed exchange rate means that you lose control over all other
instruments of monetary policy. Although the government pretended
that UK interest rate decisions we still their own (and technically they were)
any movement of the German interest rate was usually quickly followed by a
similar change in the UK. Today the Monetary Policy Committee (MPC) can
set interest rates at whatever level they want, but they cannot control the
value of the pound at the same time. Controlling one of these two instruments
means a loss of control of the other.
The need for a large pool of
reserves
To
maintain the pound's value within the ERM, the government had to have a large
pool of foreign reserves with which to buy the pound when it fell to the floor
of the bottom band. Apart from being expensive in itself, some countries may
find it hard to get their hands on sufficient stocks of reserves to support
their currency. One of the main jobs of the IMF in the Bretton Woods system was
to help poor countries in times of trouble and lend them reserves when they
were short.
Problems of uncompetitiveness
With
a freely floating currency, a deteriorating trade situation should
automatically cause the pound to fall (speculators permitting!), which, in
turn, would improve the competitiveness of British exporters and improve the
trade balance.
Economies
stuck in a fixed exchange rate system with a deteriorating trade balance may
feel that they joined the system at too high an exchange rate. Although they
may be allowed to devalue eventually, the exchange rate may be at the wrong
rate for significant periods of time. This can cause permanent job losses and
recession. Some economists feel that the recession of 1990-92 in the UK was
prolonged due to membership of the ERM.
Advantages of a floating exchange rate system
Theoretical elimination of trade
imbalances
As
we have stated before, floating exchange rates should adjust automatically to
trade imbalances, which, in turn, will eliminate the trade imbalance. Of
course, it has also been noted that this does not always work in the real world
because so few currency transactions that take place are for trade.
No need for reserves?
On
the whole, foreign reserves are used to help maintain a currency's position
within a fixed exchange rate. If a currency is freely floating, then there is
no need to use reserves to affect its value. In the real world, governments
will always have some reserves, in case of a crisis in the balance of payments,
or if they feel that their currency is getting a bit too high or too low.
More freedom over domestic policy
As
was stated above, if the government is not controlling their exchange rate,
then they can control their rate of interest. The evidence of
the past five years suggests that, although exporters suffer with a strong pound,
the economy as a whole is best served when the authorities can control domestic
monetary policy.
The disadvantages of a floating exchange rate system
Speculation
Again,
there are two ways of looking at this. You could argue that with floating
exchange rates, speculation is less likely because an exchange rate can move
freely up or down, so it is more likely to be at its true level. But the very
fact that it does move up and down easily means it can move a long way if
speculators think that it is at the wrong level. The quick rise in the value of
the pound in the second half of 1996 showed that big swings in currencies do
not just happen when speculators force them out of fixed exchange rate systems.
Uncertainty
The
biggest advantage of fixed exchange rate systems was their stability and
certainty. This tended to increase investment and trade, both good things. The
biggest disadvantage of floating exchange rate systems is their uncertainty,
reducing the rate at which investment and trade increase. Firms often use the
currency markets to hedge against large fluctuations in the exchange rate,
which helps to a certain extent, but there is still felt to be too much
uncertainty.
