Exchange Rate Systems
The meaning and measurement of an exchange rate
• Exchange rate: the external price of a currency measured against another currency.
• Only after 1945 did the £ become near universally accepted standard by which external values currencies measured.
• Response to changing patterns UK trade, sterling exchange rate interest (ERI) used measure £’s exchange rate (trade-weighted
average of £’s exchange rate against no. leading trading currencies, calculated reflect importance each currency in international
trade).
Determinants of Exchange Rates
• Differentials in Inflation: country with consistently lower inflation rate exhibits rising currency value, as purchasing power
increases relative to other currencies, increasing demand for currency.
➢ Countries with higher inflation typically witnessed depreciation in their currency compared currencies trading partners.
• Differentials in Interest Rates: by manipulating interest rates, central banks exert influence over both inflation and exchange
rates.
➢ Higher interest rates offer lenders in an economy a higher return relative other country, therefore attracts foreign capital
+ increase demand currency.
➢ Impact mitigated if relative inflation high.
• Terms of Trade: ratio comparing export prices to import prices (the terms of trade) related to current account of balance of
payments.
➢ Exports rise greater rate than imports, terms trade favourably improved.
➢ Results rising revenues from exports + increased demand country’s currency.
• Strong Economic Performance: foreign investors inevitably seek stable countries in which invest their capital.
➢ Positive attributes draws investment funds away countries perceived have more political + economic risk.
➢ Political turmoil can create loss confidence in currency + movement capital to stable countries, increasing demand
currency.
• Current Account Deficits: A deficit highlights imports greater than exports, + borrowing capital from foreign sources to reach
equilibrium.
➢ Country requires more foreign currency than receives through sales exports + supplies more of own currency than foreign
demand products.
➢ Excess demand for foreign currency lowers country’s exchange rate until domestic goods/services gain price
competitiveness, and foreign assets too expensive generate sales for domestic interests.
• Public Debt: countries will engage in large-scale deficit financing for public sector projects + governmental funding. Such activity
stimulates domestic economy, nations with large public deficits/debts less attractive for foreign investors.
➢ Large debt encourages inflation as means service debt, reducing demand currency due to reduction FDI.
➢ If government unable service debt through domestic means (increasing money supply by selling bonds), then must
increase supply securities for sale to foreigners (lowering prices).
➢ Large debt may prove worrisome to FDI if country risks defaulting on its obligations (less willing own securities
denominated in currency).
➢ Country’s debt rating, determined by Moody’s or Standard and Poor’s crucial determinant exchange rate
Different types of exchange rate system
• Managed exchange rates lie between extremes freely floating + rigidly fixed exchange rates, taking two forms: adjustable peg
and managed-floating (or dirty floating).
• Adjustable peg exchange rates resemble fixed exchange rates many respects, but rate at which exchange rate fixed may be
changed time to time.
• Formal devaluation reduced fixed exchange rate (revaluation opposite).
• Adjustable peg system, usually band in which exchange rate allowed fluctuate.
Freely-floating exchange rates
• External value currency determined on FOREX markets by forces demand/supply.
• Explaining the slope of the demand and supply curves for pounds: when exchange rate pound falls, UK exports become more
competitive overseas markets.
• Volume UK exports increases, greater overseas demand pounds to finance purchase exports, provided demand UK exports
price elastic. Explains downward-sloping demand curve for pounds.
• UK imports generate a supply of pounds. UK trading companies pay imports in foreign currencies. Importers must sell sterling
on FOREX market to purchase foreign currencies to pay for imports.
• As £’s exchange rate increases, fewer pounds needed buy given quantity foreign currency. Means sterling price imports fall.
• UK consumers likely respond falling price imports by increasing total spending imports.
• Greater total quantity sterling must be supplied FOREX markets to pay for imports – even though price each unit import fallen
(result upward sloping supply curve).
• At market equilibrium, supply pounds = demand pounds (money value exports = money value imports).
, The adjustment process to new equilibrium exchange rate
• UK residents increasing demand imports, increases demand foreign exchange pay for imports (supply shifts right S1-S2).
• New situation, current account of balance of payments deficit (X<M).
• UK residents supply/sell more £’s than prior to pay for imports. Overseas residents still demand same quantity UK goods
(assuming views quality UK goods relative foreign goods hasn’t changed) – demand pounds pay for exports stays same level.
• At exchange rate $1.30, excess supply £’s on FOREX market (distance B minus A).
• Market mechanism restores equilibrium (both exchange rate + balance payments).
• Excess holdings £’s accumulated at exchange rate $1.30 sold, £’s exchange rate falls, until equilibrium point C achieved at $1 to
£.
• Increases price competitiveness UK exports while making imports less price competitive.
• Current account of balance payments equilibrium at (X=M)2 rather than (X=M)1. Physical quantities exports imports increased.
• Conversely, shift right demand £ moves current account to surplus, £ exchange rate appreciates meet excess demand £’s.
Providing UK residents don’t change views relative quality imports, exchange rate rises until balance payments/equilibrium
restored.
Advantages of floating exchange rates
Economists generally agree that provided no distorting capital flows, following advantages hold:
• Automatically achieving balance of payments equilibrium: exchange rate fluctuates automatically to correct payments
imbalance.
➢ Provided adjustment operates smoothly, currency should never be overvalued or undervalued for long.
➢ Event overvalued exchange rate causing export uncompetitiveness/payments deficit, market forces adjust exchange rate
downward to equilibrium.
• Improving resource allocation: if world’s resources to be efficiently allocated between competing uses, exchange rates must be
correctly valued.
➢ Efficient resource allocation means market prices must accurately reflect shifts demand + changes
competitive/comparative advantage result from technical progress + discoveries new materials.
➢ A fixed exchange rate may gradually become overvalued/undervalued, as demand or competitive advantage move against
or in favour country’s industries. Different rates inflation, fixed exchange rates leads misallocation resource between
economies
• Freedom to achieve domestic policy objectives: argued free-floating exchange rate, balance payments surpluses or deficits
cease be policy problem for government.
➢ Free pursue domestic objectives full employment + growth.
➢ Market forces ‘look after’ current account. If relative inflation rate higher in pursuit domestic objectives, exchange rate
simply falls to restore competitiveness.
• Easier control of inflation rate: exchange rate insulates country against ‘importing inflation’.
➢ Inflation rates higher in rest of world, fixed exchange rate cause country import inflation through rising prices goods
imported.
➢ Floating exchange rate appreciates, lowers prices imports, insulating economy against importing inflation.
• Ability to pursue an independent monetary policy: monetary policy can be used solely to achieve domestic policy objectives,
such as control inflation.
➢ With fixed exchange rate, interest rates may be determined by events in outside world + capital flows.
➢ To maintain fixed exchange rate, interest rates may be raised prevent exchange rate falling (monetary policy not
independent).
➢ Fixed system, domestic policy objectives often sacrificed to pursuit external policy objective maintaining exchange rate
target.
Disadvantages of floating exchange rates
Modern globalised world in which financial capital is internationally mobile, capital flows rather than exports + imports can be main
determinants of exchange rates:
• The adverse effects of speculation and capital flows: argument that a F-F exchange rate never overvalued/undervalued
depends crucially upon main assumption traditional theory exchange rates, currencies bought + sold on FOREX markets only
finance trade.
➢ Over 90% currency transactions stem from capital flows from decisions individuals, businesses, financial corporations +
governments to switch wealth portfolios between different currencies.
❖ Short-run, exchange rates extremely vulnerable speculative capital or ‘hot-money’ movements.
➢ Floating exchange rate can be over/under valued; doesn’t reflect trading competitiveness countries goods + services.
➢ Speculators may buy currencies perceived be undervalued hope capital gains selling at higher price. Likewise sell
currencies perceived overvalued (avoid capital losses) when selling currencies lower rates future.
❖ Arguably, fixed exchange rates even more vulnerable than floating exchange rates to speculative capital flows as fixed e-r often
over/under valued.
➢ Overvalued currency, speculators may sell to make profit buying back at lower exchange rate after devaluation. If
devaluation doesn’t take place, speculators can enjoy ‘one-way option’: buying back currency at exchange rate sold.
The meaning and measurement of an exchange rate
• Exchange rate: the external price of a currency measured against another currency.
• Only after 1945 did the £ become near universally accepted standard by which external values currencies measured.
• Response to changing patterns UK trade, sterling exchange rate interest (ERI) used measure £’s exchange rate (trade-weighted
average of £’s exchange rate against no. leading trading currencies, calculated reflect importance each currency in international
trade).
Determinants of Exchange Rates
• Differentials in Inflation: country with consistently lower inflation rate exhibits rising currency value, as purchasing power
increases relative to other currencies, increasing demand for currency.
➢ Countries with higher inflation typically witnessed depreciation in their currency compared currencies trading partners.
• Differentials in Interest Rates: by manipulating interest rates, central banks exert influence over both inflation and exchange
rates.
➢ Higher interest rates offer lenders in an economy a higher return relative other country, therefore attracts foreign capital
+ increase demand currency.
➢ Impact mitigated if relative inflation high.
• Terms of Trade: ratio comparing export prices to import prices (the terms of trade) related to current account of balance of
payments.
➢ Exports rise greater rate than imports, terms trade favourably improved.
➢ Results rising revenues from exports + increased demand country’s currency.
• Strong Economic Performance: foreign investors inevitably seek stable countries in which invest their capital.
➢ Positive attributes draws investment funds away countries perceived have more political + economic risk.
➢ Political turmoil can create loss confidence in currency + movement capital to stable countries, increasing demand
currency.
• Current Account Deficits: A deficit highlights imports greater than exports, + borrowing capital from foreign sources to reach
equilibrium.
➢ Country requires more foreign currency than receives through sales exports + supplies more of own currency than foreign
demand products.
➢ Excess demand for foreign currency lowers country’s exchange rate until domestic goods/services gain price
competitiveness, and foreign assets too expensive generate sales for domestic interests.
• Public Debt: countries will engage in large-scale deficit financing for public sector projects + governmental funding. Such activity
stimulates domestic economy, nations with large public deficits/debts less attractive for foreign investors.
➢ Large debt encourages inflation as means service debt, reducing demand currency due to reduction FDI.
➢ If government unable service debt through domestic means (increasing money supply by selling bonds), then must
increase supply securities for sale to foreigners (lowering prices).
➢ Large debt may prove worrisome to FDI if country risks defaulting on its obligations (less willing own securities
denominated in currency).
➢ Country’s debt rating, determined by Moody’s or Standard and Poor’s crucial determinant exchange rate
Different types of exchange rate system
• Managed exchange rates lie between extremes freely floating + rigidly fixed exchange rates, taking two forms: adjustable peg
and managed-floating (or dirty floating).
• Adjustable peg exchange rates resemble fixed exchange rates many respects, but rate at which exchange rate fixed may be
changed time to time.
• Formal devaluation reduced fixed exchange rate (revaluation opposite).
• Adjustable peg system, usually band in which exchange rate allowed fluctuate.
Freely-floating exchange rates
• External value currency determined on FOREX markets by forces demand/supply.
• Explaining the slope of the demand and supply curves for pounds: when exchange rate pound falls, UK exports become more
competitive overseas markets.
• Volume UK exports increases, greater overseas demand pounds to finance purchase exports, provided demand UK exports
price elastic. Explains downward-sloping demand curve for pounds.
• UK imports generate a supply of pounds. UK trading companies pay imports in foreign currencies. Importers must sell sterling
on FOREX market to purchase foreign currencies to pay for imports.
• As £’s exchange rate increases, fewer pounds needed buy given quantity foreign currency. Means sterling price imports fall.
• UK consumers likely respond falling price imports by increasing total spending imports.
• Greater total quantity sterling must be supplied FOREX markets to pay for imports – even though price each unit import fallen
(result upward sloping supply curve).
• At market equilibrium, supply pounds = demand pounds (money value exports = money value imports).
, The adjustment process to new equilibrium exchange rate
• UK residents increasing demand imports, increases demand foreign exchange pay for imports (supply shifts right S1-S2).
• New situation, current account of balance of payments deficit (X<M).
• UK residents supply/sell more £’s than prior to pay for imports. Overseas residents still demand same quantity UK goods
(assuming views quality UK goods relative foreign goods hasn’t changed) – demand pounds pay for exports stays same level.
• At exchange rate $1.30, excess supply £’s on FOREX market (distance B minus A).
• Market mechanism restores equilibrium (both exchange rate + balance payments).
• Excess holdings £’s accumulated at exchange rate $1.30 sold, £’s exchange rate falls, until equilibrium point C achieved at $1 to
£.
• Increases price competitiveness UK exports while making imports less price competitive.
• Current account of balance payments equilibrium at (X=M)2 rather than (X=M)1. Physical quantities exports imports increased.
• Conversely, shift right demand £ moves current account to surplus, £ exchange rate appreciates meet excess demand £’s.
Providing UK residents don’t change views relative quality imports, exchange rate rises until balance payments/equilibrium
restored.
Advantages of floating exchange rates
Economists generally agree that provided no distorting capital flows, following advantages hold:
• Automatically achieving balance of payments equilibrium: exchange rate fluctuates automatically to correct payments
imbalance.
➢ Provided adjustment operates smoothly, currency should never be overvalued or undervalued for long.
➢ Event overvalued exchange rate causing export uncompetitiveness/payments deficit, market forces adjust exchange rate
downward to equilibrium.
• Improving resource allocation: if world’s resources to be efficiently allocated between competing uses, exchange rates must be
correctly valued.
➢ Efficient resource allocation means market prices must accurately reflect shifts demand + changes
competitive/comparative advantage result from technical progress + discoveries new materials.
➢ A fixed exchange rate may gradually become overvalued/undervalued, as demand or competitive advantage move against
or in favour country’s industries. Different rates inflation, fixed exchange rates leads misallocation resource between
economies
• Freedom to achieve domestic policy objectives: argued free-floating exchange rate, balance payments surpluses or deficits
cease be policy problem for government.
➢ Free pursue domestic objectives full employment + growth.
➢ Market forces ‘look after’ current account. If relative inflation rate higher in pursuit domestic objectives, exchange rate
simply falls to restore competitiveness.
• Easier control of inflation rate: exchange rate insulates country against ‘importing inflation’.
➢ Inflation rates higher in rest of world, fixed exchange rate cause country import inflation through rising prices goods
imported.
➢ Floating exchange rate appreciates, lowers prices imports, insulating economy against importing inflation.
• Ability to pursue an independent monetary policy: monetary policy can be used solely to achieve domestic policy objectives,
such as control inflation.
➢ With fixed exchange rate, interest rates may be determined by events in outside world + capital flows.
➢ To maintain fixed exchange rate, interest rates may be raised prevent exchange rate falling (monetary policy not
independent).
➢ Fixed system, domestic policy objectives often sacrificed to pursuit external policy objective maintaining exchange rate
target.
Disadvantages of floating exchange rates
Modern globalised world in which financial capital is internationally mobile, capital flows rather than exports + imports can be main
determinants of exchange rates:
• The adverse effects of speculation and capital flows: argument that a F-F exchange rate never overvalued/undervalued
depends crucially upon main assumption traditional theory exchange rates, currencies bought + sold on FOREX markets only
finance trade.
➢ Over 90% currency transactions stem from capital flows from decisions individuals, businesses, financial corporations +
governments to switch wealth portfolios between different currencies.
❖ Short-run, exchange rates extremely vulnerable speculative capital or ‘hot-money’ movements.
➢ Floating exchange rate can be over/under valued; doesn’t reflect trading competitiveness countries goods + services.
➢ Speculators may buy currencies perceived be undervalued hope capital gains selling at higher price. Likewise sell
currencies perceived overvalued (avoid capital losses) when selling currencies lower rates future.
❖ Arguably, fixed exchange rates even more vulnerable than floating exchange rates to speculative capital flows as fixed e-r often
over/under valued.
➢ Overvalued currency, speculators may sell to make profit buying back at lower exchange rate after devaluation. If
devaluation doesn’t take place, speculators can enjoy ‘one-way option’: buying back currency at exchange rate sold.
