EXCHANGE RATES
Definition:
An exchange rate is the price of one currency in terms of another
An increasing exchange rate means that currency is strengthening or appreciating
A falling exchange rate means a currency is weakening or depreciating
- Not a macroeconomic objective but can be linked with them (economic growth,
price stability, full employment, balance of payments)
There are two main types of exchange rate systems
1) A fixed exchange rate is where the government or its central bank sets the exchange
rate. This often involves maintaining the exchange rate at a target rate
2) A floating exchange rate is free to move with changing supply and demand of a
currency
3) A hybrid exchange rate system is a mixture of fixed and floating. There are a number
of different hybrid systems e.g.
a. Managed floating- the exchange rate is mainly left to market forces (i.e. to
float freely), but the government will occasionally intervene to influence the
exchange rate. For example, to reduce the impact of an economic shock on
the value of its currency
b. Semi-fixed- the exchange rate is only allowed to fluctuate within a set band
of exchange rates
c. Pegged- the value of the currency is ‘pegged’ to another currency or group of
currencies. This peg can be moved periodically or as the government sees fit
Fixed exchange rates have to stay at a target rate
A government or central bank will maintain the exchange rate at the target rate by
controlling interest rates and by buying and selling the currency (using foreign
currency reserves) to keep supply of, and demand for, the currency stable
Maintaining a fixed ER
Weaker £->sell $ buy £
Stronger £-> sell £buy $
Interest rates
Weaker £-> increase IR
o In order to attract hot money flows which means other countries will put
their money into UK banks
o They will need to convert their money to sterling
Stronger £-> decrease interest rates
o People will take their money out of the UK and convert their sterling to
foreign money and put it in foreign countries
Ways of strengthening a currency
Sell foreign exchange assets, purchase own currency
Raise interest rates (attract hot money flows)
Reduce inflation (make exports more competitive)
Supply-side policies to increase long-term competitiveness.
, Factors impacting exchange rates
FDI
Demand for goods/ services
Tourism
Increased interest rates
Speculation
There are various ways of measuring exchange rates
1) Nominal exchange rate- an unadjusted or direct comparison of the value of
currencies
2) Real exchange rate- this is a nominal rate which is adjusted to take price levels into
account
a. Nominal exchange rates don’t always reflect the true worth of currencies
b. Real exchange rates overcome this problem by taking prices in the different
countries into account (using a price index)
3) Bilateral exchange rate- the comparison of just two countries
i. E.g. comparing the US dollar and pound sterling might show that
£1:$1.50
4) Effective exchange rate- a country’s exchange rate is compared to a basket of
currencies (usually of its trading partners) it’s a weighted average- e.g. the
proportion of the country’s trade with each partner determines the size of the
weighting. The aim is to give a summary of the overall value of a currency compared
to several others
Devaluation and revaluation
Rather than the central bank intervention or other policies to maintain a fixed
exchange rate, a central bank can alter the exchange rate
Devaluation is when the exchange rate is reduced
o This should boost exports and reduce imports (opposite of SPICED)
o The effectiveness of devaluation depends on the price elasticities of both
imports and exports (j curve)
o Devaluation will also reduce hot money inflows and increase hot money
outflows
o To prevent this, some countries may impose exchange controls, restricting
the outflow of capital
Revaluation is when the exchange rate is increased
o Effects will be the opposite of devaluation
Market forces or government intervention cause exchange rates to fluctuate
1) The devaluation of a fixed exchange rate occurs when the exchange is lowered
formally by the government. They can achieve this by selling the currency
2) The opposite of exchange rate devaluation is exchange rate revaluation, achieved
by buying the currency
3) The depreciation of a floating exchange rate is when the exchange rate falls. This
might occur naturally due to market forces, although government action e.g.
lowering interest rates might affect it indirectly
4) The opposite of exchange rate depreciation is exchange rate appreciation
Definition:
An exchange rate is the price of one currency in terms of another
An increasing exchange rate means that currency is strengthening or appreciating
A falling exchange rate means a currency is weakening or depreciating
- Not a macroeconomic objective but can be linked with them (economic growth,
price stability, full employment, balance of payments)
There are two main types of exchange rate systems
1) A fixed exchange rate is where the government or its central bank sets the exchange
rate. This often involves maintaining the exchange rate at a target rate
2) A floating exchange rate is free to move with changing supply and demand of a
currency
3) A hybrid exchange rate system is a mixture of fixed and floating. There are a number
of different hybrid systems e.g.
a. Managed floating- the exchange rate is mainly left to market forces (i.e. to
float freely), but the government will occasionally intervene to influence the
exchange rate. For example, to reduce the impact of an economic shock on
the value of its currency
b. Semi-fixed- the exchange rate is only allowed to fluctuate within a set band
of exchange rates
c. Pegged- the value of the currency is ‘pegged’ to another currency or group of
currencies. This peg can be moved periodically or as the government sees fit
Fixed exchange rates have to stay at a target rate
A government or central bank will maintain the exchange rate at the target rate by
controlling interest rates and by buying and selling the currency (using foreign
currency reserves) to keep supply of, and demand for, the currency stable
Maintaining a fixed ER
Weaker £->sell $ buy £
Stronger £-> sell £buy $
Interest rates
Weaker £-> increase IR
o In order to attract hot money flows which means other countries will put
their money into UK banks
o They will need to convert their money to sterling
Stronger £-> decrease interest rates
o People will take their money out of the UK and convert their sterling to
foreign money and put it in foreign countries
Ways of strengthening a currency
Sell foreign exchange assets, purchase own currency
Raise interest rates (attract hot money flows)
Reduce inflation (make exports more competitive)
Supply-side policies to increase long-term competitiveness.
, Factors impacting exchange rates
FDI
Demand for goods/ services
Tourism
Increased interest rates
Speculation
There are various ways of measuring exchange rates
1) Nominal exchange rate- an unadjusted or direct comparison of the value of
currencies
2) Real exchange rate- this is a nominal rate which is adjusted to take price levels into
account
a. Nominal exchange rates don’t always reflect the true worth of currencies
b. Real exchange rates overcome this problem by taking prices in the different
countries into account (using a price index)
3) Bilateral exchange rate- the comparison of just two countries
i. E.g. comparing the US dollar and pound sterling might show that
£1:$1.50
4) Effective exchange rate- a country’s exchange rate is compared to a basket of
currencies (usually of its trading partners) it’s a weighted average- e.g. the
proportion of the country’s trade with each partner determines the size of the
weighting. The aim is to give a summary of the overall value of a currency compared
to several others
Devaluation and revaluation
Rather than the central bank intervention or other policies to maintain a fixed
exchange rate, a central bank can alter the exchange rate
Devaluation is when the exchange rate is reduced
o This should boost exports and reduce imports (opposite of SPICED)
o The effectiveness of devaluation depends on the price elasticities of both
imports and exports (j curve)
o Devaluation will also reduce hot money inflows and increase hot money
outflows
o To prevent this, some countries may impose exchange controls, restricting
the outflow of capital
Revaluation is when the exchange rate is increased
o Effects will be the opposite of devaluation
Market forces or government intervention cause exchange rates to fluctuate
1) The devaluation of a fixed exchange rate occurs when the exchange is lowered
formally by the government. They can achieve this by selling the currency
2) The opposite of exchange rate devaluation is exchange rate revaluation, achieved
by buying the currency
3) The depreciation of a floating exchange rate is when the exchange rate falls. This
might occur naturally due to market forces, although government action e.g.
lowering interest rates might affect it indirectly
4) The opposite of exchange rate depreciation is exchange rate appreciation
