Exchange Rates:
Exchange rate: the price of one currency in terms of another. When the demand and supply
for pounds on the forex market graph are at equilibrium, there will be a balance on the
balance of payments as this implies that there is a balance between the demand from UK
residents for foreign goods and the foreign demand for UK goods
Demand for pound: arises from overseas residents wanting to purchase UK goods, assets.
Demand curve is downwards sloping because when the ER is low, UK goods and services
are relatively cheap in terms of other currency so there is a greater demand for the pound.
Supply for pounds: domestic residents wanting to purchase overseas goods, assets.
Supply curve is upwards sloping as when ER is high, the supply will be strong as UK
residents get much of other currency for the pound and so demand foreign goods and
services, supplying bonds to buy the needed forex for transactions.
Fixed Exchange Rate System:
Fixed exchange rate system: A system in which the government of a country agrees to fix
the value of its currency in terms of that of another country
● The government will set the ER at a certain level, which may not necessarily
correspond to the market equilibrium.
● While in a free market, the demand and supply would be expected to adjust to
equilibrium, if the authorities are committed to maintaining the ER then this
adjustment won’t take place
● However if ER is not at equilibrium then there will be an imbalance in the BOP - if
supply of pounds exceeds demand, then UK residents are buying more foreign
goods than foreigners are buying British goods and vice versa.
Evaluation of Fixed ER system:
● System may operate successfully in LR if the chosen exchange rate is close to the
average equilibrium ER value over time so the central bank does not run down or
accumulate forex reserves.
● If a country tries to hold its currency away from equilibrium indefinitely this may cause
a persistent trade imbalance which must be addressed by realigning the value of the
currency either a devaluation( reduced ER to tackle CA deficit) or a revaluation
(increased ER to tackle CA surplus).
To maintain a fixed ER under rising pressure: This is when the demand of the pound
increases such that it is greater than the Supply of the pound at the fixed ER level (more
foreigners demand UK goods and services than UK demands foreign goods suggesting a
surplus in the BOP) - which would cause an appreciation in the ER - to prevent this the
monetary authorities in the UK must supply additional pounds, taking foreign currency from
the market.
, ● Buy foreign currency from the market and sell domestic currency reserves:This would
increase the supply of the domestic currency and keep equilibrium at the fixed level.
● Lower interest rates: if interest rates fall, investors will move their money out of
domestic financial institutions to seek better interest rates elsewhere - a hot money
outflow will increase the supply of the domestic currency
● In forex market below this can be illustrated- if gov was fixing ER at P1 with initial
equilibrium at S1 and D1. If D1 increased from D1 to D2, either decreasing interest
rates or buying forex from the market would shift supply from S1 to S2 bringing
market back to equilibrium at fixed ER P1.
To maintain a fixed ER under falling pressure:
This is when the demand for pounds falls, for
example because foreigners want to buy
fewer goods from the UK (suggesting that
demand for UK goods from foreigners is less
than UK demand for foreign goods suggesting
a deficit in the BOP)
● Sell foreign exchange reserves to the
market, buying up domestic currency reserves
which would decrease the supply of the
pound.
● Increase interest rates: would cause a
hot money inflow as foreign savers seek high
returns from saving in the UK - increases the
demand for domestic currency once again
● This can be illustrated if the ER rate was set at P1 and initial equilibrium was at Q3
with S2 and D1 supply and demand curve. If the demand for pound falls from D2 to
D1 then ER rate would fall to P3. Selling forex would decrease supply of pound from
S2 to S1 while increasing interest rates would just shift demand back from D1 to D2 -
both would maintain equilibrium at ER p1.
Example of a fixed exchange rate system - The Dollar Standard:
● During Bretton Wood Conference at end of WW2 countries agreed to commit to
maintaining the price of their currencies in terms of the US dollar - system remained
in place until early 1970s. This was known as the Dollar Standard.
● Problems with Dollar Standard:
○ During the Dollar Standard period, the British economy went through a
‘stop-go’ cycle of growth, whenever the government tried to stimulate
economic growth the effect was to suck in imports as the UK has a high
marginal propensity to import.
○ This generated a deficit on the current account of the balance of payments
which had to be financed by selling forex reserves.
○ This put an upwards pressure on prices as the domestic money supply
increases threatening inflation and the Bank of England had finite forex
reserves which could not be run down.
○ To combat inflation the government then had to reduce the money supply
which slowed the rate of growth again.
Exchange rate: the price of one currency in terms of another. When the demand and supply
for pounds on the forex market graph are at equilibrium, there will be a balance on the
balance of payments as this implies that there is a balance between the demand from UK
residents for foreign goods and the foreign demand for UK goods
Demand for pound: arises from overseas residents wanting to purchase UK goods, assets.
Demand curve is downwards sloping because when the ER is low, UK goods and services
are relatively cheap in terms of other currency so there is a greater demand for the pound.
Supply for pounds: domestic residents wanting to purchase overseas goods, assets.
Supply curve is upwards sloping as when ER is high, the supply will be strong as UK
residents get much of other currency for the pound and so demand foreign goods and
services, supplying bonds to buy the needed forex for transactions.
Fixed Exchange Rate System:
Fixed exchange rate system: A system in which the government of a country agrees to fix
the value of its currency in terms of that of another country
● The government will set the ER at a certain level, which may not necessarily
correspond to the market equilibrium.
● While in a free market, the demand and supply would be expected to adjust to
equilibrium, if the authorities are committed to maintaining the ER then this
adjustment won’t take place
● However if ER is not at equilibrium then there will be an imbalance in the BOP - if
supply of pounds exceeds demand, then UK residents are buying more foreign
goods than foreigners are buying British goods and vice versa.
Evaluation of Fixed ER system:
● System may operate successfully in LR if the chosen exchange rate is close to the
average equilibrium ER value over time so the central bank does not run down or
accumulate forex reserves.
● If a country tries to hold its currency away from equilibrium indefinitely this may cause
a persistent trade imbalance which must be addressed by realigning the value of the
currency either a devaluation( reduced ER to tackle CA deficit) or a revaluation
(increased ER to tackle CA surplus).
To maintain a fixed ER under rising pressure: This is when the demand of the pound
increases such that it is greater than the Supply of the pound at the fixed ER level (more
foreigners demand UK goods and services than UK demands foreign goods suggesting a
surplus in the BOP) - which would cause an appreciation in the ER - to prevent this the
monetary authorities in the UK must supply additional pounds, taking foreign currency from
the market.
, ● Buy foreign currency from the market and sell domestic currency reserves:This would
increase the supply of the domestic currency and keep equilibrium at the fixed level.
● Lower interest rates: if interest rates fall, investors will move their money out of
domestic financial institutions to seek better interest rates elsewhere - a hot money
outflow will increase the supply of the domestic currency
● In forex market below this can be illustrated- if gov was fixing ER at P1 with initial
equilibrium at S1 and D1. If D1 increased from D1 to D2, either decreasing interest
rates or buying forex from the market would shift supply from S1 to S2 bringing
market back to equilibrium at fixed ER P1.
To maintain a fixed ER under falling pressure:
This is when the demand for pounds falls, for
example because foreigners want to buy
fewer goods from the UK (suggesting that
demand for UK goods from foreigners is less
than UK demand for foreign goods suggesting
a deficit in the BOP)
● Sell foreign exchange reserves to the
market, buying up domestic currency reserves
which would decrease the supply of the
pound.
● Increase interest rates: would cause a
hot money inflow as foreign savers seek high
returns from saving in the UK - increases the
demand for domestic currency once again
● This can be illustrated if the ER rate was set at P1 and initial equilibrium was at Q3
with S2 and D1 supply and demand curve. If the demand for pound falls from D2 to
D1 then ER rate would fall to P3. Selling forex would decrease supply of pound from
S2 to S1 while increasing interest rates would just shift demand back from D1 to D2 -
both would maintain equilibrium at ER p1.
Example of a fixed exchange rate system - The Dollar Standard:
● During Bretton Wood Conference at end of WW2 countries agreed to commit to
maintaining the price of their currencies in terms of the US dollar - system remained
in place until early 1970s. This was known as the Dollar Standard.
● Problems with Dollar Standard:
○ During the Dollar Standard period, the British economy went through a
‘stop-go’ cycle of growth, whenever the government tried to stimulate
economic growth the effect was to suck in imports as the UK has a high
marginal propensity to import.
○ This generated a deficit on the current account of the balance of payments
which had to be financed by selling forex reserves.
○ This put an upwards pressure on prices as the domestic money supply
increases threatening inflation and the Bank of England had finite forex
reserves which could not be run down.
○ To combat inflation the government then had to reduce the money supply
which slowed the rate of growth again.
