EXCHANGE RATE

1.The layman's exchange rate

This is the definition that most people understand when discussing the exchange rate. It is often
referred to as the nominal exchange rate. This is defined as the rate at which one currency can be
converted, or 'exchanged', into another currency.
The pound is currently worth about one and a half US dollars. One pound can be converted into one
and a half dollars. This, therefore, is the exchange rate between the pound and the dollar. The table
below gives you some of the exchange rates against the pound over the last 20 years:
Year German mark French franc The euro
1980 4.23 9.83

2.What affects the 'price' of the pound?

The supply and demand analysis above worked quite well in the days before the war and, to a certain
extent, in the three decades afterwards. This was because there were tight capital controls, so most of
the demand for foreign currencies was for the purposes of importing goods and services. Trade deficits
would lead, eventually, to a fall in the exchange rate, and trade surpluses would cause the exchange
rate to rise.
In the last twenty years, capital markets have been opened up; there are now very few controls on the
flow of capital worldwide. In the UK, the controls on currencies were abolished in 1979; one of the
first acts of the new Conservative government. This has created many more reasons to demand and
supply currencies.

Foreign direct investment

The UK is the recipient of the second largest amount of capital from abroad for the purpose of direct
investment. Foreign direct investment includes any investment in a business overseas to gain profit. It
could also include the transfer of ownership of businesses across national boundaries. Examples
include when Nissan built a factory in Sunderland, or when Marks & Spencer invested in new shops
around the world.
The UK always used to invest more money abroad than foreigners invested in the UK. This has
changed recently, with the net flow of money being into the UK. This means that the demand for
pounds for this investment in the UK is higher than the demand for foreign currencies by UK
businessmen investing abroad. This will cause the pound to rise in value. The diagrams above can be
used to show this effect. The principle is exactly the same as when the demand for pounds to buy
British goods out-strips the demand for foreign currencies to buy foreign imports of goods.

Portfolio investment
Portfolio investment refers to investment in things like shares and bonds. Again, much of this
investment occurs across national boundaries nowadays. If a British resident decides to buy shares in
an American company, this will cause a rise in the demand for dollars in the same way that the
purchase of an American computer does. The standard supply and demand analysis can be used again.
Inflation rates
As you can see above, inflation rates affect real interest rates. Over the long term, countries with higher
inflation rates will see their currency drop in value, because their exports will become uncompetitive,
reducing future demands for their currency.
But as we have already seen, currency transactions for trade form a tiny proportion of total currency
transactions. Speculators are nervous of investing in currencies whose inflation rate is starting to rise.
This may be suggesting that the economy is over-heating. As night follows day, recessions tend to
follow booms in the economy. This leads us onto the third point.

3.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. This was
the case with the UK in the ERM. Their actions were effectively dictated by the actions of the strongest
member of the system, Germany. They were notoriously strict on inflation, perhaps keeping interest
rates higher than they needed to be. The UK was forced to follow suit and keep interest rates relatively
high to keep the pound within the ERM. The system almost forced the UK to keep inflation down.
Others would argue that the ERM simply forced the UK to stay in a recession. Anyone can keep
inflation low by having a recession!
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. The story
of the pound falling out of the ERM is a classic example where this theory went a bit wrong!
Having said that, in the run up to the introduction of the euro (a totally fixed exchange rate system!) the
rates were fixed six months before the start date of the 1st January 1999 and lots of speculation against
these rates was predicted. In this case, it simply did not happen. 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. Of course, the euro was sold after its introduction, but that is a different story (see
the next Learn-It).
The lesson, therefore, is that systems that are credible will experience less speculation. Systems, or
members within systems, that do not inspire confidence may well have to put up with lots of
speculative buying and selling.

The disadvantages of a fixed exchange rate system

The loss of monetary policy
As the UK government found when they were part of the ERM, 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.

4.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.

Appreciation
This is the term used for a gradual rise in the value of a currency in a floating exchange rate system, as
opposed to a revaluation, which is a large rise in the value of a currency, usually when it is realigned
within a fixed exchange rate system.
Balance of payments
This is a record of all the flows of money into, and out of, the UK over a given time period (usually a
year). It is split into two: the Current Account (exports and imports of goods and services) and the
Capital Account (flows of money for investment plus government reserves of foreign currencies).
Budget deficit
This is a short phrase used to describe the Public Sector Net Cash Requirement (PSNCR). It refers to
the government's budget being in deficit. This should not be confused with the trade deficit, which is
the deficit in the 'trade in goods' part of the current account of the balance of payments (for example,
the value of imports of goods are higher than the value of exports of goods).
Current account
This is one half of the balance of payments. It measures all exports and imports of goods and services
for a given country. It also includes investment income and transfers.
Current account deficit
If a country has a deficit on their current account then it means that it imports more goods and
services (in terms of value) than it exports.
Current account surplus
If a country has a surplus on their current account then it means that it exports more goods and
services (in terms of value) than it imports.
Depreciation
This is the term used for a gradual fall in the value of a currency in a floating exchange rate system, as
opposed to a devaluation, which is a large fall in the value of a currency, usually when it is realigned
within a fixed exchange rate system.

What are the major objectives of macroeconomic policy?

Macroeconomics is concerned with issues, objectives and policies that affect the whole economy. All
economic analysis that refers to aggregates is macro. The UK unemployment rate, the UK inflation
rate, the rate of economic growth in the UK; these are all UK aggregates and therefore macro issues.
The four major objectives are:

1. Full employment
2. Price stability
3. A high, but sustainable, rate of economic growth
4. Keeping the balance of payments in equilibrium.

How are these objectives measured?

1. Full employment, or low unemployment.
The claimant count is the older, more out-of-date, measure of unemployment used in the UK. Those
counted must be out of work, physically able to work and looking for it, and actually claiming benefit.
For a more realistic count, and for international comparisons, the ILO (International Labour
Organisation) measure is used. This includes the young unemployed who are not always eligible to
claim, married women who can't claim if their husband is earning enough, and those who claim
sickness and invalidity benefits. Many only slightly inconvenienced unemployed workers are paid
these benefits rather than swell the claimant count of unemployment.
Note the issue of active and inactive members of the population of working age. Only those who are
active are included in the working population (or labour force), which is defined as all those who are
employed or registered unemployed. But some of the inactive are in this category by choice, for
instance, students and those who retire early.
At the moment in the UK, the level of employment is the highest ever (nearly 28 million workers). But
one should note the significant difference in the numbers employed in manufacturing compared with
the services (approximately 4 million against nearly 18 million).
2. Price stability
Inflation is usually defined as a sustained rise in the general level of prices. Technically, it is measured
as the annual rate of change of the Retail Price Index (RPI), often referred to as the headline rate of
inflation. For prices to be stable, therefore, the inflation rate should be zero. Generally, governments
are happy if they can keep the inflation rate down to a low percentage. For an explanation of how the
RPI is formulated, see the topic called 'Unemployment and inflation'. The UK government prefers to
target the underlying rate of inflation, or the annual percentage change in the RPIX. This is the same
as the RPI except housing costs are removed in the shape of mortgage interest payments. It makes
sense for the government to use this measure because the weapon they use to control inflation, interest
rates, directly affects the RPI itself.
3. High (but sustainable) economic growth
Economic growth tends to be measured interms of the rate of change of real GDP (Gross Domestic
Product). When the word real accompanies any statistic, it means that the effects of inflation have been
removed. GDP is a measure of the annual output (or income, or expenditure) of an economy.
Sometimes GNP (Gross National Product) is used, which is very similar to GDP. The only difference
is that income earned from assets held abroad is added and the income earned by foreigners who have
assets in the UK is taken away (officially called net property income from abroad). Growth figures are
published quarterly, both in terms of the change quarter on quarter and as annual percentage changes.
UK real GDP growth was 1.8% in 1999, which is lower than the mid-90s, but much better than the
recession of the early 90s. Remember that many economists were predicting 1999 to be a year of
recession, so the final figure is really quite reasonable. Note also that there is a big difference between
the growth rates of the manufacturing sector (-0.4%) and the service sector (2.8%). The service sector
has been healthy for years, whereas the manufacturing sector, some would argue, has barely recovered
from the recession of the early 90s.
4. Balance of payments in equilibrium
This is a very big topic in itself. Look at the topic called 'The balance of payments' for much more
detail. Briefly, this records all flows of money into, and out of, the UK over a given time period
(usually a year). It is split into two: the Current Account and the Capital and Financial Accounts
(formerly the capital account, although examiners do still accept this name).
Probably the most important is the current account because this records how well the UK is doing in
terms of its exports of goods and services relative to its imports. If the UK is to 'pay its way' in the
world over the long term, then it needs to keep earning enough foreign currency from its exports to pay
for its imports. If this is not the case, the current account will be in deficit.
Japan has the largest current account surplus in the world. Although a surplus sounds better then a
deficit, both can be bad. Japan's surplus forces other countries in the world to have deficits. In fact,
while Japan's surplus is the biggest in the world, the USA's deficit is the biggest in the world. This is
not a coincidence! The UK tends to be in deficit, although the current account was in surplus a couple
of years ago, mainly due to our strength in the service sector.