Exchange rates

An exchange rate is the value of one currency expressed in terms of another currency.

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 of, and demand
for, a currency.

Fixed exchange rates

A fixed exchange rate is an exchange rate regime where the value of a currency is fixed, or
pegged, to the value of another currency, to the average value of a selection of currencies, or
to the value of some other commodity, such as gold. As the value of the variable that the
currency is pegged to changes, then so does the value of the currency.
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.

Market Forces or Government Intervention cause exchange rates to Fluctuate

1) The devaluation of a fixed exchange rate occurs when the exchange rate 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.
5) Competitive devaluation can occur in fixed or hybrid exchange rate systems.
This is when governments deliberately devalue their own
currencies to improve international competitiveness.
6) Competitive depreciation can occur in floating or hybrid exchange rate systems
— government intervention might indirectly reduce the value of the currency,
improving the country’s international competitiveness.

Floating and Fixed exchange rates have Advantages and

Disadvantages
Floating exchange rates
A floating exchange rate is an exchange rate regime where the value of a currency is allowed
to be determined solely by the demand for, and supply of, the currency on the foreign
exchange market. There is no government intervention to influence the value of the
currency.

Supply and Demand determine Floating exchange rates

1) Floating exchange rates are determined by changes in supply and
demand for a currency. For example, an increase in the supply
of pounds to S1 will cause a decrease in the value of the pound to P1. This increase
in supply may be due to things such as an increase in imports to the UK and
increased selling of the pound.

2) A decrease in the demand for pounds to D1 will cause a decrease in the value
of the pound to P1. This decrease in demand may be due to, for example, a decrease
in exports from the UK and decreased buying of the pound.
3) Supply and demand fluctuations are caused by many other factors, for example:

• Speculation — where people buy and sell currency because of changes they
expect are going to happen in the future.
• The official buying and selling of the currency by the government or central
bank.

• Relative inflation rates — if a country’s inflation rate is higher than its

competitors’, then the value of its currency is likely to fall. Prices in the country
will become less competitive, leading to reduced exports and increased imports,
so demand for the currency decreases and supply increases.
• Relative interest rates — high interest rates increase demand for a currency
because there’s an inflow of ‘hot money’.

• Confidence in the state of the economy — there’ll be greater demand for a

currency if people feel confident in, for example, a country’s growth and stability
(this will include a country’s economic and political stability — investors are
unlikely to have confidence in unstable governments).
• The balance on the current account of the balance of payments has a small effect
on the exchange rate — for example, a current account deficit will mean there’s a
high supply of the currency due to the purchase of imports.

Fluctuations in the Exchange Rate have Impacts on the economy

1) If the value of a currency falls:
• Exports will become cheaper, so domestic goods will become more
competitive.
• This means that demand for exports will increase.
• Imports will become more expensive, so demand for imports will fall.
• A current account deficit should therefore be reduced, but a surplus should
increase.
2) The current account deficit will only reduce if the Marshall-Lerner condition
holds.
3) The J-curve shows how the current account may actually worsen in the short
run, but improve in the long run.
4) A fall in the value of a currency can also mean:
• If exports increase and imports decrease, there’ll be economic growth caused by
an increase in aggregate demand.
• Unemployment may also be reduced through the creation of more jobs from
economic growth.
• Inflation may rise if demand for imports is price inelastic.
• Increased import prices can also cause cost-push inflation.
5) A rise in the value of a currency will tend to have the opposite effects on an
economy.
6) For example, exports will become more expensive and imports will become
cheaper. This will potentially mean:
• An increase in the size of a current account deficit, or a reduction in a current
account surplus.
• A fall in aggregate demand, which is likely to lead to a fall in output.
• Unemployment may rise.
• The impact on inflation will depend on the price elasticity of demand for imports
and for domestic goods.

Managed exchange rates

These are exchange rate regimes where the currency is allowed to float, but with some
element of interference from the government.
The most common systems are where a central bank will set an upper and lower exchange rate
value and then allow the currency to float freely, so long as it does not move out of that band. If
the exchange rate starts to get close to the upper or lower level, then the central bank will
intervene in the foreign exchange market for its currency. Central banks do not make the upper
and lower level values public, for fear of speculation, but they do exist.

Government measures to intervene in the foreign exchange market

There are a number of reasons why governments may intervene in the foreign exchange market
to influence the value of their currency. They may wish to:
 lower the exchange rate in order to increase employment
 raise the exchange rate in order to fight inflation
 maintain a fixed exchange rate
 avoid large fluctuations in a floating exchange rate
 achieve relative exchange rate stability in order to improve business confidence
 improve a current account deficit, which is where spending on imported goods and services
is greater than the revenue received from exported goods and services.

Whatever the reason for the intervention, we should now consider how governments attempt to
manipulate the exchange rate. There are two main methods.
1 Using their reserves of foreign currencies to buy, or sell, foreign currencies: If the government
wishes to increase the value of the currency, then it can use its reserves of foreign currencies to
buy its own currency on the foreign exchange market. This will increase the demand for its
currency and so force up the exchange rate.
In the same way, if the government wishes to lower the value of its currency, then it simply
buys foreign currencies on the foreign exchange market, increasing its foreign currency
reserves. To buy the foreign currencies, the government uses its own currency and this increases
the supply of the currency on the foreign exchange market and so lowers its exchange rate.
2 By changing interest rates: If the government wishes to increase the value of the currency then
they may raise the level of interest rates in the country. This will make the domestic interest
rates relatively higher than those abroad and should attract financial investment from abroad. In
order to put money into the country, the investors will have to buy the country’s currency, thus
increasing the demand for it and so its exchange rate.
In the same way, if the government wishes to lower the value of the currency, then they may
lower the level of interest rates in the country. This will make the domestic interest rates
relatively lower than those abroad and should make financial investment abroad more attractive.
In order to invest abroad, the investors will have to buy foreign currencies, thus exchanging
their own currency and increasing the supply of it on the financial exchange market. This
should lower its exchange rate.