• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

Economics of the Foreign Exchange Market.

Extracts from this document...

Introduction

An exchange rate is simply the price of one currency in terms of another. The process by which that price is determined depends on the particular exchange rate mechanism adopted. In a floating rate system, the exchange rate is determined directly by market forces, and is liable to fluctuate continually, as dictated by changing market conditions. In a 'fixed', or managed rate system, the authorities attempt to regulate the exchange rate at some level that they consider appropriate. Such a system often seems appealing to those who are troubled by the uncertainties of the present, highly volatile, floating rate environment. But the choice of exchange rate regime involves considerations that extend beyond the stability or otherwise of currency prices. This will become clearer after an examination of some fundamentals of the foreign exchange market. Economics of the Foreign Exchange Market In a floating exchange rate regime the price of the dollar, like any other market-determined price, depends on the relevant forces of supply and demand. But what are the relevant forces of supply and demand in the foreign exchange market? To try to answer this question, let us consider, for illustration, the factors that determine the relationship between the Australian dollar and the Japanese yen. ...read more.

Middle

That is, the balance of current account (whether positive, negative, or zero) must be precisely offset by the balance (negative, positive, or zero) of the capital account. Under floating exchange rates these outcomes are achieved automatically without the need for government intervention. By contrast, under fixed exchange rates balance of payments equilibrium is not the normal condition. These characteristics of the floating exchange rate mechanism have important implications both for the nature of our relationship with the global environment, and for the policy options available to the authorities in managing the economy. Let us now consider some of these. International Transmission of Economic Stability A flexible exchange rate acts as a kind of shock absorber that helps to insulate us against overseas disturbances. This is because the relationship between our international transactions and the foreign exchange market runs in both directions. Let us suppose, for example, that recession in the Japanese economy leads to a decline in the demand for Australian exports. In itself, this will tend to reduce economic activity in Australia. But this tendency will be offset by an associated depreciation of the dollar, which will induce an expansion of exports, a contraction of imports, and perhaps an increase in net capital inflow, all of which will help to cushion the Australian economy against recession. ...read more.

Conclusion

The appropriate monetary policy action is for the Reserve Bank to reduce interest rates. This causes a depreciation of the dollar, which in turn encourages exports, discourages imports, and increases net capital inflow. These exchange rate effects tend to reinforce any initial expansionary impulse resulting from the change in monetary policy. It can be shown, by contrast, that where the exchange rate is fixed monetary policy is quite ineffective. Indeed the logic of a fixed exchange rate system essentially precludes the conduct of an independent monetary policy. This was a primary reason for the Australian government's decision to float the Australian dollar in 1983. In the case of fiscal policy, the conventional prescription is for an increase in the government budget deficit. The associated upward pressure on interest rates induces an appreciation of the dollar, which in turn discourages exports, encourages imports, and reduces net capital inflow. These exchange rate effects on our international transactions weaken aggregate demand in Australia and accordingly tend to offset any expansionary effects of the government's fiscal program. By contrast, with a fixed exchange rate these adverse secondary effects are precluded, and fiscal policy is likely to be correspondingly more effective. These considerations help to explain why fiscal policy has come to be overshadowed by an increased reliance on monetary policy as the primary instrument of macroeconomic stabilisation. ...read more.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our GCSE Economy & Economics section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related GCSE Economy & Economics essays

  1. Chinese car market overview. Citroen case study

    The country has around 100 different car constructors, which involves a very decentralized market a lots of production sites. The national production is very much turned towards utility vehicles, such as buses, lorries, also recently the private vehicle has been very successful.

  2. The Relevant Market

    Gross Domestic Product (GDP) Gross Domestic Product, or "GDP", is a key measure provided in Australia's national accounts. The Australian Bureau of Statistics defines GDP as, "the unduplicated value of production that occurs in Australia during a particular period." Unduplicated refers to the fact that the value of goods and services used up in

  1. The Famous Grouse - company profile and exports

    US History Britain's American colonies broke with the mother country in 1776 and were recognized as the new nation of the United States of America following the Treaty of Paris in 1783. During the 19th and 20th centuries, 37 new states were added to the original 13 as the nation

  2. Discuss the policy options the Australian Government can use to achieve external stability

    the stability of Australia's currency, which acts to help stabilize Australia's external stability. This involves minimizing domestic inflation and maintaining the stability of the value of the Australia dollar. Inflation is a continuous upward movement in the general level of prices and can impose costs on individuals and the economy

  1. What might cause an appreciation of a floating exchange rate? Discuss whether an appreciation ...

    When this activity decreases there will be a decrease in the supply as lesser pounds will be sold to buy foreign currency. A fall in imports may be due to reasons such as contracted consumer demand. Pessimism of a receding economy, which causes compulsion to save rather than spend on

  2. The Ohio Pilot Scholarship Program

    about the attachment to a place that is suffering either decline (because of increased drug and crime activity) or change (gentrification), or, in the case of Kilmainham in Dublin, both. She finds that the notion of place in these neighbourhoods is "unstable, ambiguous and contested."

  1. An Empirical Investigation into the Causes and Effects of Liquidity in Emerging

    S = (PA - PB) / ((PA + PB)/2)) Volume-based measures have also been used in many studies of liquidity, however, they do not provide the variety of information in their values as is incorporated in the bid-ask spread. For example, such measures do not include the cost of trading, which is taken into account by the bid-ask spread.

  2. Selecting international modes of entry and expansion

    wholly-owned subsidiaries, a set of important factors emerged that distinguished the use of one mode from another. The following section discusses the major findings of our study. Differences in what is most important to US and Japanese managers will be highlighted.

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work