• 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...


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.


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.


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. Retailing In India - A Government Policy Perspective

    The limited commercial land that is available is taken by counter store operators, who have been in the trade for generations and often lack alternative occupations (therefore limiting supply into the market). g) Zoning laws: Zoning laws restrict the supply of real estate as well as attach constraints to property development for retail.

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

    This offers a very similar set of criteria to EMBI-G for bonds to be included in the index, allowing an exact comparison to be performed. According to the Merrill Lynch website14, the primary objective of this fund is to obtain current income.

  1. Chinese car market overview. Citroen case study

    It is also due to the conditions created to generally increase the use of cars by the population. For example, the amount of petrol stations in the whole country is always growing, taxes on the car consumption have been banned.

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

    Governments can use fiscal policy, which involves the use of Commonwealth Diagram 1.5 income within the community. The Government gives out its budget annually, in a statement about its planned income and expenditure for the following financial year. The budget, includes Direct tax income and company, Indirect Tax e.g.

  1. Exchange rate.

    FIGURE 1.5 The highest base rate is China with a base rate of 5.3%, and the lowest is Japan. According to this figures, it is easy to find that Chinese bank interest rate is the highest among all. However, China economy is not as stable as others' it till need a long time to improve.

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

    Japan is a good example of this in recent years. The Euro was weak during the first six months of its existence in part because the financial markets were worried about the slow growth of the European economy and the persistently high level of unemployment The currency of country also

  1. This report will establish the opportunities and threats presented to Sony by the EU ...

    the larger you become, so consequently firms who can place large orders have significant market power. Sony can also gain financial aid quicker with a lower rate of interest because banks feel it is less risky. Also as Sony grow they have better access to managers who are specialised at

  2. The International Monetary Fund And Global Economic Crises

    A country may draw up to a specified amount, over a period 12-18 months. 2. Extended Fund Facility are intended for countries with balance of payments difficulties related to structural problems that are medium-term. A member country can draw up to a specified amount for 3-4 years a period to tackle structural macroeconomic problems.

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