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# Exchange rate.

Extracts from this document...

Introduction

ECONOMICS ASSIGNMENT 2 EXCHANGE RATE A) What factors determine currency exchange rates? Exchange rate is often referred to as the nominal exchange rate. It is defined as the rate at which one currency can be converted, or 'exchanged', into another currency. For example, the pound is currently worth about 1.824 US dollars. One pound can be converted into 1.824 dollars. This is the exchange rate between the pound and the dollar. There are four types of currencies can be operated, which are a floating, managed and fixed exchange rate. Lots of developed industrial nations like US (\$), UK (�) and Japan (�) operate floating exchange rates. A floating exchange rate is known as freely floating and should be self-regulating. It is often determined by the market demand and supply without any other government or official interference. As the exchange rate between pound and dollar for example, the price of pound in terms of dollar would decided by the demand for pounds from whom hold dollars and the supply of pounds from sterling holder who want to buy dollars. When people in the UK try to buy US goods and services they will supply pounds to US, however, when people from US try to by UK goods and services they will demand UK pounds. At this time, the price which keeps the demand and supply force in balance is the exchange rate between pound and dollar. As it shows in Price of �s in \$s S D \$1.5 (FIGURE 1.1) D S 0 Q Quantity of �s figure1.1, when one pound equals one and a half dollars, the price is in equilibrium. Although floating exchange rate is mainly affect by market forces, actually sometimes a nation's central bank try to influence the exchange rate. They can use the way of adjusting the interest rate to influence the capital flow into or out of the country or directly buying or selling the currency. ...read more.

Middle

When people in the UK try to buy US goods and services they will supply pounds to US, however, when people from US try to by UK goods and services they will demand UK pounds. At this time, the price which keeps the demand and supply force in balance is the exchange rate between pound and dollar. As it shows in figure1.6, when one pound equals one and a half dollars, the price is in equilibrium. Figure 1.6 The floating exchange rate has several advantages. Firstly as it has stated before, floating exchange rates can adjust automatically to trade imbalances, which will remove the trade imbalance. If the value of a county' imports are greater than its exports, the supply of its currency will exceed the demand for it. As a result its currency will depreciate. Moreover, its exports are cheaper in terms of foreign currency and its imports are more expensive in terms of its own currency. Of course, it has also been noted that a floating exchange rate does not always keep balance of trade in the real world because so few currency transactions are for trade. Secondly, foreign reserves are basically used to maintain a currency within a fixed exchange rate. In theory, if a currency is freely floating, then there is no need for government to use reserves to affect its value. But In the real world, it is very likely to have an emergency in the balance of payments; in order to deal it government will always have some reserves. Otherwise, when they feel that their currency is getting a bit too high or too low they also can solve it in time. Third, a floating exchange rate gives more freedom to government to run their own domestic economic policy. If the government is not controlling their exchange rate, then they can control their rate of interest. And the interest rates do not have to be set to keep the value of the exchange rate within a certain bands. ...read more.

Conclusion

It can loss the control of independence policy. The single currency members neither can control an independent interest rate policy nor control the money supply because the monetary policy is determined by the European Central Bank. It reduces independence of fiscal policy. Euro members still have part independence on controlling the fiscal policy. Their fiscal policy is allowed to change if their budget deficits do not exceed 3% of the country's GDP. It can not devalue independently. The devaluation for the Euro members is effectiveness for instance; it cannot increase the price competitiveness of its good and services. Individual government loses its policy instrument. Misalignment can happen if joining in a single currency. Not all the EU members can get benefit form an exchange rate or interest rate. As UK for example, it has so much differences from the rest of the EU- it is a second most importer exporter of services in the world and it has the most trades than other EU members. I t can have asymmetric policy sensitivity. Different from other EU members, in the UK, the most borrowing is at variable rate. If there is a rise in interest, UK will have a greater impact on its borrowers. It has regional problems. There is a risk exist in the regional differences. Firm will move to the prosperous areas. Before considering joining the single currency the UK Labour government has set five conditions to meet, as it mentions in SJ Grant's book 'STANLAKE'S INTRODUCTORY ECONOMICS' 1999, page 496, they are Membership must be expected to create better conditions for companies to invest in the UK The effect on the UK's financial services industry would have to be beneficial. There must be a convergence of European business cycles and economic structure. There must be sufficient flexibility for the system to cope with economic change and shocks. Membership must be good for jobs and economic growth. ?? ?? ?? ?? EMF1 WANG LI LI 1 ...read more.

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