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. The reason central bank try to manage the exchange rate is to reduce the fluctuations around the equilibrium exchange rate they believed. The ERM which stands for the exchange rate mechanism is an example of a managed exchange rate. It is fundamentally for preventing large fluctuations relative to European Union's (EU) countries' currencies. the member countries of EU have to keep their currencies value within a permitted band. Country has to take actions to bring its exchange rate value within the set band when its currency moves out of it. As it shows in figure1.3 that there is an increase in demand for imports, then lead the supply curve to shift right from S to S'. In order to lower the price of the currency, the country may take actions such as raising its domestic interest rates or buy its own currency. This results demand curve shifts right from D to D' and keep the value of the exchange rate within the band.
Price of currency in Euros
D'
S
D S'
Upper margin
Lower margin
D'
S D
S'
Figure 1.2
A fixed exchange rate is a kind of currency whose value has fixed against another or other currencies. And the currency is not allowed to appreciate or depreciate against each other. It is guaranteed and totally controlled by the government. In order to keep a currency at a fixed value, the central bank must prepare to buy and sell the currency at the fixed price. In that case, central bank has to find the foreign currency supply. China is an example for operating a fixed exchange rate system and the exchange rate is fixed to US dollar at 1 US dollar = 8.73 RMB. Assume that, RMB has a fixed value to dollar that 1US dollar= 8 RMB, but now the imports in China increase, as it shows in figure 1.3, the supply curve moves from S to S', at the same time RMB in terms of dollar just 1US dollar=5 RMB. The central bank which is The Bank of China enters the market and buys its own currency raising demand from D to D' and keep the price at the level of 1 US dollar=8 RMB.
Figure 1.3
Generally, governments often use government policy to influence the value of their currency If the country is part of a fixed exchange rate system then it is common for them to use some of their official reserves to buy the currency when it threatens to drop below the allowed bands, or sell the currency and buy the appropriate foreign currencies to stop it from rising too high. With a fixed exchange system, a country may face a persistent surplus or deficit. To deal with a persistent surplus, government can increase home demand in order to encourage import, or raise home price to make export less competitive. To deal with a persistent deficit, government can reduce the home demand or decrease home price to make export more competitive. If both of measures inefficient, the only way of influence the exchange rate is to change the exchange rate. If countries with surpluses move their value of exchange rates higher, it will be revalue, if countries with deficit decrease their value of exchange rate, it will be devaluation. And usually, exports are dearer in the condition of devaluation.
If a government is confident that a floating exchange rate system can keep a balance of payments in balance. Then it will not hold reserves of foreign currency.
The market demand and supply for currency are the most significant determinant for influencing the exchange rate in a floated exchange rate system. If there is an increase in demanding pounds, the equilibrium price is likely to change. For example, as it illustrated in figure 1.4(A) (B), if an American buys a British Rover, there will be an increase in the demand curve for pounds. The demand curve will shift from D to D', In order to buy these pounds the supply of dollars will have to rise. The supply curve in the diagram 1.4(B) shifts to the right from S to S', in diagram (A), the 'price' of the pound rises from £1 = $1.50 to £1 = $1.70. In diagram (B),
price of£s in $s D' S Price of £s in $s S
D
D S'
£1:$1.7 $1 :£0.67
$1:£0.59
£1:$1.5 D'
S D
S'
0 0
Q Q' Q Q'
Quantity of £s Quantity of £s
(A) (B)
(Figure 1.4)
the price of dollar falls from $1=£0.67 to $1=£0.59.In addition, Improving or deteriorating preferences for domestic goods will be likely lead to appreciation or depreciation of the domestic currency in the long run. Improving or deteriorating preferences for foreign goods will be likely lead to ...
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price of£s in $s D' S Price of £s in $s S
D
D S'
£1:$1.7 $1 :£0.67
$1:£0.59
£1:$1.5 D'
S D
S'
0 0
Q Q' Q Q'
Quantity of £s Quantity of £s
(A) (B)
(Figure 1.4)
the price of dollar falls from $1=£0.67 to $1=£0.59.In addition, Improving or deteriorating preferences for domestic goods will be likely lead to appreciation or depreciation of the domestic currency in the long run. Improving or deteriorating preferences for foreign goods will be likely lead to depreciation or appreciation of the domestic currency in the long run.
The inflation rate also affects a country exchange rate value. Generally speaking, if a country's domestic inflation at a faster pace than that of foreign inflation, it will be likely result in depreciation of the domestic currency in the long run. And if a country's domestic inflation at a slower pace than that of foreign inflation, it will result in appreciation of domestic currency in the long run. If UK's inflation at a faster space than US, which means that its RPI Retail Price Index is higher, for instance, the same value of goods or services in UK cost more than that of US, its also means that US has an absolute advantage in international trade with UK. It induces UK goods and services become uncompetitive. In that case, the supply for pounds will increase and pounds will depreciate against dollar, and vice versa.
Country's balance between exports and imports also affect the foreign exchange value of a country's currency. As an American buys a British Rover for example again, this is a kind of export for UK product. For the popularity of British Rover the demand for British Rover will shift to right, Figure 1.2(A),from D to D', as a result, the value of pound in terms of dollar increase from £1=$1.5 to £1=$1.7,if the value of exports into the USA (from the UK) exceed the value of imports into the UK (from the USA) then the value of the pound in terms of dollars will rise and the value of the dollar in terms of pounds will fall. If the UK imports more than it exports then the value of the pound will fall. In other words, for a country, trade deficits would lead exchange rate to fall, and trade surpluses would cause the exchange rate to rise.
With a freely floating currency, as UK for example, with the interference of speculators, the deteriorating trade situation should automatically cause a fall in pound, and in that case, the competitiveness of British exporters would be improved and the balance of trade goes mature.
The capital transaction between a country and the international world will also affect the foreign exchange value of a country's currency. As speculators for example, they work in the foreign exchange markets around the world and their main job is to make money by trying to predict the movements of currencies. They buy when they think the value of currency is going to rise and sell when they think it is going to fall. If someone transfers $15000 into pounds at the exchange rate of £1=$1.5, then he can get £10000, for a while, as him expect, the exchange rate for pound in terms of dollars rises at £1=$2, he sell pounds into dollars and get $20000, in turn of that, he gain $5000 profit from buying it at a lower price and selling it at high price. In fact, these transactions always carry out on a large amount;
Different countries bank base rates affect different interest rates. As it shows in figure1.5 (A) (B).Figure1.5 (A) indicates the process of bank interest rate and base rate. Figure1.5 (B) illustrates the base rate for different currencies.
BASE RATE
TERM BASE RATE
RMB
5.3%
£
3.75%
¢
2.0%
$
.0%
¥
0.05%
UNSECURED
INFLATION RATE
BASE RATE
(A) (B)
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. Interest rates are the other factor which can influence the exchange rate. And it is also related to balance of trade and currency flows. As Japan ¥ for example, If US exchange rates are higher than Japan domestic rates, it is likely to have an outflow of funds such as a capital inflow to earn a greater interest income than in Japan domestic market. As a result, Japan domestic supply of ¥will increase, in other words, Japan demand for $ increase, consequently lead a depreciation of ¥against $.
Also, high interest rate is likely to attract more speculators and investors. Before make the decision speculators will always take risks in a forward markets. If their predictions are right they will win. If wrong, they will lose. Successful speculation likely will help foreign exchange market adjustment toward a new equilibrium; however, unsuccessful speculation may have bad effects on foreign exchange markets.
Investors also wish to invest their assets on the most profitable market and the bank interest is the link between investor and market. So normally investors would like to invest their money in the country that has the highest interest rate. If US has the interest rate of 3‰ and UK is 3.5‰, then UK is more likely to attract investors. In that case, the demand for £ will increase lead to a appreciate in pounds.
B) At certain times a country's currency may be strong. At other times it may be weak. Outline the problems which both of these situations pose to government.
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 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. For example, when the UK came out of the Exchange Rate Mechanism in September 1992, this allowed UK to cut in interest rates which helped to pull the economy out of a recession.
Operating a floating exchange rate system can avoid the exchange rate becoming a target.
The government does not need to take measures which might threaten its objective to protect the value of currency at a fixed rate.
The last advantage of a floating exchange rate system is that, the exchange rate in a floating exchange rate system changes relatively smooth than that of fixed exchange rate.
A floating exchange rate also has some disadvantages. The biggest disadvantage of floating exchange rate systems is their uncertainty. It injects the risk into the firms when they buy goods and services from abroad. For example, when the value of pounds falls more than the dollar price of cotton, then the dollar price of cotton falls while the price of cotton for UK importer rises. In that case, it discourages international trade. 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.
A floating exchange rate may make production planning very difficult when there is a constant change for the external prices of domestically-produced goods.
In a floating exchange rate system rise import prices may broke the stability of domestic price.
A floating exchange rate is referred to automatically adjust by movement in the exchange rate, but this greater freedom also brings some dangerous elements. The imports will be dearer due to the depreciation of the currency, and the dearer imports could lead to cost inflation. So the home economy can not be isolated from the external forces.
Finally, a floating exchange rate may increase speculation through a certain level of buying or selling. The exchange rate can move a long way if speculators think that it is at the wrong level and this is harm for a country's economy.
There are some advantages of a high exchange rate. Firstly, it can reduce the inflation pressure. The imported finished products' price will be low, which drives the domestic firms to keep their prices low in order to remain competitive. Relatively, the prices of some consumer products fall the wage claims will be improved. And it also keeps production cost at a low level when prices of imported raw materials are low.
Secondly, a high exchange rate can make a improvement in the terms of trade and living standard. The greater purchasing power on imports for a given quantity of exports the higher the exchange rate rises. For example, the current exchange rate is £1=$1.5,a £10 export could be exchange for $15, and could buy three imports which cost $5 each. And then, the exchange rate rise to £1=$2 it could buy four imports which cost $5 each.
A high exchange rate certainly can encourage foreign direct investment. The profit foreign firms have made from foreign countries will be worth more than that of domestic currency.
Low exchange rate also has some advantages. Domestic goods and services will be competitive in price in both domestic and foreign markets.
Low exchange rate makes the balance of goods and services in equilibrium or in surplus. If it in surplus the export prices will be low in term of foreign currency and import price high in terms of domestic currency.
It improves the demand for domestic goods and services to a high level, relatively, employment and growth are likely to be high.
A fixed exchange rate is a kind of currency whose value has fixed against another or other currencies. And the currency is not allowed to appreciate or depreciate against each other. It is guaranteed and totally controlled by the government. In order to keep a currency at a fixed value, the central bank must prepare to buy and sell the currency at the fixed price. In that case, central bank has to find the foreign currency supply. China is an example for operating a fixed exchange rate system and the exchange rate is fixed to US dollar at 1 US dollar = 8.73 RMB. Assume that, RMB has a fixed value to dollar that 1US dollar= 8 RMB, but now the imports in China increase, as it shows in figure 1.7, the supply curve moves from S to S', at the same time RMB in terms of dollar just 1US dollar=5 RMB. The central bank which is The Bank of China enters the market and buys its own currency raising demand from D to D' and keep the price at the level of 1 US dollar=8 RMB.
Figure 1.7
Fixed exchange rate has some advantages, firstly, the significant advantage compared with floating exchange rate is that it removes the uncertainly of floating exchange rate. In that case, it reduces the risk on the negotiation of long-term contract, the granting of long- term credits, and the undertaking of long- term investment overseas.
A fixed exchange rate system is said to discipline countries into keeping inflation down. Because there is nothing can devalue if increasing inflation leads to reduced competitiveness. This was the case with the UK in the ERM. Their actions were effectively charged by German, the most powerful member of the system. The UK was forced to keep interest rates relatively high to keep the pound within the ERM. The system almost forced the UK to keep inflation down.
Compared with the floating exchange rate, there is an advantage that if imports prices rise the stability for domestic prices will not be broken. Then the stability also encourages increased trade. Also, exchange rate stability provides a realistic basis for expectations.
One of disadvantages of fixed exchange rate is that the government had to have a large pool of foreign reserves with which to buy its own currency when its exchange rate too low or it faces a persistent deficit. Apart from being expensive, some countries may find it hard to get their hands on sufficient stocks of reserves to support their currency.
To solve the problem of deficit under a fixed exchange rate system, the most likely measure to reduce imports and encourage exports is to raise prices of the domestic market. The use of tariffs and quotas will raise domestic price, however, these measures are usually harm domestic employment and growth.
There is no automatic adjustment in fixed exchange rate, which means that large changes in exchange rates would result in some dangerous elements for economy.
Fixed exchange rate will cause government losing control over all other instruments of monetary policy. In that case, the government can not set interest rates at whatever level they want.
With a freely floating currency, a deteriorating trade situation should automatically cause the currency to fall. It would improve the competitiveness of its exporters and improve the trade balance. However, it can not happen under the fixed exchange system. So the exports would become less competitive, and there would be no improvement in the trade balance.
Under the fixed exchange rate system, the internal economic policy is largely dictated by external factors.
With a fixed exchange system, a country may face a persistent surplus or deficit. When the county' fixed rate is well below its true market of exchange, it faces a persistent surplus and if its fixed rate is well above its true market, it faces a persistent deficit. To deal with a persistent surplus, government can increase home demand in order to encourage import, or raise home price to make export less competitive. To deal with a persistent deficit, government can reduce the home demand or decrease home price to make export more competitive. If both of measures work inefficiently, the only way of influence the exchange rate is to change the exchange rate. If countries with surpluses move their value of exchange rates higher, it will be revalue, if countries with deficit decrease their value of exchange rate, it will be devaluation. And usually, exports are dearer in the condition of devaluation.
The euro ¢ is the European single currency which came to use on 1 January 1999.Eleven EU members joined which are Austria, Belgium, Finland, German, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. Greece had wanted to join but did not meet the criteria; however, Denmark, Sweden and the UK did not want to join.
A country has to meet certain criteria if it wants to join the single currency. According to SJ Grant's book 'STANLAKE'S INTRODUCTORY ECONOMICS' 1999 in page494, the criteria are as follows,
The government budget deficit must not exceed 3% of GDP
Government debt must not be more than 40% of GDP
a stable inflation rate, and one which for at least a year before membership is no more than 1.5% points above the average of the three member countries with the lowest inflation rates.
The long term interest, which for at least a year before membership does not exceed 2% point above the average of those countries with the lowest inflation.
A stable exchange rate which for at least two years before membership has stayed within the margins of the ERM.
There are possible benefits for countries who join the single currency
It can reduce the transaction cost. When firms and individuals move themselves or goods and services from one EU country to another they do not need to pay the extra money for change currencies.
It also can reduce the uncertainly of exchange rate. Firms can avoid the money paid for European suppliers or the amount they will earn from European countries. This changing as a result of currency values changing.
It can lower interest rate. Most EU countries had to remain their interest rate above that of Germany's prior to the formation of the single currency, in order to prevent founds flowing to Germany. Otherwise, some countries can operate with lower interest rates if they have a firm and credible commitment to low inflation.
It can lower the inflation level. The ECB stands for European Central Bank with the great responsibility of fight against the inflation. If inflation rises above its target rate of 2%, the ECB will change its monetary policy.
There are some possible costs of joining the single currency
Transaction costs, which include psychological costs, for example, resistance to change, which the elderly usually experienced more, and the costs of changing tills and staff training, are included in financial costs.
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.
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