Economic Unit 2 handout

EXCHANGE RATE

This is the rate at which one country’s currency can be exchanged for other currencies in the
foreign exchange market. NB: You are required to be aware of the exchange rates of countries in
the region. See link http://www.forexpros.com/currencies/caribbean

Important Concepts

 Devaluation vs. Depreciation

A devaluation of the dollar occurs when the government lowers the value of the dollar
from fixed rate to another. It is the downward movement in the domestic currency,
making the currency cheaper on the foreign exchange market. This can make exports
cheaper and thus increase the demand for exports. This will raise our trade balance.
However, devaluation can lead to inflation as import prices rise. Since the Caribbean is
heavily dependent on the importation of many basic goods this can lead to rapid
increases in inflation. Depreciation means that the external value of the currency has
fallen because of market forces (demand & supply)

 A revaluation of the dollar occurs when the government raises the value of the dollar
from one fixed rate to another. It is the upward adjustment of the domestic currency
making the currency more expensive on the foreign exchange market. Appreciation
means that the external value of the currency has risen because of market forces.

 Purchasing Power Parity: this theory suggests that the prices of goods in countries will
tend to equate under floating exchange rates so that people will be able to purchase the
same quantity of goods on any country for a given sum of money.

TYPES OF EXCHANGE RATE SYSTEMS:

Floating Exchange Rate

Where exchange rates are allowed to float freely, the value of one currency in terms of
others is determined by the market forces, that is, the interaction of demand and supply.
Demand for foreign currency arises out of the desire to purchase another country’s
exports or to invest abroad. Like all demand curves, the demand for the dollar varies inversely
with its prices. As the rate of exchange falls, there will be a rise in the quantity of the dollar
demanded on the foreign exchange market to pay for the country’s exports, for example, if the
value of the $US falls, more of its currency will be demanded by Jamaica to pay for goods and
services being imported from the US

The supply of foreign currency on the exchange market arises from the demand of
importers within the country, who imports goods and services produced abroad or from the
desire to invest abroad.

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The Equilibrium Exchange Rate

Price of
$US S

Q qty of $US

In a free market, exchange rates will be determined by the interaction of demand for, and supply
of the currency. The rate established will be the equilibrium rate and there can be no deviation
from this unless the condition of demand and supply changes. In the diagram, the equilibrium
exchange rate is $1 = $3. At any rate below this there will be a shortage of the currency and its
value will rise. Any rate above this there will be a surplus of $US and its exchange value will
fall.

Factors Influencing Floating Exchange Rates

 A country’s current account balance

 Changes in interest rates- this will cause changes in the country’s capital flow and hence
demand and supply
 Rumours of expected changes in exchange rates

Advantages of Floating Exchange Rates

 Automatic adjustment to balance of payment disequilibrium

This system provides an automatic mechanism for the maintenance of balance of payments
equilibrium, e.g. if there is rising demand for imports by the UK relative to the rest of the
world’s demand for UK’s exports, there will be an excess supply of sterling on the foreign
exchange market. As a result, the sterling exchange rate will depreciate, reducing the price of
exports in foreign markets and raising the price of imports in the domestic markets. As UK’s
exports get cheaper, foreigners will buy more of them and as imports become more
expensive, less will be bought by domestic residents.

 Greater freedom to pursue domestic goals

Governments are more free to pursue policies designed to achieve full employment and
economic growth under a floating exchange rate system, since balance of payments

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 equilibrium is automatically maintained. Conversely, under a fixed exchange rate system, a
policy designed for growth may result in an increase in imports which will cause further
problems for the balance of payments.

 Economies can use foreign exchange reserves

There is no need for the Central Bank to hold large sum of foreign currency reserves. It
means that foreign exchange earnings can be used to financed other policies

 Useful instrument of macroeconomic adjustment

A floating rate can act as a useful tool of macroeconomic adjustment – for example
depreciation should provide a boost to net export demand and therefore stimulate growth.
This assumes that the gains from a lower exchange rate are not dissolved in higher wage
claims or export prices. The countries inside the Euro Zone for example might be hoping for
a more competitive exchange rate as a means of creating an injection of demand into their
slow-growing economies

 It encourages efficiency since the external value of the currency is determined by market
forces and not set by the government.

Disadvantages of Floating Exchange Rates

 Increased uncertainty
Floating exchange rates may increase uncertainty in international trade. The possibility of
changes in the external value of different currencies may deter long-term international
investment or may make firms reluctant to negotiate long-term trade contracts with different
countries. There is much greater certainty when foreign exchange rates are fixed.

 Increase volatility of exchange rates

Frequent short-run change in exchange rates can have serious repercussions in the
domestic economy. Floating exchange rates may lead to flows of capital into a currency,
attracted by higher short-term interest rates. This will cause the currency to appreciate.
Conversely, flows capital out of a currency can cause it to depreciate.
When a country’s currency appreciates, its exports become less competitive in the
international markets, and industries which produce import substitutes may have difficulty
competing in the domestic economy because imports become relatively cheaper. On the
other hand, when a country’s currency depreciates, export and import competing industries
boom.

Fixed Exchange Rates

The governments may fix the external value of their currency in relation to other currencies. A
fixed exchange rate is maintained by intervention through central banks in the foreign exchange
market. Such intervention is designed to offset changes in the conditions of supply of demand in
the foreign exchange market which would otherwise cause fluctuations in exchange rates.

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Price of S1
£ $ S2

D2
D1
A B qty of £

In the diagram above the rate of exchange between the sterling and the dollar is fixed at £1 = $3.
The initial supply and demand conditions for the pound are represented by S1 and D1
respectively. If the UK’s demand for imports increases, there will be an increase in the supply of
the sterling on the foreign exchange market shown by the shift in the supply curve to S2. This
will cause downward pressure on the sterling exchange rate and under a floating exchange rate
its value would fall to $2. However, because the rate is fixed at £1 = $3, authorities will be
forced to buy the will be forced to buy the excess supply of sterling represented by AB. This
move will lead to an increase in demand for the sterling shown by an outward shift of the
demand curve to D2. This will offset increase in supply and prevent any change in the exchange
rates.

Advantages of Fixed Exchange Rate

 Trade and Investment:

Currency stability can help to promote trade and investment because of lower currency risk.

 Reductions in the costs of currency hedging

Since we can never predict what will happen to the market value of a currency, many
businesses hedge against this volatility by buying the currency they need in the forward
currency markets. With fixed exchange rates, businesses have to spend less on currency
hedging if they know that the currency will hold its value in the foreign exchange markets
(hedging involves risk)

 Disciplines on domestic producers and guard against inflation

A stable (fixed) currency acts as a discipline on producers to keep their costs and prices down
and may lead to greater pressure for exporters to raise labour productivity and focus more
resources on research and innovation. In the long run, with a fixed exchange rate, one
country’s inflation must fall into line with another (and thus put substantial competitive
pressures on prices and real wages)

 There is less speculation as the value of the currency is fixed.

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Disadvantages of Fixed Exchange Rate Systems

 No automatic balance of payments adjustment

A floating exchange rate should deal with disequilibrium in the balance of payments without
government interference, and with no effect on the domestic economy. If there is a deficit
then the currency falls, making the country competitive again. However, with a fixed rate, the
problem would have to be solved by a reduction in the level of aggregate demand. As
demand drops people consume less imports and also the price level falls making you more
competitive.

 Large holdings of foreign exchange reserves required

Fixed exchange rates require a government to hold large scale reserves of foreign currency to
maintain the fixed rate - such reserves have an opportunity cost

 Loss of freedom in your internal policy

The needs of the exchange rate can dominate policy and this may not be best for the
economy at that point. Interest rates and other policies may be set for the value of the
exchange rate rather than the more important macro objectives of inflation and
unemployment

Depreciation in the Exchange Rate

This is where there is fall in the demand for a country’s currency. There will be an inward shift
of the demand curve. Illustrated below:

Price of $ S$

P2

P1

D1
D2
qty of $

The shift in demand will lead to a reduction in the value of the dollar in terms of other
currencies, moving from P2 to P1. This could be caused by a reduction in exports or r reduction
investment in the country’s economy. The depreciation of the currency may lead to an increase
in the competitiveness of domestic companies compared to imported goods and services.
Secondly, a depreciation of a country’s exchange rate will also lead to a reduction in its export
prices. Firms could become more competitive with firms in the overseas market.

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Appreciation in the Exchange Rate

This occurs where there is a decrease in the supply of the dollar. The supply curve will shift to
the left. This is illustrated below:

Price of $ S2

S1
P2

P1

D
qty of $

The leftward shift will result in an increase in the currency’s value moving from P1 to P2. The
shift could be caused by a decrease in the number of domestic investors who wants to invest
abroad. When a country’s currency appreciates, import prices will fall and export prices will
rise. Domestic consumers will switch to imported goods and services while foreign consumers
will turn to their own country’s products in preference to imports.

Managed Float Exchange Rate System

This describes an exchange rate policy in which the value of the currency is broadly
decided by market forces but the government takes action to influence the rate of change of the
currency’s value. Therefore, the government may intervene to slow down the rate of
depreciation of a country’s currency. They can intervene directly by buying and selling
currencies in order to offset upward or downward pressure on the exchange rate. Here, the
government must have access to large a quantity of reserves of foreign exchange that is sufficient
to influence the price in the market.
They can also intervene indirectly through variations in the rate of interest. If for
example, there is downward pressure on the exchange rate because of excess supply of the
currency on the foreign exchange market, an increase in interest rates could attract capital
inflows. This will lead to an increase in the demand for the domestic currency which will offset
the impact of the excess supply.

Pegged Exchange Rate System

This is a system in which the government declares a central value for its currency and then
intervenes in the foreign exchange market to maintain this value.

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Determinants of Exchange Rates

 Changes in tastes
Changes in consumer tastes or preferences for imported goods or services will alter the
demand for or the supply of that nation’s currency and change its exchange rate.

 Relative Income Changes:

If the growth of a nation’s real income is more rapid than other countries, its currency is
likely to depreciate. A country’s imports vary directly with its level of income. For example,
as real income of Jamaica increases, Jamaican consumers will buy more domestically
produced goods and more imported goods. The demand for imported goods will lead to a
depreciation of the Jamaican dollar

 Relative Price Changes:

If the domestic price level rises rapidly and remains constant in foreign countries with which
we trade domestic consumers will gravitate to these low-priced imported products. This will
increase the demand for the US$ thus increasing its value against the Jamaica dollar

 Relative Real Interest Rate

If the domestic country, in carrying out a tight money policy, restricts its money supply, real
interest rate will increase. Higher interest rates will attract foreign investors and hence an
increase in the supply of foreign currency in the domestic economy. This will lead to an
appreciation of the domestic currency.

 Speculation
If it is widely anticipated that a country’s economy will (1) grow faster than other economies,
(2) experience more rapid inflation and (3) have lower future real interest rates its dollar
value will be expected to depreciate against other currencies. Holders of the country’s
currency will attempt to convert it into another country’s currency which is relatively
stronger in value. The excess supply of the domestic currency will lead to a reduction in its
value.

Exchange Rates, Inflation and the Rate of Interest

There is a complex relationship between the exchange rate, the rate of inflation and
interest rate. Inflation means that the currency is losing its purchasing power. If one country is
inflating faster than its trading partners, its currency will depreciate. If the exchange rate
remains stable for a while, export prices will rise and demand will fall. This will reduce demand
for the currency and decrease its value. If import prices rise slower than prices of domestic
goods, imports will be more competitive and demand for them will rise leading to a depreciation
of the country’s currency.
High inflation rates may lead to higher interest rates as government try to control
monetary expansion. Higher interest rates are likely to attract capital inflow leading to an
appreciation of the currency.

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Exchange Rate and Price Elasticity

The exchange rate will determine the prices of goods that are traded among countries. The
response to price changes is determined by elasticity. Where the demand for a particular
country’s product (exports) is elastic, and there are good substitutes, an appreciation of the dollar
will cause a reduction in demand while a depreciation of the dollar will increase demand for such
exported products.
Where there are good domestic substitutes, demand will be elastic and a depreciation of
the country currency will encourage falling imports. If demand for imports is inelastic because
there is no close domestic substitutes a depreciation of the currency will have little effect on the
level of imports.

The ‘J’ Curve Effect

Overtime the demand for exports and imports will become much more elastic leading to a
change in the patterns of consumption and investment flows in response to the price changes
brought about by depreciation. As a result, depreciation will only lead to an improvement in the
balance of payments in the long-run. The initial depreciation and subsequent improvement in the
balance of payments is usually referred to as the ‘J’ curve effect.

+
p a y men ts
o f
Bal a n ce
s ur pl u s

0 time
devaluation
occurs here
de fi ci t

As long as the elasticity conditions are favourable depreciation will lead to an improvement in
the balance of payments position. However, elasticity conditions are unlikely to be favourable in
the short-run. It takes time for people to adjust their pattern of consumption and change their
investment plans. The result is that depreciation initially leads to an increased balance of
payments deficit.