3.2 EXCHANGE RATES

EXCHANGE RATES

• Exchange rate is the value of one currency expressed in terms of another
• Currencies are exchanged on the foreign exchange market
• Central banks, Govt's, MNC's exchange on the Forex
• An example: £1 = $1.63 or $1 = £ 0.61

EXCHANGE RATE SYSTEMS

• Fixed exchange rates
• Floating exchange rates
• Managed exchange rates

Fixed Exchange Rates

• Is maintained by government or central bank
• value fixed to other currencies or commodities (gold)
• Revalued = Increase in relative value of currency
• Devalued = Decrease in relative value of currency
• Ex: Barbadian Dollar

Supply Side Analysis of the Barbadian Dollar

• 1Bds$ = .50 USD$ or 1 USD$ = 2 Bds$
• If Barbadians purchase more imports supply of Bds on Forex increase
• If Govt does not intervene exchange rate will fall causing depreciation 
• Govt solves problem by buying excess Bds with foreign currencies 
• This causes demand to shift right bring the price back to the fixed rate

Demand Side Analysis of the Barbadian Dollar

• Foreigners wish to visit the Barbados for the holidays 
• They trade their rcurrencies for Bds$ and Demand shifts right
• W/o Govt intervention the exchange rate will rise 
• So the Govt supplies Bds buy selling its currency on the Forex
• This shifts supply to the right and brings the Bds back to equilibrium 

Floating Exchange Rates

• Value is determined by the demand and supply of the currency in the FOREX
• Appreciation = Increase in the relative value of currency
• Depreciation = Decrease in the relative value of currency
• Consider a change in the value of the $ from 1$ = 0.80€ to 1$ = 0.85€
• What does this mean? *Note the reciprocity!!!

Factors that influence the value of a currency

• Exercise 1
• List/explain the factors that might lead to a fall in the demand of for $/€
• Exercise 2
• List/explain the factors that might lead to a fall in the supply of for $/€
• Demonstrate both of these shifts with a graph

Advantages of High Exchange Rates

• Downward pressure on inflation
• More imports can be bought
• Forces domestic producers to become more efficent

Disadvantages of High Exchange Rates

• Damage to Export Industries
• Damage to Domestic Industries

Advantages of Low Exchange Rate

• Greater Employment in Export Industries
• Greater Employment in Domestic Industries

Disadvantages of Low Exchange Rate

In Conclusion

• High Exchange rates fight inflation, but may create unemployment.
• Low Exchange rates help with unemployment but may cause Inflation
• Exercise 3
• Explain these principles with the help of a diagram

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Government measures to intervene in FOREX

• Using reserves of Foreign currency to buy/ sell
• Changing Interest Rates
• *Review reasons for Govt Involvement (289)

Advantages of Fixed Exchange Rates

• Reduces uncertainty
• Ensures sensible Govt policies on inflation
• Reduces speculation in the FOREX 

Disadvantage of Fixed Exchange Rate

• Conflicts with domestic macroeconomic goals
• Maintain high levels of foriegn currency reserves
• Very difficult to maintain
• International disagreement and potential retaliation

Advantages of Floating Exchange Rate

• Interest rates are free to be employed as a monetary tool
• In theory floating exchange rates should be self correcting
• High levels of foreign reserves are not necessary to correct 

Disadvantages of a floating exchange rate

• Create uncertainty on international markets
• In reality affected by events outside of supply and demand eg: 9/11
• May worsen exisiting levels of inflation (cost-push inflation)

Exercises

Ch Review Questions

• W/ diagram explain 3 factors that would cause a currency to appreciate
• W/ diagram explain likely effects of high inflation on a countries currency
• Discuss the consequences of depreciation on the countries economy
• Compare advantages and disadvatages of fixed and floating exchange rates