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2.6.4 Exchange rate systems (A-level only)

In a Floating System, the Exchange Rate Is Set by the Demand for and Supply of the Currency on the Foreign Exchange Market

Definition

Exchange rate: the price of one currency expressed in terms of another currency.

  1. An exchange rate is the price of one currency in terms of another.
  2. A freely floating rate is set by the demand for and supply of the currency, with no government intervention.
  3. Demand for the currency comes from exports and inflows of investment, while supply comes from imports and outflows of investment.
  4. The rate settles where demand equals supply, and a shift in either curve changes the equilibrium rate.
  5. A rise in demand or a fall in supply causes the currency to appreciate, while a fall in demand or a rise in supply causes it to depreciate.

Determination of a floating exchange rate

Interest Rates, Inflation, Trade and Speculation All Shift the Demand for and Supply of a Currency

  1. Relative interest rates change investment flows: higher UK rates attract inflows of hot money and raise demand for the pound.
  2. Relative inflation changes competitiveness: higher domestic inflation makes exports dearer and tends to weaken the currency.
  3. The strength of export and import demand shifts the demand for and supply of the currency.
  4. Speculation can move the rate sharply, and in the short run capital flows dwarf trade flows.
Example
  • A rise in UK interest rates can attract inflows seeking higher returns.
  • This raises demand for the pound and causes it to appreciate.
  • A surge in imports raises the supply of the currency on the market and causes the pound to depreciate.

Appreciation and Depreciation Occur Under Floating Rates, While Devaluation and Revaluation Are Deliberate Policy Moves Under Fixed Rates

  1. Appreciation is a market-driven rise in a floating exchange rate.
  2. Depreciation is a market-driven fall in a floating exchange rate.
  3. Revaluation is a deliberate rise in the official value of a fixed exchange rate.
  4. Devaluation is a deliberate cut in the official value of a fixed exchange rate.
Note
  • Use appreciation and depreciation only for market movements under a floating system.
  • Use revaluation and devaluation only for deliberate changes made by the authorities under a fixed system.
  • A weaker currency lowers export prices abroad and raises import prices at home, which can add to inflation.
Example

Worked example: converting prices and a depreciation

Start with an exchange rate of £1=$1.50\pounds 1 = {\char"24}1.50£1=$1.50. A UK export priced at £100 sells for £100×1.50=$150\pounds 100 \times 1.50 = {\char"24}150£100×1.50=$150 in the United States, and a US good priced at $30{\char"24}30$30 costs $30÷1.50=£20{\char"24}30 \div 1.50 = \pounds 20$30÷1.50=£20 in the UK.

Now suppose the pound depreciates to £1=$1.20\pounds 1 = {\char"24}1.20£1=$1.20. The same £100 export now sells for £100×1.20=$120\pounds 100 \times 1.20 = {\char"24}120£100×1.20=$120, so it is cheaper and more competitive abroad. The $30{\char"24}30$30 import now costs $30÷1.20=£25{\char"24}30 \div 1.20 = \pounds 25$30÷1.20=£25, so imports are dearer at home.

A handy check is SPICED: a Strong Pound makes Imports Cheap and Exports Dear, and a weaker pound does the reverse. Cheaper exports and dearer imports can improve the current account, but only if demand is elastic enough, which is the Marshall-Lerner condition.

Distinction between depreciation and appreciation of a float

AD/AS analysis of the impact of exchange rate changes on the

AD/AS analysis of the impact of exchange rate changes on the

Governments Can Hold a Currency Away From Its Market Rate Using Reserves, Interest Rates and Direct Intervention

  1. To hold the rate above its market level, the central bank buys its own currency with foreign exchange reserves, or raises interest rates to attract inflows.
  2. To hold the rate below its market level, the central bank sells its own currency, which builds up foreign exchange reserves.
  3. Under a managed float the rate moves with the market but the central bank intervenes to smooth large swings or keep it within a target band.
  4. An overvalued rate weakens export competitiveness, while an undervalued rate supports exports but can add to inflation; both affect the current account and reserves.
Note
  • Defending an overvalued currency drains reserves, which are finite, so fixed rates can collapse under speculative pressure.
  • Raising interest rates to defend the currency can conflict with domestic goals such as growth and employment.

Fixed Rates Give Certainty but Tie up Policy, Whereas Floating Rates Give Freedom but Can Be Volatile

  1. A fixed rate gives certainty for trade and investment and imposes discipline on inflation.
  2. But defending a fixed rate can drain reserves and ties monetary policy to holding the rate.
  3. A floating rate frees monetary policy for domestic goals and can adjust automatically towards equilibrium.
  4. But a floating rate can be volatile and driven by speculation, and it does not always self-correct a deficit.
Note
  • A floating rate only self-corrects a current account deficit if the Marshall-Lerner condition holds, and the J-curve means the balance can worsen before it improves.
  • No single system is best for all: the choice depends on whether an economy values stability and discipline or policy freedom and automatic adjustment.

Joining a Currency Union Brings Certainty and Lower Costs but Means Giving up an Independent Interest Rate and Exchange Rate

  1. Economic and monetary union means adopting a single currency and a single monetary policy, as in the eurozone with the euro and the European Central Bank.
  2. Members gain exchange-rate certainty and lower transaction costs, which can raise trade and investment within the union.
  3. Members lose their own interest rate and exchange rate, and can no longer devalue against other members to restore competitiveness.
  4. Optimal currency area theory judges whether a single currency suits members, looking at labour mobility, wage and price flexibility, fiscal transfers and similar economic structures.
Note
  • In the eurozone, labour mobility is limited by language and culture and fiscal transfers between members are small.
  • This makes a shock that hits one member hard to absorb, because it has neither its own interest rate nor its own exchange rate to adjust.
Self review
  • How is the exchange rate determined in a freely floating system?
  • How can a government intervene to influence the exchange rate?
  • What are the main advantages and disadvantages of fixed and floating exchange rate systems?
  • What are the advantages and disadvantages for a country of joining a currency union such as the eurozone?
  • Why is it important to distinguish a depreciation under a floating rate from a devaluation under a fixed rate?
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