Exchange Rates - Chapter 26 PDF

Chapter 26: Exchange Rates Real World Issue: Who are the winners and losers of the integration of the world’s economies? Chapter Objectives  Define, explain and give examples of an exchange rate  Define, explain, illustrate and give examples of a fixed exchange rate system  Distinguish be...

Chapter 26: Exchange Rates Real World Issue: Who are the winners and losers of the integration of the world’s economies? Chapter Objectives  Define, explain and give examples of an exchange rate  Define, explain, illustrate and give examples of a fixed exchange rate system  Distinguish between a devaluation and a revaluation of a currency  Define, explain, illustrate and give examples of a floating exchange rate system  Distinguish between depreciation and appreciation of a currency  Calculate exchange rates and changes in exchange rates  Describe factors leading to changes in the demand for, and supply of, a currency  Define, explain, illustrate and give examples of a managed exchange rate system  Evaluate the advantages and disadvantages of high and low exchange rates  Explain government measures to intervene in the foreign exchange market  Compare and contrast a fixed exchange rate system with a floating exchange rate sytem  Exchange Rates  Basic Introductory idea:  The only place you can get TL is Turkey  The only place you can get Canadian Dollars is Canada  The only place you can get Pound is England.  Etc…  Exchange Rates  definition: an exchange rate is the value of one currency expressed in terms of another currency. US$1 = 9.69 TL US$1 = 18.59 TL (what is it today?)  currencies are exchanged on the foreign exchange market, the largest market in the world in terms of cash movement  the market includes the trading of foreign currencies between governments, central banks, private commercial banks, multinational corporations (MNCs), and other financial institutions  Exchange rates cannot be changed by small people like us travelling from one country to another, exchanging our currency! We don’t have an impact on the currency market! *Which currencies do you think are the world's most valuable? *Which are the least valuable?  https://prezi.com/p/c0klkkzm7nel/copy-of-the-worlds-most-least- valuable-currencies/  Who benefits most from a strong or weak currency?  A strong currency means that you as a consumer can purchase imported goods and services cheaper in terms of your own currency. Similarly, businesses which rely on importing products from overseas, such as retail businesses, will benefit from a stronger currency.  However, a strong currency is unpopular with manufacturers who fear that a strong national currency makes their own products less competitive, relative to goods and services produced overseas. This is a view that the new President of the US has emphasized on several occasions, with strong condemnation of nations such as Japan, China and Germany accused of deliberately making their currencies weaker to under cut American products.  Exchange Rate Systems  There are a number of different exchange-rate systems operating in the world.  The way that a country manages its exchange rate is known as its exchange rate regime (system).  There are three main types: 1. fixed exchange rate system 2. floating exchange rate system 3. managed exchange rate system The Exchange Rate Diagram Fixed Exchange Rate System understanding it, expressing it and advantages and disadvantages  Fixed exchange rate  definition: a fixed exchange rate is an exchange rate regime where the value of a currency is fixed, or pegged, to the value of another currency, to the average value of a selection of currencies, or to the value of some other commodity, such as gold  As the value of the variable changes (because it is pegged), then so does the value of the currency.  carried out and maintained by the government or the central bank  two key terms used only when referring to a fixed exchange rate  revaluation of the currency  if the value of the currency is raised = revaluation  devaluation of the currency  if the value is lowered = devaluation Fixed exchange rates – Devaluation and Revaluation  These terms are very specific and must be used in the appropriate circumstances,  i.e: only when referring to exchanges in fixed exchange rates.  A fixed exchange rate is maintained by government intervention in the foreign exchange market. Fixed exchange rates  Ex: The quantity of Barbadian dollars available in the foreign exchange market  The Barbadian $ (Bds $) has been fixed againts the US $ at a rate of 2 Bds $= 1 US $ since 1975.  So 1 Bds $ = 50 cent US.  Fixed exchange rate  example 1: supply of Barbadian dollars is increasing on the foreign market Example 1: Supply of Barbadian dollars is increasing on the foreign market  The example shows the situation where the supply for Barbadian dollars is increasing on the foreign exchange market.  This may be because more Barbadians travel to the USA for vacation. They exchange the Barbadian dollars for US dollars.  Greater amount of imports  The supply curve would shift outward leading to a decrease in its value (devaluation) leading to an excess supply, (Q1-Q2) new equilibrium price would go down (Barbadian dollars become cheaper) ---- see D1 and S1. Example 1: Supply of Barbadian dollars is increasing on the foreign market  Without government intervention, the exchange rate will fall.  To maintain its fixed exchange rate, the Barbadian government needs to buy its own currency on the foreign exchange market in order to satisfy the excess supply.  This will shift the demand curve outwards. D1 to D2. Barbadian government buying its own money.  The government does this by buying Barbadian dollars with previously amassed reserves of foreign- currency.  Fixed exchange rate system  example 2: demand of Barbadian dollars is increasing on the foreign market Example 2: Demand of Barbadian dollars is increasing on the foreign market  The example shows the situation where the demand for Barbadian dollars is increasing on the foreign exchange market.  This may be because more foreign travelers (ex: USA) are visiting Barbados for vacation.  Greater amount of exports.  The demand curve would shift outward leading to an increase in the value (revaluation) of Barbadian dollar – see S1 and D2  Barbadian dollars would be more scarce on the international market.  Leading to an excess demand (Q1-Q2) for Barbadian dollars—see D2-S1. Example 2: Demand of Barbadian dollars is increasing on the foreign market  Without government intervention, the exchange rate will rise.  To maintain its fixed exchange rate, the Barbadian government needs to sell its own currency on the foreign exchange market in order to satisfy the excess demand.  This will shift the supply curve outwards.  This will then increase the Barbadian reserves of foreign currencies. Fixed Exchange Rate  One other way that a fixed exchange rate may be maintained is by making it illegal to trade currency at any other rate.  However, this is hard to in force unless the government of the country has an effective monopoly over the conversion of the currency.  The danger of this sort of control is that a black market may emerge in the currency, operating at a different exchange-rate.  Advantages: fixed exchange rates HL  a fixed exchange rate should reduce uncertainty  businesses will be able to plan ahead with the knowledge that the predicted costs and prices will not change  if exchange rates is fixed, then inflation may have a very harmful effect on the demand for exports and imports  because of this, the government is forced to take measures to ensure that inflation is as low as possible  in theory, the existence of a fixed exchange rate should reduce speculation in the foreign exchange markets  However, in reality this is not always the case and there are often attempts to destabilize fixed exchange rate systems, in order to make speculative gains.  Disadvantages: fixed exchange rates HL  the government is compelled to keep the exchange rate fixed  manipulation of interest rates can do this  however, if the exchange rate is in danger of falling, then the government will have to raise the interest rate (price of money) in order to increase demand for the currency, but this will have a deflationary effect on the economy, lowering demand and increasing unemployment  this means the domestic macroeconomic goal of the low unemployment may have to be sacrificed  Disadvantages: fixed exchange rates HL  the government or central bank has to maintain high levels of foreign reserves to keep the exchange rate fixed to instill confidence on the foreign exchange markets.  Hence, being able to defend its currency by the buying and selling of foreign currencies.  setting the level is not simple  if the rate is set at the wrong level, then export firms may find that they are not competitive in the foreign markets  if this is the case, then the exchange rate will have to be devalued, but again, finding the exact right level is very difficult  a country that fixes its exchange rate at an artificially low level may create international disagreement  this is because a low exchange rate will make the country’s exports more competitive on the world market and may be seen as an unfair trading advantage  Ex: China-low exchange rate Floating Exchange Rate System understanding it, expressing it and advantages and disadvantages  Floating exchange rate  definition: a floating exchange rate is an exchange rate regime where the value of a currency is allowed to be determined solely by the demand and supply of the currency on the foreign exchange market  there is no government intervention to influence the value of the currency  the diagram below represents the market for US dollars in terms of euros Floating exchange rate system  What causes a change in the value of a country’s currency in terms of another currency?  We need to consider what factors will shift the demand and supply curves for a currency.  First look at the demand curve, using the example of the demand for US dollars by people in the European Union.  Scenario: Travel from Europe to US Floating Exchange Rates: Increase in Demand of a currency understanding it and expressing it Increase in demand for US dollars Increase in demand for US dollars  The diagram represents the market for US dollars in terms of euros.  See how the demand curve is downward sloping, representing the demand for dollars by people in the European Union.  The supply curve is also normal and represents the supply of dollars which comes from the United States.  The equilibrium price or the exchange rate is US$1.00 for €.80.  Correct labelling *******  Increase in demand for US dollars BUT!  What would buy US goods cause this to IF happen?  inflation rates in US is lower  invest in US firms than EU inflation rates  save in dollars (in US banks)  increase in income in the EU  speculate in dollars to make  investment prospects in US money improve  interest rates (for savings) in US increase  speculators in the EU think the value of the US dollar will rise in the future  Scenario: Travel from US to Europe Floating exchange rate: increase in supply of a currency understanding it and expressing it Increase in supply of US dollars Increase in supply for US dollars  As we can see, an increase in the supply of US dollars on the US dollar/euro market will shift the supply curve of US dollars to the right.  When this happens, the dollar will depreciate, and it will now be worth €.70.  Each US dollar may be exchanged for a smaller amount of euros.  Increase in supply of US dollars  buy EU goods and services  inflation rates in US is higher  invest in EU firms than EU inflation rates  save in EU banks  increase in income in the US  speculate in euro  investment prospects in EU to make money improve.  interest rates (on savings) in EU increase  speculators in the US think the value of the US dollar will fall in the future so they buy Euros  Advantages of floating exchange rate HL  interest rates  Because the exchange rate does not have to be kept at a certain level, interest rates (price of money) are free to be employed as domestic monetary tools and can be used for demand management policies, such as controlling inflation  self-adjusting  in theory, the floating exchange rate should adjust itself, in order to keep the current account balanced  For example, if there is a current account deficit, then the demand for the currency is low, since exports sales are relatively low. The supply of the currency is high, since the demand for imports is relatively high.  This should mean that the market will adjust and that the exchange rate should fall.  Following this, export prices become relatively more attractive, import prices relatively less so, balancing itself out.  no need for high levels of foreign currency  because reserves are not used to control the value of the currency, it is not necessary to keep high levels of reserves of foreign currencies and gold  Disadvantages of floating exchange rate HL  create uncertainty on international markets  businesses trying to plan for the future find it difficult to make accurate predictions about what their likely costs and revenues will be  investment is more difficult to assess and there is no doubt that volatile exchange rates will reduce the levels of international investment, because it is difficult to assess the exact level of return and risk  impacted by more factors than simply demand and supply  In reality, floating exchange rates are affected by more factors than simply demand and supply, such as government intervention, world events like 9/11, and speculation.  Because of this they do not necessarily self-adjust in order to eliminate current account deficits.  may worsen existing levels of inflation  If the country has high inflation relative to other countries, then this will make its exports less competitive and imports less expensive.  The exchange rate will then fall, in order to rectify the situation.  However, this could lead to even higher import prices of finished goods, components, and raw materials, and thus cost- push inflation, which may further fuel the overall inflation rate. Key Points!  Ex: change in the value of the US$ from a first exchange rate of  US$1= Euro 0.80 To a second exchange rate  US$1= Euro 0.85 What does this mean?  Key Points!  Ex: change in the value of the US$ from a first exchange rate of  US$1= Euro 0.80 To a second exchange rate  US$1= Euro 0.85 What does this mean?  Dollar has appreciated against euro  At first 1 US$ could buy 0.80 Euros now it could buy 0.85 Euros.  If: Key Points!  Notice that the appreciation of the US dollar against the euro occurs at the same time as the depreciation of the euro against the US dollar  Exchange rates are essentially two sides of the same coin.  This can be explained by looking at these two figures on the left.  Ex: Canadian Dollars vs Euro Key Points! Calculating exchange rates and the price of a good in different countries Calculating exchange rates and the price of a good in different countries https://youtu.be/Xh4M34r-SVY Managed exchange rate system understanding what it is  Managed exchange rate system  definition: managed exchange-rate systems are where the currency is allowed to float, but with some element of interference from the government  In reality, there is no currency in the world that is completely free-floating  at times, the central bank will intervene  frequent fluctuations are bad for foreign investment  completely free-floating, frequent changes in the exchange rate, may cause uncertainty for businesses.  This is not good for trade, so governments will be forced to intervene in order to stabilize the exchange rate.  Because of the above, most exchange-rate regimes in the world are managed exchange rates.  Managed Exchange Rates  The most common systems are where a central bank will set an upper and lower exchange rate value and then allow the currency to float freely-- as long as it does not move out of that band.  If the exchange rate starts to get close to the upper or lower level, the central bank will intervene in the foreign exchange market for its currency.  Central banks do not make the upper and lower level values public, for fear of speculation.  The actual level of the exchange rate will have marked economic effects upon a country, and we need to look at these to understand fully why governments intervene to influence the value of the exchange rate. Strong exchange rate advantages and disadvantages Strong (High Value) Exchange Rates - Advantages  Advantages: Strong Exchange Rates: Example US$1 = TRY 1.5  Downward pressure on inflation:  If the value of the exchange rate is strong then the price of finished imported goods will be relatively low.  In addition, the price of imported raw materials and components will reduce the cost of production for firms, which could lead to lower prices for consumers.  The lower price of imported good also puts pressure on domestic producers to be competitive by keeping prices low. Strong (HighValue) Exchange Rates – Advantages  More imports can be bought:  If the value of the exchange rate is strong, then each unit of the currency will buy more foreign-currency, and so more foreign goods and services.  This would include both visible imports, such as technology, and invisible imports, such as foreign travel.  A strong exchange rate forces domestic producers to improve their efficiency:  The strong exchange rate will threaten their international competitiveness of domestic producers, so they will be forced to lower costs and become more efficient in order to maintain competitiveness internationally=good in the long run Strong (High Value) Exchange Rates – Disadvantages  Disadvantage: Strong (high value) Exchange Rates: Example US$1 = TRY 1.5  Damage to export industries:  If the value of the exchange rate is strong, then the export industries may find it difficult to sell their goods and services abroad, because of the relatively high prices.  This could lead to unemployment in these industries.  Damage to domestic industries:  With greater levels of imports being purchased, because imports are now relatively less expensive, domestic producers may find that the increased competition causes of fall in the demand for their goods and services.  This may lead to a further increase in the level of unemployment as firm’s cutback. IMPORTANT SUMMARY  A strong (high-value) of the currency may be good to fight inflation, but may create unemployment problems, where as a weak (low value) of a currency maybe good for solving unemployment problems but may create inflationary pressure. Strong exchange rate favors who? Japan’s major automakers hit by strong yen; export orders down  https://www.gulftoday.ae/business/2019/08/03/japans-major-automakers- hit-by--strong-yen-export-orders-down Weak exchange rate advantages and disadvantages Weak (Low Value) Exchange Rates – Advantages  Advantages: Weak (Low Value) Exchange Rates: Example US$1 = TRY 11,2  Greater employment in the export industries:  If the value of the exchange rate is weak, then exports from the country will be relatively less expensive and so more competitive.  This in turn may lead to more employment in the export industries (ex: foreign visitors coming to Turkey)  Greater employment in domestic industries:  The weak exchange rate will make imports more expensive than they were.  This may encourage domestic consumers to buy domestically produced goods, instead of imports, and this may also lower unemployment. Weak (Low Value) Exchange Rates - Disadvantages  Disadvantages: Weak (Low Value) Exchange Rates: Example US$ 1= TRY 11,2  Inflation:  A low value of the currency will make imported final goods and services, imported raw materials, and importing components more expensive.  The raw materials and components are needed by firms and their cost of production that will rise, possibly leading to higher prices in the economy.  The final goods and services will have higher prices.  Thus, there is a serious likelihood of inflation  Ex: gasoline is imported to Turkey, guess what happens to the prices of all of the products in Turkey. Important Summary  A strong (high-value) of the currency may be good to fight inflation, but may create unemployment problems, where as a weak (low value) of a currency maybe good for solving unemployment problems but may create inflationary pressure. Weak exchange rate favors who? Why do governments intervene in the foreign exchange?  To lower the exchange rate in order to increase employment  To raise the exchange rate in order to fight inflation  To maintain a fixed exchange rate  To avoid large fluctuations in a floating exchange rate  To achieve a relative exchange rate stability in order to improve business confidence  To improve a current account deficit, where spending on imported goods and services is greater than the revenue received from exported goods and services.  Why do governments intervene in the foreign exchange?  How do they do it? 1. Using their reserves of foreign currencies to buy or sell foreign currencies:  to increase the value of the currency: buy its own currency by using its reserves of foreign currency on the foreign exchange market (this will increase demand for its currency and force up the exchange rate)  To lower the value of the currency: buy foreign currencies on the foreign exchange market, increasing its foreign currency reserves (this will increase supply for its currency and lowers its exchange rate)  Why do governments intervene in the foreign exchange market?  How they do it? 2. By changing interest rates:  to increase the value of the currency: raise level of interest rate in the country (this will make domestic interest rates relatively higher than those abroad and should attract financial investment abroad (from other countries). To put money into the country, the investors will have to buy the country’s currency, thus increasing the demand for it, so its exchange rate.  to lower the value of the currency: lower level of interest rate in the country (this will make domestic interest rates relatively lower than those abroad and should make financial investment abroad (to other countries) more attractive. In order to invest abroad, the investors will have to buy the foreign currencies, thus exchanging their own currency and increasing the supply for it on the financial exchange market.