objectives
• Explain how ER is determined in floating ER system.
• Reasons causing fall in ER – depreciation
• Reasons causing rise in ER - appreciation
Three types of ER systems :
Floating ExchangeRate
Fixed ExchangeRate
Managed Floating
• Floating Exchange Rates:– Price determined only by demand and
supply of the currency – no government intervention
• Fixed Exchange Rates:– The value of a currency fixed in relation
to an anchor currency – not allowed to fluctuate
• Dirty Floating or Managed Exchange Rate: – rate influenced by government via central bank around a preferred
rate
• The ER is allowed to find its own level in the market.
• Floating ER is determined by equating the forces of dd & ss of that country’s currency.
• no intervention by govt.
Floating ER System
fig
$ / £
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
70
80
90
100
110
120
130
140
150
$ / £ exchange rate and £ exchange rate index: 1976-2003
$ / £ exchange rate and £ exchange rate index: 1976-2003
• DD for £• The lower the ER of £, the cheaper
the UK goods, the more people buy their goods, therefore the higher the dd for a currency
• The DD curve for £ is __________ sloping.
Floating ER System
fig
$ pr
ice
of £
DD by USA
Q of £
Determination of the rate of exchangeDetermination of the rate of exchange
Downward Slopingfrom Left to Right-Rate Lower,-Quantity Higher
1.00
1.20
1.40
1.60
1.80
2.00
2.20
0
• SS of £
• The higher the ER of £, the more UK residents want to sell £ (to buy the cheaper American goods or to invest in US as it is now cheaper)
• Therefore ss curve is __________ sloping.
Floating ER System
fig
1.00
1.20
1.40
1.60
1.80
2.00
2.20
0
(pri
ce)
$=f
£
Q of £
Determination of the rate of exchangeDetermination of the rate of exchange
SS by UKUpward SlopingFrom left to right-Rates Increase-Quantity Increase
fig
$ pr
ice
of £
S by UK
Q of £
Determination of the rate of exchangeDetermination of the rate of exchange
D by USA
Determined by British demandfor US goods
Determined byUS demand for British goods
1.00
1.20
1.40
1.60
1.80
2.00
2.20
0
fig
1.00
1.20
1.40
1.60
1.80
2.00
2.20
0
(pric
e) $
=f
£
QS
S by UK
Q of £
ER disequlibriumER disequlibrium
D by USA
QD
b a
a)Excess SS of £
• If ER = $1.80, there will be an excess ss or surplus of £ of QdQs amount.
• Banks wishing to make money by exchanging currency, would have to lower the ER in order to encourage a greater dd for £ & reduce the excess ss.
• They will continue lowering the rate until dd = ss
ER disequilibrium
fig
1.00
1.20
1.40
1.60
1.80
2.00
2.20
0 QS QD
d
(pri
ce)
$=f
£
S by UK
Q of £
c
D by USA
ER disequlibriumER disequlibrium
a)Excess dd of £
• If ER = $1.40, there will be an excess __ or ________ of £ of _____ amount.
• Banks wishing to make money by exchanging currency, would have to raise the ER in order to encourage a greater ss of £ & reduce the excess dd.
• They will continue raising the rate until dd = ss
ER disequilibrium
• The equilibrium ER will not change unless the conditions of dd or ss changes, thus shifting the dd or ss curve to the left or right.
Changes in ER
• A fall in exchange rate of one currency in terms of another.
• means the £ buys less US$ • eg US$2 = £1 to US$1 = £1• caused by • i) a fall in demand for the £ or • ii) an increase in ss of the £
Currency Depreciation
Factors causing ER to change
•
E.g. if UK's inflation rate is higher than abroad, UK exports will become more expensive, X will __
• The dd of £ will __ , dd curve shift left. • At the same time, imports will become
cheaper, • M __• The ss of £ will __ - ss curve shifts right. • Result - ER i.e. DEPRECIATION
1)Changes in prices of domestic goods vs. foreign goods
fig
Floating exchange rates: movement to a new equilibrium
Floating exchange rates: movement to a new equilibrium
$ =
£
S1
D1
Q of £0.60
0.80
1.00
1.20
1.40
1.60
1.80
0
fig
$/ £
S1
D1
S2
D2
Q of £
movement to a new equilibrium -depreciation
movement to a new equilibrium -depreciation
0.60
0.80
1.00
1.20
1.40
1.60
1.80
0
• Changes in IR causes changes in short term capital flows.
• Funds may be transferred from country to country to secure the highest rate of return.
IR inflow of hot money
DD for currency
ER - APPRECIATION
2) Changes in relative Interest Rates
0.60
0.80
1.00
1.20
1.40
1.60
1.80
0
D
D1
S
$ = £1
Quantity of £
movement to a new equilibrium -appreciation
movement to a new equilibrium -appreciation
CA surplus
X - dd for X dd for £ M - dd for M ss of £
__ ER
CA deficit
X - dd for X dd for £
M - dd for M ss of £ __ ER
3 ) Changes in Current Account
If investment prospects become higher abroad than UK, perhaps due to better economic conditions overseas or because of impending recession in UK, then DD for £ will __ & SS of £ will __
4) Changes in relative investment prospects
• If UK’s AD/NY, DD for M __, ss of £ __ ER___
• If UK’s AD/NY, DD for M __, ss of £ __ ER___
5) Changes in relative incomes
• If speculators including importers & exporters etc think that the ER is about to fall they will ____ £ now.
• Therefore ss of £ __• At the same time, people requiring £
will wait until the rate has fallen before they purchase them.
• Therefore dd for £ __• Result: ___ ER
6)Speculation
• Terms of Trade improves
• SOL improves
• X is expensive – XM is cheaper - M CA worsens (if dd for X n M r elastic)
• Terms of Trade deteriorates
• SOL worsens
• imported inflation
• M is expensive - M • X is cheaper - X
CA improves (if dd for X n M r elastic)