The price of a nation’s currency in terms

of another currency.

An exchange rate thus has two

components, the domestic currency and

a foreign currency.

For example our domestic currency is the

Jamaican Dollars (JMD) and the Foreign

Currency can be United States Dollars

(USD) or Euros (EUR) just to name a few.

We will be exploring three types of

Exchange Rates which are:

1. Fixed Exchange Rate

2. Floating/Flexible Exchange Rate

3. Managed Float

This is where a Government maintains a

given exchange rate over a period of

time.

This could be for a few months or even

years.

In order to maintain the exchange rate

at the stated level government uses

fiscal and monetary policies to control

aggregate demand.

In a fixed exchange rate system the XR is set by the government or central bank at a particular rate.

E.g. BBD to US 2:1.

The forces of supply and demand do not determine the rate. The central bank holds reserves of US dollars and intervenes in order to keep the exchange rate pegged at that level known as the Official Rate.

1. The risk and uncertainty of trade and

promoting foreign direct investment (FDI) is

reduced thus making business and

investment planning possible.

2. Reduced Currency Speculation.

3. Creates a stability in knowing the

exchange rate

1. Protecting the exchange rate requires domestic economic policies to be frequently adjusted. Monetary policy focuses on keeping the rate stable.

2. Reserves are needed to protect the value.

3. An improvement in an economy’s competiveness that results in lower prices will not be fully passed on to export customers if the exchange rate remains unchanged.

4. Exchange rate may be undervalued or overvalued.

A floating exchange rate regime is

where the rate of exchange is

determined purely by the demand and

supply of that currency on the foreign

exchange market.

The value of a currency is allowed to be

determined by the forces of demand

and supply on the foreign exchange

market.

There is no government intervention.

Any change in supply or demand for a

currency will cause a depreciation or

appreciation in the exchange rate.

An increase in demand for the local

currency causes it to appreciate or rise.

However, if there is a greater demand

for the foreign currency the value of the

local currency falls or depreciates to the

foreign currency.

Do not

Pay

attention

to the

current

xrate as

this was

way back

in 1999

and just

an

example

An appreciation means an increase in the

value of a currency. It means a currency is

worth more in terms of foreign currency.

A rise or appreciation in the economy in the

country’s currency will mean that the price

of imports into the country will fall and the

price of the country’s exports will rise.

This is represented by a shift in the supply

curve to the left.

Do not

Pay

attention

to the

current

xrate as

this was

way back

in 1999

and just

an

example

This could be caused by:

1. A decrease in the number of foreign

goods and services imported into the

economy.

2. A decrease in the number of the

economy’s investors who want to place

their funds in foreign economies.

1. Exports more expensive. The foreign price of Ja Exports will increase and US will find Ja exports more expensive. Therefore with a higher price, we would expect to see a fall in the quantity of Ja exports.

2. Imports are cheaper. Ja consumers will find that JA$1 now buys a greater quantity of US goods. Therefore, with cheaper imports we would expect to see an increase in the quantity of imports.

3. Lower (X-M) With lower exports, higher demand and greater spending on imports, we would expect a fall in domestic Aggregate Demand (AD), causing lower economic growth.

4. Lower inflation. An appreciation tends to cause lower inflation because:

1. import prices are cheaper. The cost of imported goods and raw materials will fall after an appreciation, e.g. imported oil will decrease, leading to cheaper petrol prices.

2. Lower AD leads to lower demand pull inflation.

3. With export prices being more expensive manufacturers will have greater incentives to cut costs to try and remain competitive.

A depreciation means a decrease in the

value of a currency. It means a currency is

worth less in terms of a foreign currency.

A fall or depreciation in the value of the

exchange rate will mean the opposite, that

is the price of imports into the country will

rise and the price of the country’s export

will fall.

This is represented by a shift of the demand

curve to the left.

Do not

Pay

attention

to the

current

xrate as

this was

way back

in 1999

and just

an

example

This could be caused by:

1. A reduction in the number of the

economy’s goods and services sold

abroad.

2. A reduction in the number of

international investors who wish to place

their funds in the economy.

1. Exports cheaper. A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports

2. Imports more expensive. A devaluation means imports will become more expensive. This will reduce demand for imports.

3. Increased AD. Devaluation could cause higher economic growth. Part of AD is (X-M) therefore higher exports and lower imports should increase AD (assuming demand is relatively elastic). Higher AD is likely to cause higher Real GDP and inflation.

4. Inflation is likely to occur because:

Imports are more expensive causing cost push inflation.

AD is increasing causing demand pull inflation

With exports becoming cheaper manufacturers may have less incentive to cut costs and become more efficient. Therefore over time, costs may increase.

5. Improvement in the current account. With exports more competitive and imports more expensive, we should see higher exports and lower imports, which will reduce the current account deficit.

market determined, so it is more efficient

no need for reserves to intervene

exchange rate would reflect its true value

absorbs economic shocks better

freedom of government to pursue internal policies

Automatic BOP adjustment, less likelihood of a BOP crisis

large depreciation may occur

instability of exchange has a negative impact on domestic economy

terms of trade may decline with fall in exchange rate

Uncertainty of currency

Speculation of currency

reduced investment as this would be too risky

The Fixed exchange rate is the rate which is officially fixed in terms of gold or any other currency by the government. It does not change with change in demand and supply of foreign currency.

As against it, flexible exchange rate is the rate which, like price of a commodity, is determined by forces of demand and supply in the foreign exchange market. It changes according to change in demand and supply of foreign currency. There is no government intervention.

This is where the currency is broadly

managed by the forces of demand and

supply but the government takes action

to influence the rate of change in the

exchange rate.

The Central Bank seeks to stabilize the exchange rate within a predetermined range for a given period of time, but DOES NOT FIX IT at any particular level. This allows for policy makers the benefit of planning with some degree of certainty, for the macroeconomic affairs of a country.

Central bank intervenes to smoothen out ups and downs in the exchange rate of home currency to its own advantage.

The managed float attempts to combine

the advantages of both the fixed and

flexible exchange rate systems,

depending on the degree of instability.

The less instability, the less intervention is

necessary by central banks and they

can pursue quasi-independent domestic

monetary policies to stabilize their own

economies.

The greater the instability, the more

intervention is necessary by central

banks and the less free they are to

pursue independent domestic monetary

policies because they are frequently

required to use their money supplies to

calm disturbances in the foreign

exchange markets.

The big problem with a managed float comes in determining the timing and magnitude of the instability and the necessary intervention. Does a one day drop (rise) in a currency warrant intervention? A week? A month? A year? Five years? Is a 1% drop (rise) in a currency's exchange rate destabilizing? A 2% change? A 5% change? A 10% change?

If the central banks are too quick to respond or if the amount of intervention is inappropriate, their actions may be further destabilizing. This increased instability has a tendency to dampen international flows and contract world trade. If they wait too long, permanent damage may be done to some countries' trade and investment balances.

Changes in the exchange rate will cause an Appreciation or Depreciation in the local currency as explained earlier.

If the currency is devalued then:

1. The price effect – goods become cheaper and imports become more expensive. The devaluation worsens the BOP.

2. the volume effect – cheaper exports mean that more will be sold and less imports will be bought thus improving the BOP.

The devaluation worsens the current account balance initially, and then it improves. Reasons being:

Time lag in consumer response –people may still want the expensive good. Consumers may be concerned about the quality and quantity of the local good and may continue buying the foreign goods in the short-run.

Time lag in producer response –producers may take a long time to adapt to say changing their plant size to accommodate the increase in demand.

THE END