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)