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Exchange Rates (Edexcel A Level Economics A)

Revision Note

Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Exchange Rate Systems

  • An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18

    • International currencies are essentially products that can be bought & sold on the foreign exchange market (forex)

  • The Central Bank of a country controls the exchange rate system that is used in determining the value of a nation's currency

  • There are three exchange rate systems

    • A floating exchange rate

    • A fixed exchange rate

    • A managed exchange rate

Exchange Rate Systems

Exchange Rate System

Explanation

Floating 

 

  • As with any market, if there is excess demand for the currency on the forex market, then prices rise (the currency is worth more)

    • In a floating exchange rate system this is called an appreciation

  • If there is an excess supply of the currency on the forex market, then prices fall (the currency is worth less)

    • In a floating exchange rate system this is called a depreciation

Fixed 

 

  • The Central Bank negotiates with the international Monetary Fund (IMF) to fix (peg) their currency to another one

    • Sometimes the peg is at parity e.g. 1 Brunei Dollar = 1 Singapore Dollar

    • Often the peg is not at parity e.g. Hong Kong has pegged its currency to the US$ at a rate of HK$ 7.75 = US$ 1

  • A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency

  • A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currency

Managed

 

  • This is a combination of the fixed & floating mechanism

  • The Central Bank determines the preferred currency value - and then the currency is free to fluctuate within a certain range of this value e.g 0.75%

  • If it goes above this range then the Central Bank will intervene by selling its own currency in forex markets so as to increase supply

    • Increased supply of their currency in the forex market decreases the value of the currency & brings it back within the range

  • If it goes below this value then the Central Bank will intervene by buying its own currency in the forex market using its foreign reserves (US$, Euros etc.)

    • Increased demand for their currency in the forex market increases the value of the currency & brings it back within the range

  • Interest rates can also be used to intervene

    • Raising interest rates appreciates a currency as returns on investment/savings become more attractive to foreigners & they demand local currency 

    • Decreasing interest rates depreciates a currency as returns on investment/savings become less attractive to foreigners & they sell their local currency & move their money elsewhere

Factors Influencing Floating Exchange Rates

  • Numerous factors influence floating exchange rates, resulting in an appreciation or depreciation of a currency

4-1-8-exchange-rates-influences
Factors influencing floating exchange rates

  1. Relative interest rates: influence the flow of hot money between countries. If the UK increases its interest rate, then demand for £'s by foreign investors increases & the £ appreciates. If the UK decreases its interest rate, then the supply of £'s increases as investors sell their £'s in favour of other currencies & the £ depreciates

  2. Relative inflation rates: as inflation in the UK rises relative to other countries, its exports become more expensive so there is less demand for UK products by foreigners, which means there is less demand for £s & so the £ depreciates

  3. Net investment: foreign direct investment (FDI) into the UK creates a demand for the £ which leads to the £ appreciating. FDI by UK firms abroad creates a supply of £'s which leads to the £ depreciating

  4. The current account: UK exports have to be paid for in £'s. UK imports have to be paid for in local currencies, which requires £'s to be supplied to the forex market. Due to this, an increasing trade surplus will result in an appreciation of the £ & an increasing deficit will result in a depreciation of the £

  5. Speculation: the vast majority of currency trades are speculative. Speculation occurs when traders buy a currency in the expectation that it will be worth more in the short to medium term, at which point they will sell it to realise a profit

  6. Quantitative easing: involves increasing the money supply & much of the new supply is used to buy back gilts. Many of these gilts are owned by foreigners who then exchange the £s received for their own currency. The increase in the supply of £'s depreciates the £

Intervention in Markets Using Forex Transactions & Interest Rates

  • When using a managed exchange rate system, Government intervention in currency markets takes place in two ways & is managed by the Central Bank

  1. Changing interest rates: if the Central Bank wants to appreciate the country’s currency, it would raise interest rates thereby making it more attractive for foreigners to move money into the country's banks (hot money). Decreasing interest rates has the opposite effect & causes a depreciation

  2. Buying & selling currency in the forex market: The Central Bank can change the demand or supply for their currency using their reserves. If they want to appreciate the currency then they buy it on the forex market using foreign currencies e.g. to bolster the value of the £, the Central Bank could take US$'s from their reserves & buy £'s. If they want to depreciate the currency then they sell their own currency & buy foreign currencies

The Consequences of Competitive Devaluation/depreciation

  • When a currency is intentionally devalued/depreciated by a government, it makes the country's exports cheaper

    • If demand for their exports is price elastic, then the country is likely to experience higher export volumes & higher export revenues

    • E.g. for many years China prevented the value of their currency from appreciating & saw a boom in their export sales

  • Intentional devaluation/depreciation has several consequences

    • It is anticompetitive & upsets international competitors

    • Large countries usually have more financial resources to manipulate markets & so gain unfair advantages over smaller countries

    • Other countries may respond by also lowering the value of their currencies resulting in very little change to market share

    • The devaluation/depreciation raises the cost of imports used in production & with little change to the value of exports - profits decrease

Impacts of Changes in Exchange Rates

  • Changes to exchange rates may have far-reaching impacts on an economy

4-1-8-impact-of-exchange-rate
The impact of changes to exchange rates on an economy

 

Economic Indicator

Explanation

The Current Account

  • Depreciation of the £ causes exports to be cheaper for foreigners to buy & imports to the UK are more expensive

  • The extent to which this improves the current account balance depends on the Marshall-Lerner condition

    • This follows the revenue rule which states that in order to increase revenue, firms should lower prices for products that are price elastic in demand

    • If the combined elasticity of exports/imports is less than 1 (inelastic), a depreciation (fall in price) will actually worsen the current account balance

  • It is also important to recognise that there is a time lag between the depreciation of the £ and any subsequent improvement in the current account balance

    • This is explained by the J-Curve effect

      • It takes time for firms & consumers to respond to changes in price

      • Once it becomes evident that price changes will last for a longer period of time, firms & consumers switch

      • E.g. a firm in the USA has been importing electric scooters from the UK. If the Euro depreciates, the price of scooters in France becomes relatively cheaper. In the short-term, the USA firm will not switch immediately to purchasing scooters from France as the exchange rate may soon bounce back. They also have a good relationship with their UK suppliers. In the long term they are likely to switch

Economic growth

  • Net exports are a component of aggregate demand (AD)

    • A depreciation that results in an increase in net exports will lead to economic growth

Inflation

  • Cost push inflation is likely to occur as the price of imported raw materials increases with currency depreciation

  • Net exports are a component of aggregate demand (AD)

    • A depreciation that results in an increase in net exports will lead to an increase in aggregate demand

    • This may lead to an increase in demand pull inflation

  • An appreciation of the currency will have the opposite effect

Unemployment

  • If depreciation leads to an increase in exports, unemployment is likely to fall as more workers are required to produce the additional products demanded

  • An appreciation of the currency will have the opposite effect

Living standards

  • The impact of a depreciation on living standards can be muted

    •  As imports are more expensive, households face higher prices & less choice, which detracts from living standards

    • Rising exports can decrease unemployment & increase wages/income which means an improved standard of living for some households

  • The impact of an appreciation on living standards will be the opposite

Foreign direct investment (FDI)

  • Depreciation of a currency makes it cheaper for foreign firms to invest in the country and can increase the FDI

    • The money they have available to invest is worth more when the currency has depreciated

  • An appreciation has the opposite effect

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    Author
    Reviewer
    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

    Jenna Quinn

    Author: Jenna Quinn

    Expertise: Head of New Subjects

    Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.