Exchange Rates

Different Measures of the Exchange Rate

The exchange rate is simply the price of one currency in terms of other currencies. For instance if I can exchange £1.00 for $2.00, the exchange rate is 2 dollars to the pound (or 50 pence to the dollar).

There is a number of different measures of the exchange rate:

The spot market rate – This is the exchange rate that can be obtained at the present time, if you want to exchange say pounds for euros today.

The forward market rate – This is the rate that currency traders (mainly banks) are prepared to buy or sell a currency at some future date. The forward market is used by firms importing or exporting goods. It is a way of hedging (reducing risk) against an unexpected change in the exchange rate.

The nominal and real exchange rates – The nominal rate means no adjustment has been made for changes in relative inflation rates between trading partners. Suppose for instance that over the last year the U.K. has experienced 10% inflation, but in the eurozone it has only been 4%. This will be reflected in UK export prices rising relative to the prices of its imports from Europe. If the market exchange rate between the pound and the euro has not changed over the year, the real exchange rate will have risen by 6%, but the nominal exchange rate will be unchanged. A rise in the real exchange rate means that the terms of trade have improved.

The trade weighted exchange rate – This measure of the exchange rate (which is also known as the effective exchange rate), measures how the exchange rate is changing against other currencies in general, rather than a single currency. It takes into account not only the changes of a currency’s exchange rates, but also the proportion of trade with each country. It uses an index number to measure changes in the effective exchange rate.

Suppose country X has just two trading partners, Y and__ Z__. 60% of its trade is with Y __and 40% with __Z. At the start of the year the trade weighted index of its currency is 100. At the end of the year its currency has depreciated by 10% against the currency of country Y and by 20% against the currency of Z.

The fall against Y’s currency contributes a 6% fall to the trade weighted value of X’s currency (60% x 10%) and the fall against Z’s currency contributes 8% (40% x 20%).

The overall (or average) fall in X’s exchange rate is therefore 14% (6% + 8%). Notice that this is less than the 16% figure we would obtain by simply adding together the non-trade weighted falls in the exchange rate.

At the end of the year__ X__’s trade weighted exchange rate index is now 86.

Floating Exchange Rates

Under a floating rate system, a currency’s exchange rate is simply determined by the free market forces of demand and supply, without any intervention by the government or its central bank. To understand what determines the equilibrium exchange rate, we need to look at the factors that create a demand or supply of a currency.

Demand for a currency is created by:

Exports of goods and services – This causes foreign buyers to sell their own currency in exchange for the exporter’s currency to pay for the goods. For instance when Jaguar sells cars in Europe it wants to be paid in £s, so it can pay its workers and suppliers.

Long term capital inflows – Foreign direct investment into a country, such as Toyota building a car plant in the U.K. creates a demand for £’s as the Japanese company has to buy land and pay for the building.

Short term capital inflows – currency speculators may buy a currency if they think it is likely to appreciate in value or if they believe interest rates in the country are likely to rise.

Supply of a currency is created by:

Imports of goods and services

Long term capital outflows

Short term capital outflows

Like any other demand and supply curves, the demand curve is downward sloping and the supply curve upward sloping. A fall in the exchange rate of the pound, for instance would make Britain’s exports more competitive, so other countries would want to buy more £s in order to buy more British goods. A cheaper pound would also make the U.K. more attractive for foreign investment as assets could be purchased more cheaply.

An increase in the value of the pound, by contrast would encourage more selling of sterling, as imports into Britain would be cheaper. It would also lead to a greater outflow of capital as U.K firms will be able to afford to buy more assets abroad.

The conditions of demand/supply could change as a result of the following:

  1. _Changes in the value of exports _– An increase in a country’s exports will cause an increase demand for its currency. A decrease in exports will cause a decrease in demand for the currency.
  2. _Changes in the value of imports _– An increase in imports will result in an increase in the supply of a country’s currency and vice versa.
  3. _Changes in long term capital flows _– A capital outflow (caused perhaps by a loss of confidence in the economy or better opportunities to invest overseas) will cause an increase in the supply of a currency and vice versa.
  4. Changes in interest rates – A rise in interest rates will attract an inflow of short term capital, resulting in an increase in demand for the currency. It will also lead to a decrease in its supply as holders of the currency will be less willing to sell.
  5. Speculative activity – If currency speculators believe a currency will appreciate in value (perhaps because of favourable economic news) this will result in an increase in its demand and a decrease in supply and vice versa.

An increase in demand is shown by a rightward shift of the demand curve (and vice versa). An increase in supply is shown by a rightward shift of the supply curve (and vice versa).

An increase in demand or decrease in supply will push the exchange rate up.

A decrease in demand or increase in supply will push the exchange rate down.

Possible changes in the demand and supply of a currency, and the effect on the equilibrium exchange rate are shown in Fig 2 below:

Exchange Rates, figure 1

Suppose the exchange rate is initially in equilibrium at point A, where demand curve D1 intersects supply curve S1. An increase in demand for the currency would move the equilibrium to__ B__, causing the exchange rate to rise. A decrease in demand to D2 would shift the equilibrium to C, with a fall in the exchange rate.

An increase or decrease in supply would shift the equilibrium to D or J respectively, and a fall or rise in the exchange rate.

If demand increased and supply decreased, the equilibrium would move to H. If demand decreased and supply increased, the equilibrium would be at__ F__.

The Purchasing Power Parity Theory

This theory argues that in the long run exchange rates will move to a level so that a unit of any currency will have the same purchasing power wherever it is spent (ie at home or abroad).

Suppose a Big Mac costs £3.00 in the UK and $6.00 in the USA. Provided these prices are typical of all prices (ie dollar prices are twice sterling prices), the theory suggests that the exchange rate will be £1 to $2.

Now suppose that over the next year there is rapid inflation of 50% in the UK, but prices are stable in the USA. The sterling price of the BigMac rises to £4.50, but the American price stays at $6.00.

The pound is now overvalued by 50%. An American tourist buying a burger in London would have to buy $9 worth of pounds to pay for the burger. British goods in general would now be more expensive (and less competitive) than American ones. This will cause an increase in imports from the USA and a fall in British exports. The resulting increased buying of dollars and selling of pounds will drive down the pound until it reaches its purchasing power parity rate of exchange, which is now £1.00 = $1.33 (6/4.5).

Put another way, the PPP theory argues that the exchange rate will move towards a level where the current account is in balance.

There is plenty of evidence that supports the view that changes in domestic price levels are a very important determinant of exchange rates in the long run. Countries with persistently high inflation do experience falls in their exchange rates, whilst countries like Switzerland have seen a steady rise in the value of their currency over many decades; the consequence of very low inflation over that period of time.

The theory is less good at predicting short run changes in the exchange rate, because there are so many factors affecting capital flows between countries, and these are very important in determining exchange rate fluctuations on a daily or monthly basis.

The real strength of the theory is that it shows that a government will find it very difficult to maintain an exchange rate for long if it is seriously over or undervalued.

Fixed Exchange Rates

A country can try to maintain a fixed exchange rate against one or more other currencies. In the 19th and earl 20th centuries, the major economies in the industrialised world belonged to the Gold Standard. Each currency was freely convertible into gold at a fixed price. So if the £ was worth four times as much gold as the dollar, the exchange rate of the £ to the $ would be 1:4. Under the rules of the Gold Standard a country would increase or reduce the amount of its domestic currency in circulation according to the amount of old held by the central bank.

The Gold Standard was abandoned in the 1930s as the Great Depression resulted in countries trying to boost their economies by devaluing their currencies.

There is no longer a global attempt to operate a fixed rate system, but many smaller countries try to fix their exchange rate against one of the major currencies, usually the American dollar or the euro.

Some of the smaller countries in South America for instance, fix their exchange rate against the dollar. Holders of the currency can freely exchange them for dollars, so the central bank has to restrict the issue of its own currency in line with its reserves of dollars.

A country’s central bank will have to intervene in the foreign exchange market to maintain the fixed exchange rate. If there was downward pressure on the exchange rate (caused for example by a current account deficit), the central bank could sell some of its reserves of foreign currencies to buy its own currency, thereby increasing demand for it and pushing the exchange rate back to the fixed rate. Alternatively it could raise interest rates to attract an inflow of short term capital. If the exchange rate faces upward pressure, the central bank has to sell its own currency in exchange for foreign currency, or lower interest rates.

Managed Exchange Rates

Most countries adopt a hybrid exchange rate policy, called a managed exchange rate. This means the exchange rate is neither rigidly fixed or allowed to float freely. There are several approaches to managed exchange rates:

Adjustable peg system – This system was used between the end of World War 2 and the early 1970s. It was introduced alongside the establishment of the International Monetary Fund (IMF), the World Bank and GATT (which later became the WTO). It became know as the __Bretton Woods system __(the place where the agreement was signed) and aimed to restore trade and growth amongst countries by providing stable exchange rates rather than the competitive devaluations of the 1930s.

Each country had a central fixed exchange rate, but with a small band of flexibility, allowing the rate to fall slightly below, or rise slightly above the central rate. If the rate threatened to go above the ‘ceiling’ or below the ‘floor’, the central bank would have to intervene by lowering/raising interest rates or selling/buying foreign currency.

In exceptional circumstances countries were allowed to devalue or revalue (for instance if a country had a large and persistent current account deficit that it could not finance), but only with the agreement of other countries in the system.

The system was abandoned after 1972 when the U.S.A. (by far the biggest economy in the world) let the dollar float because of the country’s vast current account deficit.

Crawling peg system – This is similar to the adjustable peg, but allows for more frequent changes in the fixed rates. It is therefore closer to a floaing rate system than the adjustable peg.

Dirty or managed float – Under this approach a government is not committed to maintaining any particular exchange rate, but will intervene to keep the rate at a level it thinks is appropriate for the economy, and to prevent sharp rises or falls. This is currently the approach adopted by most of the major economies in the world, including the eurozone, the USA and the UK.

As well as buying/selling foreign currencies and raising/lowering interest rates, a government has other options to control its exchange rate in a managed system:

International borrowing by the government – This usually means going to the IMF. This is a drastic measure, as the IMF usually imposes conditions on its loans, such as reducing government spending. The loans of foreign currency can be used to buy its own currency to maintain the exchange rate.

Exchange controls – The central bank can restrict access to foreign currency by firms wanting to import and therefore keep the exchange rate above its free market level. (see notes on 4.1.6)

Devaluation/Revaluation – Under an adjustable peg a currency may be devalued (ie fixed at a lower rate) or revalued (at a higher rate). This usually happens if the central bank can no longer keep the currency at its existing exchange rate. Speculators can identify if a currency is fundamentally over or under valued and massive buying or selling of the currency will overwhelm the central bank’s ability to maintain the existing rate by buying or selling currency from the country’s official reserves.

A devaluation or revaluation means declaring a new fixed rate the government will defend. It is likely to be accompanied by a fall (for devaluation) or rise (for revaluation) in interest rates.

Devaluation/revaluation must be distinguished from a currency depreciation/appreciation.

The latter refers to changes in the exchange rate that occur naturally as a result of market forces; an increase in the buying or selling of a currency by traders will drive its value up or down.

Pros and Cons of Different Exchange Rate Systems

There is no easy answer as to which is the best system, which is probably why most countries adopt a managed, rather than fixed or floating rate. There are three main issues to consider with regard to exchange rate policy:

Robustness – Because of its flexibility, a floating rate system can cope better with big trade imbalances; deficit countries will see their currencies depreciate against surplus countries. A rigidly fixed exchange rate system is likely to break up if a country has a persistent deficit and not enough foreign currency reserves.

Trade and investment flows – A fixed exchange rate system produces less uncertainty and risk for international trade and investment. This is a major reason for the creation of the euro, which eliminates all exchange rate risks between member countries. Fluctuating exchange rates can make it hard to predict the prices and profits firms will earn from exporting. Risks can be reduced by buying currency on the forward market, but usually only for up to 6 months ahead. Long term contracts priced in a given currency are therefore still risky.

Economic costs of correcting current account imbalances – Under a floating rate system current account imbalances are corrected by exchange rate changes. This means that a deficit country does not have to reduce domestic demand to reduce imports. Under a fixed rate system this is the only option, and can result in rising unemployment and falling output.

On the other hand, a fixed exchange rate system is likely to result in greater financial discipline and lower inflation, because countries cannot let their currencies depreciate if they are losing competitiveness because of higher domestic inflation than in competitor countries.

Identify and explain the factors that can cause an exchange rate to rise or fall.
Your answer should include: exports / imports / short term capital / long term capital / interest rates / speculative activity / speculation