Exchange rates

Exchange rates

Exchange rates	An exchange rate is the value of one currency expressed in terms of another currency  1 Euro- 1.28 dollars
Exchange rate systems- Fixed rate	When the value of a currency is pegged (fixed) to the value of: a.       another currency b.      the average value of a selection of currencies c.       the value of a commodity (gold for example) As the value of the variable that the currency is pegged to changes, then so does the value of the currency. Choosing and maintaining the fixed value  source of the currency is done by the government or central bank. If the value of the currency is raised, we call it a revaluation, if lowered, a devaluation.
Floating	A type of regime where the value of a currency is determined solely by demand for, and supply of, the currency on the Forex. There is no government intervention. When the value of the currency rises in a floating exchange rate regime, we say it has appreciated (appreciation), when it falls, it has depreciated (depreciation).
Demand shifts in the country's currency	Buy US exports of goods or services Change in taste in EU in favor of US products Increase in European incomes, thereby increasing demand for all things, including US imports Lower inflation rates in US, thereby making US products/services relatively cheaper than EU products/services Travel to the US Save their money in US banks or financial institutions US interest rates increase, making it more attractive to save money in the US than in the EU Make money speculating on the US dollar European speculators think the value of the dollar will rise in the future, so they buy it now to sell once it has appreciated and make financial gain.
Managed exchanged rates	No currency in the world is completely free floating. Certain circumstances require non-interventionist governments to get involved. –      For example: when a currency experiences extreme &/or frequent fluctuations, governments tend to intervene to stabilize the currency. –      Why are frequent &/or extreme fluctuations bad for business?
The possible advantages and disadvantages of high and low exchange rates	Pros- high Downward pressure on inflation- overall price levels experience downward pressure due to inexpensive imports More imports can be bought- each unit of currency buys more foreign currency, and therefore, more foreign goods and services. Forces domestic producers to improve efficiency to remain competitive Cons-high Damage to export industries- Exporters may find it difficult to sell abroad, could possibly lead to unemployment. Damage to domestic industries- With more imports purchased, domestic producers may find increased competition causes a fall in demand for domestic goods/services, could also lead to unemployment. Pros- low Greater employment in export industries- Exports from the country are attractive to buyers abroad, possibly leading to more employment. Greater employment in domestic industries- Relatively expensive imports encourages domestic consumption & therefore domestic employment . Cons- low Inflation- Imports needed for production will be relatively expensive, increasing the cost of production for firms which leads to overall higher prices in the economy. Increased demand for products/services from international buyers encourages  firms to raise prices across all economic sectors. Pros and cons of all
Gov. intervention to intervene in the foreign exchange market	Lower exchange rate to increase employment Raise exchange rate to fight inflation Maintain fixed exchange rate Avoid large fluctuations in a floating exchange rate. Achieve relative exchange rate stability to improve business confidence Improve a current account deficit (when spending on imports exceeds revenue earned from exports) Use foreign currency reserves to buy, or sell foreign currencies. Use reserves of foreign currencies to buy own currency (increasing demand forcing exchange rate up) Buy foreign currency (increasing the supply of own currency on the Forex) Change interest rates Raise interest rates- encouraging foreign investment saving Lower interest rate- making foreign investment abroad attractive, increasing supply of currency on the Forex
Advantages and disadvantages of fixed exchange rate	Pros fixed Reduces uncertainty- business can plan ahead knowing cost & prices for international trading agreements will not change. Ensure sensible government policies on inflation (because damage from inflation could be so harmful if competitiveness is not maintained) Theoretically, should reduce speculation on the Forex Cons fixed The macroeconomic goal of low unemployment may have to be sacrificed to maintain the fixed rate through interest rate changes. Country must maintain high levels of foreign reserves to defend it’s own currency on the Forex. Choosing the exact “fixed” level is complicated and difficult and may require revaluation/devaluation. A country (China) that fixes its exchange rate artificially low risks international disagreement. •       Its exports would gain an unfair trade advantage on the world market, possibly infuriating other nations. Pros floating Frees up interest rates to be employed as domestic monetary policy tools to control aggregate demand & therefore inflation/employment Floating exchange rates should adjust themselves to maintain a current account balance. (Explain) High levels of foreign currency reserves or gold are not necessary. Cons floating Creates uncertainty, hard for businesses to plan for costs, investments are difficult to assess. Self-adjustment doesn’t always work (fast enough) to eliminate current account deficits. Can worsen existing levels of inflation. •       A country with relatively high inflation has difficultly exporting to others. •       The exchange rate would then fall to rectify the situation •       But this could lead to high import costs on raw materials/components necessary for production •       Leading to cost-push inflation