Definitions
- Exchange rate is the value of one currency expressed in terms of another currency.
- Floating exchange rate is an exchange rate regime where the value of a currency is allowed to be determined solely by the demand for, and supply of, the currency on the foreign exchange market. There is no government intervention to influence the value of the currency.
- Depreciation is a fall in value of one currency in terms of another currency in a floating exchange rate system.
- Appreciation is an increase in value of one currency in terms of another currency in a floating exchange rate system.
- Speculation is the buying and selling of currencies in a foreign exchange market in order to from differences in its price.
- Fixed exchange rate is an exchange rate regime where the value of a currency is fixed, or pegged, to the value of another currency, or to the average value of a selection of currencies. This fixed exchange rate is maintained by government intervention in a foreign exchange market.
- Revaluation is an increase in value of one currency in terms of another currency in a fixed exchange rate system.
- Devaluation is a fall in value of one currency in terms of another currency in a fixed exchange rate system.
- Managed exchange rate is an exchange rate regime where currencies are allowed to fluctuate (float) within a narrow band, but where authorities will intervene if they consider the movement of the exchange rate to be undesirable.
Exchange Rate Systems
1. Fixed Exchange Rate
- Value of one currency is fixed/pegged, to the value of another currency.
- Increase in value of currency in terms of another currency → Revaluation.
- Fall in value of currency in terms of another currency → Devaluation.
- Government intervention is involved.
● Advantages of fixed exchange rate:
- Reduces uncertainty for all economic agents in the country, such as businesses.
- Ensure sensible government policies on inflation to reduce harmful effect on the demand for imports and exports.
- Should reduce speculation in foreign exchange market in theory.
● Disadvantages of fixed exchange rate:
- Government is compelled to keep the exchange rate fixed. Increase interest rates → Deflationary pressure → Low demand → Increase unemployment.
- Countries have to maintain high foreign reserves in order to defend its currency by buying and selling foreign currencies.
- Setting fixed exchange rate isn’t simple as it involves multiple variables and they change heavily over time.
- May create international disagreement → Economics disputes or Retaliation.
2. Floating exchange rate
- Value of the currency is determined by the demand for, and supply of, the currency on the foreign exchange market.
- No government intervention to influence the value of the currency.
- Increase in value of currency in terms of another currency → Appreciation.
- Fall in the value of currency in terms of another currency → Depreciation.
● Factors that increase demand for a currency (US dollars and UK pounds):
- Increase in demand for US goods and services caused by:
- US inflation rates being lower than UK → Cheaper prices for US products.
- Increase in incomes for the British → Increases demand for all things, including imports from the US.
- Change in tastes in the UK in favor of the US products.
- Improvement in US investment prospects.
- Increase in interest rates in the US → More attractive to save there than in the UK.
- Speculation that US dollar will wise → Buy it early → Sells it after a while → Makes a financial gain.
● Factors that increase supply for a currency (US dollars and British pounds):
- Increase in demand for UK goods and services caused by:
- US inflation rates being higher than UK → Higher prices for US products.
- Increase in incomes for the Americans → Increases demand for all things, including imports from the UK.
- Change in tastes in the US in favor of the UK products.
- Improvement in UK investment prospects.
- Increase in interest rate in the UK → More attractive to save there than in the US.
- Speculation that UK pounds will rise → Buy it early → Sells it after a while → Makes a financial gain.
● Advantages of floating exchange rate:
- Interest rates are free to move as domestic monetary tools and can be used for demand management policies.
- Should adjust itself → Keep the current account balanced.
- Not necessary to keep high levels of reserves of foreign currencies.
● Disadvantages of floating exchange rate:
- Creates uncertainty in international markets → Businesses can’t make important strategies as it might lead to inaccurate predictions.
- Affected by more factors than demand and supply, such as government intervention, natural disasters, terrorist attacks and speculation.
- Worsen existing levels of inflation → Higher import prices.
3. Managed exchange rate
- Currency is allowed to float, but government intervention is involved.
- Most countries uses this exchange rate regime.
- Mix of fixed and floating exchange rate regimes.
Possible advantages of high exchange rate
- Downward pressure on inflation → Price of imported goods will be relatively low → Reduce costs of production for firms as there’s a decrease in prices of raw materials → Lower price for consumers.
- More imports can be bought → Buy more foreign currencies → Buy more foreign goods and services.
- High value of the currency → Domestic producers improving their efficiency → Lowering costs to maintain competitive.
Possible disadvantages of high exchange rate
- High prices for exports → Export industries find it difficult to sell their goods and prices → Increase unemployment.
- Less demand for domestic goods and services due to increased competition → Imports being relatively less expensive → Increase unemployment.
Possible advantages of low exchange rate
- Exports from the country is less expensive → More employment in export industries.
- Imports are more expensive → Encourage consumers to buy domestically produced goods instead of imports → More employment in domestic industries.
Possible disadvantage of low exchange rate
- Low value of a currency → Imported goods, raw materials and components become more expensive.
Paper 3 Question
Country X has a currency known as the “pesho”. The country is involved in international trade and the pesho is fully convertible currency that is allowed to float freely on the foreign exchange markets.
The demand and supply functions for the pesho are given below:
QD = 3200 – 400P
QS = -400 + 400 P
Where P is the exchange rate of the pesho against the US dollar.
- Produce a table that shows the demand schedule and supply schedule for the pesho when exchange rates are $0, $1, $2, $3, $4 and $5.
