16.

1 Floating Exchange Rates

Foreign Exchange: international transitions that involve the use of different national currencies

Exchange Rates: the value of one currency expressed in another

- Demand for foreign currency → supply of domestic currency
- Demand for domestic currency → supply of foreign currency

Determination of Floating Exchange

- Exchange rates determined by market forced (supply and demand_ without any government or
central bank intervention
- Price of currency is expressed in another country

Description of Graph Graph

- Demand curve: downward sloping as

demand decreases as the price of
dollars in terms of euros increases
- Supply Curve: as the price of dollars
in terms of euros increases, quantity
of dollars supplied increase
- Equilibrium point: where the dollar
equals the euro

Exchange Rates: Appreciation and Depreciation

Appreciation Depreciation

- Increase in the value of a current in a - Decrease in the value of a currency in

floating exchange rate system a floating exchange rate system
- When a currency appreciates, others - When a currency depreciates, others
depreciate appreciate
 Causes of Changes in Exchange Rates

Changes in currency demand Changes in currency supply

- Inflows of funds into a country - Outflows of funds from a country

Factors affecting exports Factors affecting imports

- Changes in foreign demand for a - Domestic demand for imported
country’s exports/services goods/services → sell more domestic
- Greater demand → appreciate currency in foreign exchange market
- Rate of inflation relative to other → depreciate
countries - Other countries have low inflation →
- Low inflation → appreciate demand for imports increase →
- Relative growth rates depreciate domestic
- High economic growth → - Increased demand for imports →
increased incomes → more domestic currency supply increase →
exports → appreciate appreciate

Factors affecting investment Factors affecting Investment

- Inward FDI and portfolio investments - FDI: outward investment → increases
are investments usually made by domestic currency → depreciation
foreigners - Relative Interest rates
- FDI: investment by - Foreign investments decrease
multinational corporations in → interest rates in domestic
productive facilities falls → financial capital falls
- Portfolio Investment: out → supply increase →
financial investments (stock depreciate
and bonds)
- Increase investment → Other Factors
appreciate - Outward flow of remittance
- Relative interest rates - Increases supply of currency
- Increase interest rate → → depreciates
financial investment demand - Speculation that currency will
increases → appreciate depreciate
- Sell → increase supply
Other factors - Central bank intervention
- Inward flow of remittance - Lower value of domestic
- Remittance: involves transfer currency → sells more →
of money from one country increase supply → depreciate
 - Speculation that currency will
appreciate
- Speculation: involved buying
and selling currencies to
make profit from changes in
exchange rates
- Speculate to appreciate →
appreciate
- Central bank intervention to increase
the value of a currency
- Central bank wants to
increase domestic currency’s
value → buy foreign currency
→ more demand for domestic

Changes in Currency Demand and Supply

- Rate of inflation
- Domestic has lower inflation rate → demand for exports increase, demand for
imports decrease → appreciation
- Interest rates
- Domestic increases interest rates → attracts financial capital → demand for
domestic currency to increase, supply of domestic pound decreases →
appreciation

Summary

Calculations Using Exchange Rates

Value of a Currency in terms of another
- 1.5 dollars = 1 euro
1
1) 1 𝑑𝑜𝑙𝑙𝑎𝑟 = 1.5
= 0. 67 𝑒𝑢𝑟𝑜
Calculating Prices in Different Currencies
- Exchange Rate: 1.22 euro = 1 pound, price/bottle=5 euros, imports for 1000 bottles in pounds?
1) 𝐸𝑢𝑟𝑜𝑠: 1000 𝑏𝑜𝑡𝑡𝑙𝑒𝑠 × 5 𝑒𝑢𝑟𝑜𝑠 = 5 000 𝑒𝑢𝑟𝑜𝑠
2) 𝑃𝑜𝑢𝑛𝑑𝑠: 1. 22 𝑝𝑜𝑢𝑛𝑑 × 5 000 𝑏𝑜𝑡𝑡𝑙𝑒𝑠 = 6 100 𝑝𝑜𝑢𝑛𝑑𝑠

Calculating percentage changes in the value of a currency

*usually asked by IB*

-
- % change in currency (Jan 2020-Dec 2020)
1.69−1.22
1) 1.22
× 100 = 38. 52%

16.2 Consequences of Changes in Exchange Rates: An

Evaluation

Consequences of Exchange Rates in relation to Net Exports

- Currency appreciates → one unit can buy In Summary

more of other currencies → buy more - Currency appreciation → decrease in net
foreign goods → imports increase exports (exports>imports)
- Foreigners give up more of their - Currency Depreciates → increase in net
currencies → more expensive to buy exports
domestic goods → net exports fall

Effects on the Rate of Inflation

Low Rate of inflation High rate of inflation

1. Increase in exports 1. Domestic residents will find imported
a. Cheaper for foreign countries goods/services cheaper
2. Increase in demand for domestic 2. Supply more domestic currency for
foreign currency
3. Greater demand for foreign
goods/services

Demand Pull Inflation: excess AD over AS at Cost Push Inflation: caused by increases in costs
the full employment level of output caused by of production or supply-side shocks
 increase in AD - Currency depreciation
1. Increase in net exports 1. Imports more expensive
2. Increase in AD 2. If domestic products are heavily
a. Currency appreciation reduces dependent on imported factors of
demand pull inflation production → costs of production
b. Recession: increase in AD will increases
not cause demand pull inflation 3. Decrease in SRAS
c. At/close to potential output: - Currency appreciation
inflationary pressure → excess 1. Imports are less expensive
AD 2. Increase in SRAS → low inflationary
pressure

Effects on Economic Growth

Currency Depreciation Currency Appreciation

Impact on Demand Impact on Demand

1. Increased net exports 1. Decrease in net exports
2. Increased AD 2. Decrease in AD
3. Increase in real output 3. Negative effect on the growth of real GDP
4. Economic growth Impact on Supply
Impact on Supply 1. Imports are cheaper
1. Increase net exports 2. Increased imports of factors of production
2. Growth of export industries → increased 3. Increased investment spending
investment spending in domestic economy 4. Greater potential output
(production of capital goods)
3. Investments increase productivity of the
factors or production → increase LRAS
 Effects on Employment

Currency Depreciation Currency Appreciation

1. Increase net exports 1. Decrease in net exports

2. Increased AD 2. Decrease in AD
3. Unemployment dependent on graph 3. Unemployment dependent on graph
a. Recessionary: fall in cyclical a. Recessionary: increase in cyclical
unemployment unemployment
b. At/close to potential output: b. At/close to potential output:
temporary decrease in natural recessionary gap and cyclical
unemployment + strong demand unemployment
pull inflationary pressure

Effects on the Current Account Balance

Balance of Payments: record of all transactions between residents of the country and residents of all
other countries
 - Purpose: show payment received (credits/inflows) from others and payments made
(debits/outflows) to others
- In the course of the year: all inflow payments = outflow payments
- Current account, capital account, financial account
- Current Account: balance of exports and imports of goods and services
- Imports>exports = trade deficit
- Exports>imports = trade surplus

Currency Depreciation Currency Appreciation

Begins with trade deficit Begins with trade deficit

1. Depreciation decrease trade deficit 1. Appreciation increase trade deficit
Begins with trade surplus Begins with trade surplus
1. Depreciation increase trade surplus 1. Appreciation decreases trade surplus

Effects on Foreign Debt

Currency Depreciation Currency Appreciation

1. Lowers value of domestic currency 1. Increase value of domestic currency

2. Value of foreign debt increases 2. Value of foreign debt decreases

Effects on Living Standards

Currency Depreciation Currency Appreciation

1. Imported goods are more expensive 1. Decrease in prices of imported good

2. Residents are worse off 2. Imported inputs are less expensive
a. More inelastic the good → greater 3. Downward pressure on inflation rate
increase in price (demand pull inflation)
4. Real income increases - travelers abroad
1. Increased price of imports will benefit
2. Cost push inflation
3. Increased price level
4. Higher cost of living
5. Decrease in real income of residents
a. Mixed with effects of
unemployment

16.3 Government Intervention

Fixed Exchange Rate System: exchange rate that is fixed by the central bank of a country
- No change from changes in currency supply and demand
- Fixed by constant intervention by the central bank/government
- How: central bank can buy/sell reserves or foreign currencies + make other adjustments in the
domestic economy
- Objective: shift demand/supply for currency to eliminate disequilibrium in the foreign exchange
market

Fixed Exchange Rate System

Explanation and Assumptions Diagram

- Assumption: fixed currency

- Fall in demand (D1 to D2)
- Excess supply of currency: at fixed
exchange rate

Intervention to maintain fixed exchange rates

Using official reserves to maintain exchange rate

- When there is excess supply → central

bank can intervene
1. Buy excess currency by exchanging some
of the foreign currency reserves it holds
2. Increases demand for currency
3. Fixed exchange rate is maintained

- When there is excess demand → central

bank can intervene
1. Sell currencies
2. Increase supply for currency → decreases
demand

Increase in Interest Rates

 1. Lenders have higher return on money
lent/invested in the domestic economy
2. Attract foreign investment from other
countries
3. Higher demand for domestic currency

HOWEVER
1. Increase in interest rates → contractionary
monetary policy
2. May lead to recession in domestic
economy
3. Decrease AD bc of decrease in
consumption/expenditure/investments by
firms

Borrowing from Abroad

1. Borrows abroad → loans are from foreign

currency
2. Must exchange to domestic currency
3. Increase in demand for domestic currency

HOWEVER
1. High levels of foreign debt
a. Problems with Balance of
Payments
i. exports < foreign debt →
further borrowing abroad
b. Possible debt trap
i. Debt rises → foreign
borrowing needed
c. Gov’t budget towards servicing
debt → less available to invest in
domestic economy

Efforts to limit imports

1. Limit imports
2. Reduce demand for foreign exchange to
buy imports
3. Reduce supply of domestic currency

HOW
1. Contractionary monetary and fiscal policy
a. Low AD → low incomes
b. Less disposable income
c. Lower demand for imports
2. Trade protection policies
a. Work directly to limit imports
 HOWEVER
1. May lead to recession
2. Trade protectionism → retaliation →
lower exports

Devaluation and Revaluation

Devaluation: decrease in the value of a currency in the context of a fixed exchange rate system
- When: if a currency has a higher value that can be maintained through intervention, the
government can change the fixed rate to a lower value
- Results: cheaper exports to foreigners, expensive imports for domestic residents

Revaluation: increase in the value of a currency in the context of a fixed exchange rate system
- When: if the currency has a lower value that can be maintained, through intervention, the
government can change the fixed rate to a higher new value
- Results: expensive exports to foreigners, cheaper imports for domestic residents

Managed Exchange Rate

Managed Exchange Rate: combo of free floating exchange rate system and fixed rate exchange rate
system
- Exchange rates usually free to float to market equilibrium levels
- Central bank can periodically intervene to stabilize in the short term
- Objective: prevent large and abrupt fluctuations if exchange rates completely free
- How: buying/selling currencies, change interest rates, contractionary policies/trade protection

Pegging Exchange Rates

Pegged exchange rates: type of exchange rate that is fixed against the value of another country’s
currency rate
- Usually as the US dollar/euro

How it works:
- Country sets target exchange rate system and range to fluctuate in related to pegged country
- Central bank intervenes when exchange rate hits ceiling/floor by buying and selling its own
currency in the foreign exchange market to keep exchange rate within the limits

Significance:
- Stabilized exchange rate of the pegged country in relation to the currency to which it is pegged
- Prevents abrupt/strong fluctuations
- Facilities trade and investment between two countries

Disadvantages
- Vulnerable to negative shocks
- Large amount of reserves

Overvalued and Undervalued Currencies

Overvalued Currency
- Currency that has a value that is too high relative to its equilibrium free market value
- Exchange rate higher than equilibrium exchange rate

Advantages Disadvantages

- Imports are cheaper - Exports are more expensive

- Better industrialization
- Increased imports, reduced exports
- Worsening current account
balance → payment
difficulties
- Disadvantage domestic
producers and unemployment
and resource allocation

Undervalued Currency
- Currency that has a value that is too low relative to its equilibrium free market value
- Exchange rate lower than equilibrium exchange rate

Advantages Disadvantages

- Exports are less expensive to foreign - Unfair competitive advantage

buyers
- Imports become more expensive
domestically
 16.4 The Balance of Payments

*calculation based - most likely for a paper 3*