4.1.8 exchange rates

what can a central bank do to preserve a fixed exchange rate- to stop from peg breaking on the downside, central bank must intervene in FOREX markets

- increase the demand - keep supply constnat

advantages of a managed exchange rate: keeping your currency artificially weak because

- to promote export led growth: an artificially weak currency lowers export prices and raises import prices. therefore, intervening to keep a currency artificially weak can be used to improve a country's international price competitiveness. it cold be argued that running an under-valued managed exchanged rate is unfair, and an example of protectionism. - to minimise a country's current account deficit- an under-valued currency makes export appear cheaper and imports more expensive. as long as demand for import and export is price elastic. .

advantages of a managed exchange rate: keeping your currency artificially strong because

- to reduce the burden of external foreign currency denominated debt: in the developing world, some government have a tendency to print the currency needed to finance interest payments to bondholders. as a result, the money supply grows rapidly, causing inflation. overseas bondholders receive their interest, but it doesn't buy very much. this is called an inflationary sovereign default. government that used this type of default in the past are typically shunned by the bond market. to run a fiscal deficit in the future, government in this position typically have to denominate government bonds in dollars; a currency that they cannot print. most of Argentina's public debt is denominated in US dollars. every year, when the Argentine government pays interest to its bondholders, the Argentina government will have to convert some of the peso the tit collects by taxing households and firms in Argentina into US dollars. in these case there is a clear advantage in running a managed exchange rate that overvalues the peso against the dollar. can collect less peso- spend more of taxes on life enhacning public services. - to reduce cost-push inflationary pressure- an artificially strong currency will reduce the price of imported food and raw materials. therefore, a strong currency can helot reduce etc cost of production across an economy. this will increase SRAS making cost-push inflation highly unlikely. if a strong currency does result in deflation the real wages of workers will increase, even if they do not receive na increase in their nominal wages. prior to the euro, the cost of living in Germany was very low. this was in large part due to the might German Deutschmark.

what are the macro-impacts of a currency depreciation

1. export prices will fall and import prices will rise. 2. impacts on export income and import expenditure will vary- the impacts will depend on the PED of exports and imports. most Keynesian economists assume that the deamdn for imports and exports is price elastic. e.g. if export demand in price elastic, then the fall in export prices created by the depreciation will cause a proportionately greater increase in quantity demanded. as revenue equals price x quantity, total revenue must rise. the percentage fall in price is less than the percentage increase in quantity demanded. the Marshall-lerner condition states that a depreciation will only reduce a country's current account deficit if a country's imports and exports have a PED of above one. (i.e. price elastic). 3. impacts on cost-push inflation. when the er decreases, import prices rise. imported raw materials, energy all become more expensive. uk production costs across the economy rise, therefore the short run AS decreases (shifts to the left) due to decreased profitability across the whole economy. stagflation- increase in prices, decrease in output. fewer goods and services but at higher prices 4. impacts on FDI- when the er goes down, inward FDI in the UK increases. fall in ER-> decrease in uk asset prices when denominated in US dollars. so foreign nationals are more likely to invest in uk.

reasons why the demand for sterling might fall

1. falling uk export sales due to falling consumption abroad- if the level of consumption falls in America, fewer goods and services will be sold in America. in addition to domestically produced goods, a fall in us aggregate demand will also cause a fall in the demand for us imports. one country's imports are another's exports. therefore, if use buys fewer imports, uk export sales to us will also fall. if us buys fewer uk exports, they will also need to buy less sterling on forex markets, causing sterling to depreciate against the dollar. 2. falling uk export sales due to worsening uk international competitiveness- international competitiveness describes an economy's ability to compete, both in terms of price and product quality of goods produced, with other economies. if the uk's output becomes relatively expensive, or deteriorates in terms of product quality, foreigners will respond by substituting uk exports in favour of domestically produced alternatives. when foreigners buy British goods they have to demand sterling to pay British firms. if uk export sales to the rest of the world fall, international firms will not have to demand as much sterling on forex markets. if demand for sterling on forex markets falls, the pound will depreciate against the dollar. 3. falling uk real interest rates - if the bank of England loosens monetary policy, the returns on offer to foreign savers will fall. lower British interest rates will decrease hot money inflows into sterling. this is bceaseu lower interest rates will have reduced the yield on offer for holding cash in sterling in uk banks. if the demand for sterling falls, sterling will depreciate ceteris paribus. 4. British assets become less attractive to foreign buyers- assets are bought because they generate unlearnt income. if the uk is expected to go into recession in the future, international investors will predict that uk firms will experiecne falling sales. in turn this will lead to falling revenues, falling profits and hence falling dividends paid to shareholders. the recession would almost certainly lead to an increase in unemployment, which would lead to a decrease int eh demand for London property, causing rents to fall. if uk assets generate lower real rates of true, inward foreign direct investment in Britain would fall. this would decrease the demand for sterling on forex markets.

advantages of fixed exchange rates

1. greater certainty, leading to greater foreign trade and investment if the ER is fixed, exports will know for sure what their sterling export revenues will be from a given volume of exports. if exporters know what their sterling export revenues will be, they will also be able to reliably predict what profit they will make from exporting. the extra certainty created by fixed exchange rates should give UK firms the confidence to seek out and accept new export orders. as a result, uk firms will expand. the extra output create by taking on additional export orders will add to the UK's GDP and employment. floating exchange rates, on the other hand, discroauged firms from taking on export orders. this is because a sudden appreciation of a floating exchange rate can turn what was a profitable export order in into a loss maker that could sink a company. E.G. imagine that a UK company receives an enquiry for a German business regarding a potential order. the German buyer will only go ahead if they can pay in euro. the British firm estimates that they will need an export revenue of £60 per unit. if the exchange rate is £1: 1.2 euro the UK firm will have to charge the german firm 72 euros to make its target sterling revenue of £60 per unit (60 x 1.2= 72). the German is prepared to sign a five year contract at 72 euros a unit. whether the UK firm accepts will depend on exchange rate expectations, if pound appreciates will get fewer pounds for same euros paid. the firm's appetite for risk. if the uk firm can afford to take out hedging insurance that will insulate them from the risk of a currency appreciation. if don't accept- poentital economic growth and jobs lost. 2. a tough external discipline that promotes efficiency - for the last 20 years, uk firms have repeatedly made themselves uncompetitive by paying wage increases that have not been justified by productivity increases. as a result, British unit labour costs have rise. to stop profit margins from falling, British firms have passed cost increases onto the consumer via higher prices. these price increases have made the uk economy uncompetitive. many of theses firms should have failed. unfortunately for hem, they have not been bailed out by the bank of England's and the bank of England is unwilling to defend sterling. instead, the bank of England has allowed sterling to float. year after year, the bank of England has allowed sterling to depreciate. depreciation has prices British firms back into their export markets. it could be argued that his automatic stabiliser effect has created a moral hazard for many UK firms. why bother to make the internal changes needed to make your business more competitive, if you know that depreciation will do the job for you. fixed exchange rates remove this moral hazard. they provide firms with a tough external discipline. if the uk ran a fixed exchange rate, britshi firms would be forced to take greater responsibility for their own International competitiveness. they would have to improve their internal efficiency. inside a fixed exchange rate regime, firms that fail to improve their own internal efficiency would face the very real threat of liquidation. more productive- boost long run trend rate of economy growth. in the long term a currency that perpetually falls is not beneficial. the cost push ifaltlion caused by rising import prices will raise the cost of living, which will reduce the real incomes of those that have the misfortune to live int e country that uses the currency that is in perpetual free fall. 3. a lower cost of living- a strong currency helps a developing country because it will help to reduce etc cost of buying imports. in the short term, an overvalued fixed exchange rate can reduce the cost of living, which boosts real wages, enhacning the material standard of living. the opportunity cost of running na overvalued exchange rate is debt. an overvalued exchange rate will make the country running the fixed exchange rate policy internationally uncompetitive. countries in this position tend to run up huge ca deficits. this means that they have to attract currency inflows on the financial account. this means assets must be sold off to overseas buyers, or borrowing. 4. lower debt servicing costs- due to inflationary defaults in the past, many developing countries now have to issue government bonds in US dollars, rather than in their own currency. a high fixed exchange rate currency will help a developing country that has borrowed in dollars to reduce th cost of their severing a dollar denominated debt.

disadvantages of fixed exchange rates

1. loss of automatic stabiliser effect- in a floating exchange rate regime, fluctuations in market exchange rates create automatic stabiliser effects that prevent a country from running a permanent current account deficit or surplus. e.g. china. china has run a current account surplus for years. the Chinese opera a fixed exchange rate policy. the fixed exchange rate set by the Chinese authorities is too low. ordinary, countries like china that run current account surpluses tend to have appreciating currencies. an appreciating currency will make china's export appear more expensive. the demand for Chinese exports should fall, reducing Chinese export income. at the same time, imports will seem cheaper in china, leading to a rise in Chinese import expenditure. a current account surplus occurs when a country's export income exceeds its import expenditure. if china's export income drops relatively to its import expditure, chain's current account surplus will decrease. fixed exchange rates prevent this automatic stabiliser effect from taking place. if china keeps its exchange rate fixed too low for long chain might end up destabilising the economic of countries that it trades with . one country's current account surplus is another's current account deficit. china cannot expect to run a current surplus forever because it would mean that other countries would have to run permanent current account deficits. over time the buyers of chinas sports will become more and more indebted. eventually, these overseas buyers will not be able to take on and service anymore debt to buy Chinese exports with. at this point, the export orientated approach to economic growth breaks down. the assets bought using the currency china's currency will also stop returning income because the loans that these assets are based will eventually start to default. 2. fixed exchange rates attract speculation imagine a country that runs an overvalued er that has an international competitiveness problem. this corny will suffer from a chronic ca deficit. to maintain the fixed exchange rate the central bank will have to intervene to manipulate the supply and demand of their currency on forex markets. if speculators believe that the country running the fixed er might run out of foreign currency reserves and /or struggle to raise interest rates any further (e.g. suppose that the country running the fixed encahgen rate is mired in recession and suffering from very high levels of unemployment. in this situation would the government or central bank real be prepared to raise interest rates again.), then speculators might start to think that the fixed exchange rate is untenable; this exchange has to fall. to make profit from this prediction, speculators will begin short-selling the currency, i.e. selling the currency at today's exchange rate, and then buy it back once the devaluation has happened, pocketing the difference as profit. in most cases the govenmetn and central bank running the fixed er will try to fight the speculators. speculators know that eventually economic fundamentals will win out. when the governmet/cerntal bank finally runs out of currency reserves and/or cannot bear to raise interest rates higher, the currency might cash by 25% in one day. on black Wednesday in 1992 the pound was forced out of its semi-fixed exchange rate with the Deutschmark and fall by 20%. the instability created by sudden currency crashes could have been avoided if countries used floating rather than fixed exchange rates. 3. monetary policy can no longer be used for inflation targeting purposes- policy trade off. countries that run fixed er are forced into using monetary policy to support their currency. for example, interest rates may have to be cut if there is a danger that the er might appreciate above the fixed rate set by the government. however, at the same time, the cut in interest rates will increase domestic AD. inflation, 4. retaliation- countries that try to gain an unfair competitive advantage over their trading partners by running a fixed exchange rate that deliberately undervalues the currency are likely to become unpopular. e.g. America and china. many Americans blame china for its ca deficit. a weak yuan allows Chinese firms o charge low prices that undercut American suppliers. the Chinese appear to be wedded to the export-orienatated model of industrialisation. in the long run it could be said that the strategy of running an undervalued fixed er will fail bc: - retaliation, in the form of tariffs and quotas imported on hina - china's export led model is unsustainalbe- eventually American households will reach the point of debt saturation. when Americans cannot afford to service the debts that they have already got they will not be able or wiling to take on the extra debt. if Americans are forced or choose to stop borrowing American ad will crash, and with it the demand for chineses exports.

reasons why the supply of sterling might increase

1. uk import expenditure increases, because British households are consuming more- an increase in ad -> Britain will suck in more imports -> uk firms are required to buy more foreign currency -> uk firms are required to sell sterling on forex markets -> pushing the exchange rate down 2. rising uk import expenditure caused by deindustrialization and falling uk international competitiveness- if uk international compeitiveness falls, the demand for imports will increase. if uk buys more imports because they are cheaper or better quality than domestically produced substitutes, British firms will need to buy more foreign currency. in order to do this, firms will have to sell sterling. 3. hot money flows out of sterling because uk real interest rates have fallen- a cut in interest rates will turn the sterling into a low-yielding currency. low uk interest rates will reduce the unearned income available for those willing to save in sterling. currencies the offer modest rates of return will be unpopular with foreign multinationals that have surplus working capital to deposit with banks for relatively short periods of time. hot money is internationally mobile cash that moves from one currency to another in search of the highest interest rate. over the last decade, nominal interest rates have been about as low as they can go. negative nominal interest rates don't tend to work, because savers will respond to them by taking their savings out of the bank. the only other option is to create inflation via qe. if inflation can be increased, interest rates in real terms will fall, even if nominal interest rates remain the same. 4. capital flight from the uk, caused by a loss of confidence. capital flight occurs when investors lose confidence in an economy. they respond by selling assets that they own in the country that they are no longer confident about. the local currency generated for the sale of assets is then sold on forex markets in exchange for US dollars, which can be used to buy assets in other counties that are thought to have a better future. capital flight can be prompted by many factors: political turmoil/civil unrest/risk of civil conflict; fears that the goverment plant o take assets under state control i.e. nationalisation; exchange rate uncertainty for a country running a fixed exchange rate e.g. ahead of a possible devaluation; fears over the stability of a country's banking system; a high public debt to gdp ratio that gives rise to an increased perceived risk of a sovereign default; higher rates of corporation tax for foreign-owned businesses. the uk property market is also important too. suppose that overseas investors woke up to the fact that the uk economy is an accident waiting to happen? the London property market is in a bubble. if you owned London property, you might be tempted to sell now before prices crash. 5. capital flight from the uk, caused by higher rates of uk inflation, which reduce the real rates of return available on uk assets. inflation reduces the real rates of return offered by British assts. therefore, inflation makes uk assets less desirable for foreigners to own. the same principle applies to cash held in sterling at uk banks. inflation comprises sterling's ability to act as a store of value. in addition inflation will also reduce uk real interest rates. as a result, foreigners are likely to want to transfer their wealth out of the sterling, in order to move it into another currency that might perform better as a store of value. other currencies might offer a better inflation adjusted yield too. hot money flowing out of sterling will race the exchange rate down.

distinction between devaluation and depreciation

A devaluation occurs when a country makes a conscious decision to lower its exchange rate in a fixed or managed exchange rate. A depreciation is when there is a fall in the value of a currency in a floating exchange rate

difference between fixed and managed exchange rate

Definition of a Fixed Exchange Rate: This occurs when the government seeks to keep the value of a currency fixed against another currency. e.g. the value of the Pound Sterling fixed against the Euro at £1 = €1.1 Semi-Fixed Exchange Rate. This occurs when the government seeks to keep the value of a currency between a band of the exchange rate. In other words, the exchange rate can fluctuate within a narrow band. For, example the Exchange rate mechanism. For example, the Pound Sterling could fluctuate between a target exchange rate of £1 = €1.05 and £1 = €1.15

what is the Marshall-lerner condition

a depreciation will only reduce a country's current account deficit if a country's imports and exports have a PED of above one. (i.e. price elastic). if the Marshall-lerner condition is met, a currency depreciation will lower export prices and increase export incomes. the PED is greater than one, so the increase in quantity demanded is greater than the decrease in price. total revenue will increase if the increase in quantity demanded is greater than the decrease in price (TR= Q x P). increase import prices, and reduce import expenditure. PED is greater than one-> percetnage fall in quantity demanded is greater than the percentage increase in price. in the last 25 years the sterling has depreciated against most currencies. however, despite this the uk's current account deficit has worsened. this suggests that the uk has not met its Marshall-lerner condition. why? deindustrialisation and poor International competitiveness had led to a situation where there are now very few substitutes for the imported manufactured goods that we want to consume . when sterling depreciates and uk import prices rise, imports by volume fall marginally, but imports by value will increase. uk households can't espcae more expensive imports as there are no domestically produced substitutes.

what is a floating exchange rate?

a floating exchange rate is one that is determined by market forces. i.e. the relative strength of supply and demand on forex markets.

what is a managed exchange rate

a managed currency that officially floats in foreign exchanger markets but is subject to intervention from time to time by the government by and/or central bank. aka dirty floats. by inflcuinecing either the supply or demand for a currency on FOREX markets, intervention is supposed to control currency fluctuations that are considered to be economically undesirable.

what is a fixed or pegged exhvnage rate

an exchange rate regime where the currency's value is fixed against either the value of another currency, or to another measure of value, such as gold. Hong Kong.

what is the exchange rate

measures the amount of foreign currency that can be bought with one unit of domestic currency appreciation -> one unit of domestic currency can buy more units of foreign currency. depreciation -> one unit of domestic currency buys fewer units of foreign currency.

british households and firms who need to supply/sell sterling to buy a foreign currency needed to buy imported goods and services/overseas assets/save in foreign currency. foreign multinationals that have surplus working capital (i.e. cash balance) might also choose to buy sterling if UK interest rates are higher. working capital is the money used to finance the day to day running of a business. hot money is internationally mobile cash that cashes high yielding currencies that pay the highest interest rates.when investing surplus cash, multinationals will seek out the bets rates of interest possible. if the best possible rate of interest on offer is sterling, hot money will flow into the pound, pushing the exchange rate up.

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foreign nationals who want to buy British exports, assets, save in sterling

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what are the macro impacts of a currency appreciation

opposite of a currency depreciation

the inverse j curve effect

the impacts of a currency appreciation on a country running a current account surplus will vary over time. in the short run, the red of imports and exports is likely to be below one. therefore, int eh story run, an appreciation will increase the country's current account surplus. in the long run, ped becomes greater than one as new substitutes emerge, from this point on, the current account surplus will start to fall.

what is the j curve effect- see notes for diagrams

the impacts of a currency depreciation on a country's current account balance varies over time. in the short run, the Marshall Lerner condition isn't usually met. therefore, in the short run, a currency depreciation increases a country's current account deficit. however, in the long run, the damdn for imports and exports will become price elastic. when the Marshall Lerner i.e. met, the depreciation will reduce the current account deficit. why does import/export demand become price elastic in the long run. new substitutes emerge when - patents expire - reindustrialisation - contracts with existing suppliers end - technological advances

government and central bank intervention in foreign currency markets

to run a fixed exchange rate, or just a managed exchange rate, the government and/or central bank must intervene in FOREX markets to alter the supply and/or demand for their currency. types of intervention 1. foreign currency reserves. the world's reserve currency is the dollar. therefore, most central banks hold a high proportion of their foreign currency reserves in dollars. in a central bank wants to stop their exchange rate from falling they can do this by selling off some of their foreign currency reserves. the diagram dhows a country that has decided to fix its exchange rate at ER1. unfortunately, the supply of their country's currency on FOREX markets looks set to increase from S1 to S2. this could eb because foreign investors have lost confidence int eh country's economy and/or its currency, and are looking to liquidate their investments. if nothing is done, the currency peg of ER1 will break on the downside and the exchange rate will depreciate to ER2. to prevent the depreciation that would otherwise occur, the central bank will need to sell off some of its foreign currency reserves on FROEX markets in rode to increase the demand for its currency on FOREX markets from D1 to D2. if this increase in demand can be achieved, the exchange rate peg will be preserved at ER1. where do central banks get their foreign currency reserves from? some central banks ask their treasures to issue government bonds that are denominated in a foreign currency. e.g. the bank of England could ask its chancellor to issue and sell 1m government bonds. where each bond has a nominal face value of 1000 dollars. the transaction will generate a foreign currency reserve of 1m dollars. issuing government bonds in a foreign currency has its drawbacks. the main one being that the government will need to pay the interest owed to the bondholders in foreign currency. ac country could easily run out of foreign currency reserves ceased, as British national debt rises, it will become increasingly difficult to find buyers for the new dollar denominated British bonds that the government wants to issue. 2. monetary policy: interest rate changes. suppose that a pegged or fixed exchange rate is under unwanted downward pressure. to stop the fall in the exchange rate, the central bank could raise interest rates. higher interest rates will increase th return on offer for those who are prepared to save in this currency. as a result, hot money willl flow into this currency. this will increase the demand for the currency concerned on FOREX markets. the fall in the exchange rate that would have otherwise happened will have been prevented. to evaluate, explore the opportunity cost of using tight monetary policy to prop-up an exchange rate that is under pressure. using monetary policy to fix or manage an exchange rate means act monetary policy cannot be used to pruseu another macroeconomic policy objective. for example, imagine that the central bank is concerned that there is a risk of deflation in the future. to counter this risk , interest rates would have to be cut now. however, this will not be possible, if the central bank is also truing to run a pegged or fixed exchange rate that is currency of falling (need raised interest rates). in the 1990s the uk tried to run a fixed exchange rate against the Deutschmark. uk firms failed to understand the economic implications of this policy. uk firms paid wage increases that were well above productivity growth. as a result, British unit labour costs increased. higher British unit labour costs increased average costs. to persevere profit margins, British firms raised their prices. the resulting cost-push inflation managed UK international competitiveness. in a floating exchange rate environment, the pound would have depreciated, which would have restored brisith price competitiveness. unfortunately, Britain's decision to run a fixed exchange rate meant that this automatic stabiliser effect did not happen. as a result, britiain;sinternaitonla competitiveness with Germany progressively worsened. with every passing year, Britain's current account deficit with Germany increased. to stop the sterling from depreciation below its fixed exchange rate peg the bank of England was forced to tighten monetary policy. unfortunately, the increase in interest rates needed to preserve the peg led to low levels of consumption and investment, which are both components of AD. the high interest rates needed to support the pound led to a very deep recession. it was not until bank Wednesday in 1992 that the bank of England let the pound float and there was an improvement in uk international price competitiveness which enabled to the uk to embark on an export led recovery. 3. monetary policy: QE. QE desribes a process whereby the central bank creates new electronic money. the extra cash created is used by the central bank to purchase government bonds from commercial banks. QE does not directly lead to an increase int eh supply of sterling on FOREX markets. QE increases the domestic money supply. this tends to lead to higher rates of domestic inflation. this is because monetarists believe that inflation is always and everywhere a monetary phenomenon (Milton Friedman). if the money supply (M) grows faster than the national output (T) the result will be inflation. the increase in domestic inflation created by QE will cause real interest rates to fall. as a result, hot money will flow out of sterling on FOREX markets. this causes the supply of sterling on FOREX markets to increase, which in turn causes sterling to depreciate. 4. foreign currency controls- currency controls are sometimes referred to as foreign exchange controls. they can be used to manage the exchange rate because they limit the convertibility of local currency into foreign currency. some foreign currency controls can or restrict the amount of foreign currency that can be bough each year by domestic citizens. if domestic citizens are not able to buy foreign currency on FOREX markets, their ability to supply their own domestic currency on FOREX markets will be limited too. this type of foreign currency or exchange control tends to eb used when a government is trying to prevent its currency from depreciation. other countries use foreign currency controls to stop or limit the amount of domestic currency that can be bought by foreign nationals. this type of exchange control tends to be used to stop a currency from appreciating. foreign currency controls ahve been used in britain to defend the value of the pound. in 1966 the government restricted the amount of currency that British holidaymakers could take out of the country to £50 plus £15 in sterling cash. this restricted the supply of sterling on FOREX markets. exchange controls in the uK were abolished by margarate thatcher in 1979 5. capital controls. - capital controls are laws that restrict the ability of foreign nationals to either buy or sell domestic assets. china uses capital controls to stop the yuan from appreciating. by law, a foreign can only own one property in china and it has to be residential. in Argentina, the government stopped the peso from depreciating by shutting down the commercial banking system. this prevented Argentine households from withdrawing their peso savings in the hope that they could convert them into US dollars. in some cases, the government might restrict the amount of cash that each citizen is allowed to withdraw from their bank account. in recent times, this type of capital control was used in the EU by Greece. greeks thought they were going to be kicked out of the EUO- savings would be denominated in drachma- try to convert to dollars.

what is a currency war

when trading partners engage in competitive rounds of currency depreciation against each other. currency wars are fought by central banks- they use loose monetary policy to depress the value of their currencies. by cutting interest rates. lower interest rates cause hot money flows from a currency. when interest rates have been cut as far as they can, central bank turn to qe. monetarists believe that qe creates inflation. the inflation reduces real rates of interest. falling interest rates will make a currency less desirable to own, leading to renewed hot money outflows and thus a weaker currency. the qe will also reduce the real rates of return on other assets, such as shares, bonds and property. investors will most likely react by selling theses assets in order to buy assets in other countries that offer higher real rates of return. this is called capital flight,and it creates a lower exchange rate by increasing the supply of a currency on foreign exchange markets.