Exchange Rates

Exchange rates are a fundamental concept in international economics, influencing the flow of goods, services, capital, and investment across borders. For students of Economics, a robust understanding of exchange rate systems and their economic implications is essential for interpreting real-world events and policy decisions.

Exchange Rate Systems

Exchange rate systems refer to the method by which a country manages its currency in relation to others. The three main types are floating, fixed, and managed exchange rate systems.

Floating Exchange Rate System

A floating exchange rate system exists where the value of a currency is determined by market forces – specifically the supply of and demand for that currency in the foreign exchange market. There is no official intervention, and rates can fluctuate freely. Most major economies today, such as the United States and the United Kingdom, operate floating exchange rates.

• Advantages: The system automatically adjusts to economic shocks, allowing currencies to reflect changes in competitiveness and economic conditions.
• Disadvantages: It can lead to volatility, which may create uncertainty for businesses, especially those involved in international trade.

Fixed Exchange Rate System

A fixed exchange rate system is one in which a currency’s value is pegged to another currency, a basket of currencies, or a commodity such as gold. The government or central bank intervenes in the foreign exchange market to maintain the currency’s value at the fixed rate.

• Advantages: Offers stability and predictability for traders and investors, potentially reducing inflationary pressures.
• Disadvantages: Requires large reserves of foreign currency, and the system can be vulnerable to speculative attacks if the fixed rate is perceived as unsustainable.

Managed (Dirty Float) Exchange Rate System

A managed exchange rate system, sometimes called a ‘dirty float’, involves a currency primarily determined by market forces but with periodic intervention by the central bank to stabilise or influence its value. For example, the Chinese yuan operates under a managed float.

• Advantages: Offers a compromise between stability and flexibility, allowing the government to intervene in times of volatility.
• Disadvantages: May lack transparency and could be subject to political manipulation.

Distinction between Revaluation and Appreciation of a Currency

Appreciation refers to an increase in the value of a currency in a floating exchange rate system, driven by market forces such as higher demand for the currency due to increased exports or inward investment.

Revaluation is the deliberate upward adjustment of the value of a currency by the government or central bank in a fixed or managed exchange rate system. This is a policy decision rather than a market-driven movement.

• Example: If the British pound appreciates against the euro because of strong UK exports, this is appreciation. If the Bank of England formally raises the pound’s pegged exchange rate, this is revaluation.

Distinction between Devaluation and Depreciation of a Currency

Depreciation is a decrease in the value of a currency under a floating exchange rate system caused by market forces, such as reduced demand for the currency.

Devaluation is the deliberate downward adjustment of a currency’s value in a fixed or managed system, typically made by the government or central bank.

• Example: If the Japanese yen falls in value due to lower foreign demand for Japanese goods, that is depreciation. If the government lowers the official pegged rate, that is devaluation.

Factors Influencing Floating Exchange Rates

Floating exchange rates fluctuate due to a variety of factors:

• Interest Rates: Higher interest rates attract foreign capital, increasing demand for the currency and causing appreciation.
• Inflation Rates: Lower inflation typically boosts currency value, as purchasing power is maintained.
• Economic Growth: Strong growth may lead to increased demand for the currency as investors seek opportunities.
• Current Account Balance: A surplus (exports > imports) increases demand for the currency.
• Speculation: Expectations of future appreciation or depreciation can drive short-term demand or supply.
• Political Stability: Stable governments attract investment and support currency strength.
• Central Bank Interventions: Even in a floating system, occasional interventions can influence rates.

Government Intervention in Currency Markets

Governments and central banks may intervene in currency markets to influence exchange rates for economic stability, competitiveness, or inflation control.

Foreign Currency Transactions

Authorities can buy or sell their own currency or foreign currencies to affect supply and demand, thereby influencing the exchange rate.

• Example: If a central bank sells its own currency, its value may fall (depreciate).

Use of Interest Rates

Adjusting interest rates can indirectly influence exchange rates by attracting or discouraging capital flows.

• Example: Raising interest rates may attract foreign investors, increasing demand for the currency and leading to appreciation.

Competitive Devaluation/Depreciation and Its Consequences

Competitive devaluation or depreciation occurs when countries intentionally reduce the value of their currency to gain trade advantages, often referred to as ‘beggar-thy-neighbour’ policies.

• Consequences:
• Boosts exports by making domestic goods cheaper for foreign buyers.
• May provoke retaliatory actions and trade disputes.
• Can lead to imported inflation, harming consumers.
• Risk of instability in the global financial system.

Impact of Changes in Exchange Rates

Exchange rate movements can have wide-reaching effects on various aspects of the economy:

The Current Account of the Balance of Payments

A depreciation may improve a country’s current account by making exports cheaper and imports more expensive, provided demand is price elastic. The Marshall-Lerner condition states that a depreciation will improve the current account if the sum of the price elasticities of exports and imports exceeds one.

The J curve effect describes how, in the short term, a depreciation might worsen the current account because contracts and habits are slow to adjust, but in the long run, the current account improves as demand responds.

Economic Growth and Employment/Unemployment

• Depreciation may stimulate economic growth by boosting exports, leading to increased employment.
• However, it can also raise input costs for businesses reliant on imports, potentially causing layoffs in those sectors.

Rate of Inflation

• Depreciation can make imported goods more expensive, contributing to cost-push inflation.
• Appreciation, on the other hand, may reduce inflation by lowering the cost of imports.

Foreign Direct Investment (FDI) Flows

• A depreciated currency may attract FDI as assets become cheaper for foreign investors.
• However, volatile exchange rates may deter investment due to increased risk.
• Stable currencies are generally more attractive for long-term foreign investment.

Summary

The complexities of exchange rate systems and their economic consequences are central to international economics. For Economics students, understanding these mechanisms is vital for analysing policies, interpreting global trends, and evaluating government interventions. Whether considering the impact on inflation, employment, investment, or trade balances, exchange rates permeate the global economic landscape, shaping the fortunes of nations and their citizens.