3.2. Exchange Rates

Exchange rates

In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another.

Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous.

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in terms of another currency. For example, an inter-bank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91.

Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today, but for delivery and payment on a specific future date.

The three major types of exchange rate systems are the float, the fixed rate, and the pegged float (managed).

One of the key economic decisions a nation must make is how it will value its currency in comparison to other currencies. An exchange rate regime is how a nation manages its currency in the foreign exchange market. An exchange rate regime is closely related to that country's monetary policy. There are three basic types of exchange regimes: floating exchange, fixed exchange, and pegged float exchange.

The Floating Exchange Rate

A floating exchange rate, or fluctuating exchange rate, is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. The dollar is an example of a floating currency.

Many economists believe floating exchange rates are the best possible exchange rate regime because these regimes automatically adjust to economic circumstances. These regimes enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism.

The Fixed Exchange Rate

A fixed exchange rate system, or pegged exchange rate system, is a currency system in which governments try to maintain a currency value that is constant against a specific currency or good. In a fixed exchange-rate system, a country's government decides the worth of its currency in terms of either a fixed weight of an asset, another currency, or a basket of other currencies. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price.

To ensure that a currency will maintain its "pegged" value, the country's central bank maintain reserves of foreign currencies and gold. They can sell these reserves in order to intervene in the foreign exchange market to make up excess demand or take up excess supply of the country's currency.

The most famous fixed rate system is the gold standard, where a unit of currency is pegged to a specific measure of gold. Regimes also peg to other currencies. These countries can either choose a single currency to peg to, or a "basket" consisting of the currencies of the country's major trading partners.

The Pegged Float Exchange Rate (Managed)

Pegged floating currencies are pegged to some band or value, which is either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes. There are three types of pegged float regimes:

§ Crawling bands: The market value of a national currency is permitted to fluctuate within a range specified by a band of fluctuation. This band is determined by international agreements or by unilateral decision by a central bank. The bands are adjusted periodically by the country's central bank. Generally the bands are adjusted in response to economic circumstances and indicators.

§ Crawling pegs: A crawling peg is an exchange rate regime, usually seen as a part of fixed exchange rate regimes, that allows gradual depreciation or appreciation in an exchange rate. The system is a method to fully utilize the peg under the fixed exchange regimes, as well as the flexibility under the floating exchange rate regime. The system is designed to peg at a certain value but, at the same time, to "glide" in response to external market uncertainties. In dealing with external pressure to appreciate or depreciate the exchange rate (such as interest rate differentials or changes in foreign exchange reserves), the system can meet frequent but moderate exchange rate changes to ensure that the economic dislocation is minimized.

§ Pegged with horizontal bands: This system is similar to crawling bands, but the currency is allowed to fluctuate within a larger band of greater than one percent of the currency's value.

Source: https://www.boundless.com/economics/textbooks/boundless-economics-textbook/open-economy-macroeconomics-32/exchange-rates-130/exchange-rate-systems-518-12614/

Summary of advantages of strong currency

1. Cheaper imports for consumers: A high pound leads to lower import prices – this boosts the real living standards of consumers at least in the short run – for example an increase in the real purchasing power of UK residents when travelling overseas or the chance to buy cheaper computers from the United States or Europe.

2. Lower production costs for producers: When the sterling exchange rate is high, it is cheaper to import essential raw materials, component parts and capital inputs such as plant and equipment – this is good news for businesses that rely on imported components or who are wishing to increase their investment of new technology from overseas countries. A fall in import prices has the effect of causing an outward shift in the short run aggregate supply curve. And if a country can now import more productive technology, the long-run aggregate supply curve may shift outwards as well.

3. Lower inflation: A strong exchange rate helps to control the rate inflation because domestic suppliers now face stiffer international competition from cheaper imports and will look to cut their costs accordingly. Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of consumer price inflation.

4. If inflation is lower, then interest rates will be lower than if the exchange rate was weaker – and cheaper money will stimulate higher consumer spending and capital spending.

Disadvantages of a strong currency

1. Increase in the trade deficit: The lower price of imports leads to consumers increasing their demand and this can cause a larger trade deficit. Exporters lose price competitiveness (because they will find it more expensive to sell in foreign markets) and face losing market share – this can damage profits and employment in some sectors. For example the high exchange rate had damaged employment in Britain in sectors such as textiles and clothing, car manufacturing and semi-conductor production as production has shifted away from the UK towards countries with lower production costs

2. Slower economic growth: If exports fall, this causes a reduction in aggregate demand and reduces the short-term rate economic growth as measured by the % change in real GDP. This affects some regions of the UK economy more than others. In the North-East for example, manufacturing industry accounts for over 28% of regional GDP whereas the percentage for the UK as a whole is just 19%. So a strong exchange rate may threaten output, employment living standards more in some regions than others.

3. If exports fall, then so will business confidence and capital investment – because investment is partly dependent on the strength of demand

4. Understand that a strong currency is not always seen as a positive for a particular economy (case of Dutch Disease) - https://www.investopedia.com/terms/d/dutchdisease.asp

Managed exchange rate regimes

Managed float regimes are where exchange rates fluctuate, but central banks attempt to influence the exchange rates by buying and selling currencies.

Managed float regimes, otherwise known as dirty floats, are where exchange rates fluctuate from day to day and central banks attempt to influence their countries' exchange rates by buying and selling currencies. Almost all currencies are managed since central banks or governments intervene to influence the value of their currencies. So when a country claims to have a floating currency, it most likely exists as a managed float.

How a Managed Float Exchange Rate works

Generally, the central bank will set a range, which its currency's value may freely float between. If the currency drops below the range's floor or grows beyond the range's ceiling, the central bank takes action to bring the currency's value back within range.

Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance. For example, if a currency is valued above its range, the central bank will sell some of its currency it has in reserve. By putting more of its currency in circulation, the central bank will decrease the currency's value.

Why Do Countries Choose a Managed Float?

Some economists believe that in most circumstances floating exchange rates are preferable to fixed exchange rates. Floating exchange rates automatically adjust to economic circumstances and allow a country to dampen the impact of shocks and foreign business cycles. This ultimately preempts the possibility of having a balance of payments crisis. A floating exchange rate also allows the country's monetary policy to be freed up to pursue other goals, such as stabilizing the country's employment or prices.

However, pure floating exchange rates pose some threats. A floating exchange rate is not as stable as a fixed exchange rate. If a currency floats, there could be rapid appreciation or depreciation of value. This could harm the country's imports and exports. If the currency's value increases too drastically, the country's exports could become too costly which would harm the country's employment rates. If the currency's value decreases too drastically, the country may not be able to afford crucial imports.

This is why a managed float is so appealing. A country can obtain the benefits of a free-floating system but still has the option to intervene and minimize the risks associated with a free floating currency. If a currency's value increases or decreases too rapidly, the central bank can intervene and minimize any harmful effects that might result from the radical fluctuation.

Source: Boundless. “Managed Float.” Boundless Economics. Boundless, 21 Jul. 2015. Retrieved 18 Sep. 2015 from https://www.boundless.com/economics/textbooks/boundless-economics-textbook/open-economy-macroeconomics-32/exchange-rates-130/managed-float-520-12616/

• Task 11: Do you notice a relationship between movements in the SDG:HKD exchange rate and SGD:USD exchange rate?

Task 12: What would be the implications of this relationship for the type of exchange rate regime Singapore uses?

See http://www.singapore-window.org/sw05/050723ft.htm

& http://www.economist.com/news/finance-and-economics/21599399-lessons-chinas-currency-regime-singapore-charm-bbc

Government Intervention

A fixed exchange rate system does not imply that the rate will stay at that same level all the time. The government may decide to change the rate because of adverse effects on the economy. For example, if the currency is overvalued exporting industries will become less internationally competitive, affecting international trade and the balance of payments and the government might take action to devalue the exchange rate.

Devaluation and Revaluation

• A devaluation of a currency occurs under a fixed exchange rate system when there is deliberate action taken by a government to decrease its value in the FOREX market.
• Alternatively, a revaluation occurs under a fixed exchange rate system when there is deliberate action taken by the government to increase the value of the currency in the FOREX market.

Question on pegged exchange rates

Suppose a nation’s central bank is committed to holding the value of its currency, the peso, at US$2 per peso. Suppose further that holders of the peso fear that its value is about to fall and begin selling pesos to purchase U.S. dollars. What will happen in the market for pesos? Explain your answer carefully, and illustrate it using a demand and supply graph for the market for pesos. What action will the nation’s central bank take? Use your graph to show the result of the central bank’s action. Why might this action fuel concern among holders of the pesos about its future prospects? What difficulties will this create for the nation’s central bank?

Task 10: What are the implications for a country's monetary policy if it pegs its currency to another currency or basket of currencies - case of Hong Kong

Purchasing Power Parity (PPP) – a method of determining the over/under valuation of a currency

Purchasing power parities (PPPs) are the rates of currency conversion that equalise the purchasing power of different currencies by eliminating the differences in price levels between countries. In their simplest form, PPPs show the ratio of prices in national currencies of the same good or service in different countries (https://data.oecd.org/conversion/purchasing-power-parities-ppp.htm#indicator-chart)

Consequences of overvalued and undervalued currency

‘In IB Economics we’re studying the theory of exchange rates. A floating exchange rate system should be in equilibrium when the rate enables people in different countries to buy the same basket of goods with an equal amount of money. In other words, If I walk into McDonalds in the US and have to pay $3.00 for a Big Mac, then board a plane, land in Shanghai and walk into a McDonalds there, the price I pay in Shanghai should, given current exchange rates, be the same as what I paid in the US. In reality, a Big Mac in Shanghai costs about 56% less than one in the US. This tells economists something about the value of the Chinese RMB.

If the price of a particular basket of goods for Americans is higher than the same basket of goods for Chinese given current exchange rates, than that would be a sign that the Chinese currency is undervalued. In the long run, “exchange rates should move towards levels that would equalise the prices of an identical basket of goods and services bought in either of the two countries whose exchange rates are being compared.” This concept is known as Purchasing Power Parity (PPP).

One way to test the level of undervaluation of the yuan is to apply the principle of PPP. If we could compare the price of a particular basket of goods (or even ONE good that can be bought in both countries), then we can determine whether at current exchange rates the RMB is under or over-valued. Luckily, the Economist magazine has developed its own measure of PPP, and it’s chosen one product that can be purchased in nearly every country in the world, the BIG MAC!

Current Burgeronomics - https://www.economist.com/news/2018/07/11/the-big-mac-index

The index is supposed to give a guide to the direction in which currencies should, in theory, head in the long run It is only a rough guide, because its price reflects non-tradable elements—such as rent and labour. For that reason, it is probably least rough when comparing countries at roughly the same stage of development. [http://welkerswikinomics.com/blog/2007/11/06/burgernomics-and-the-purchasing-power-parity/accessed Sunday October 4^th 2015]

Overvalued Currency

Advantages

1. Downward pressure on inflation i.e. imported goods will be cheaper

2. More imports can be bought

3. High value of currency forces domestic producers to improve their efficiency to be more competitive in the international market.

Disadvantages

1. Overvalued currency will make exports uncompetitive in the international market, which will hurt the export industries

2. Imports are relatively cheaper to buy due to overvalued currency. Consumers will go in for more imports, which will damage to domestic industries

Undervalued currency

Advantages

1. If currency is undervalued, the exports will be cheaper and they will grow leading to greater employment in export industries

2. Undervalued currency will make imports expensive for consumers, they will divert to domestic goods and thus employment in domestic industries will increase.

Disadvantages

1. An undervalued currency makes imports expensive which also leads to Imported inflation i.e. all the products using imported components/raw material will become expensive thus effecting the general price level.

Source: http://www.dineshbakshi.com/ib-economics/international-economics/157-revision-notes/2088-consequences-of-overvalued-and-undervalued-currencies, accessed Friday September 18 2015

Evaluation of fixed and floating exchange rates

The case for floating exchange rates

1. Reduced need for currency reserves: There is no exchange rate target so there is little requirement for the central bank (e.g. the Bank of England) to hold large scale reserves of gold and foreign currency to use in possible official intervention in the markets

2. Useful instrument of macroeconomic adjustment: A floating rate can act as a useful tool of macroeconomic adjustment – for example a depreciation should provide a boost to net export demand and therefore stimulate growth. This assumes that the gains from a lower exchange rate are not dissolved in higher wage claims or export prices. The countries inside the Euro Zone for example might be hoping for a more competitive exchange rate as a means of creating an injection of demand into their slow-growing economies.

3. Partial automatic correction for a trade deficit: Floating exchange rates offer a degree of adjustment when the balance of payments is in fundamental disequilibrium – i.e. a large trade deficit puts downward pressure on the exchange rate which should help the export sector and control demand for imports because they become relatively expensive.

4. Reduced risk of currency speculation: The absence of an explicit exchange rate target reduces the risk of currency speculation. Often, currency market speculators target an exchange rate target that they believe to be fundamentally over or undervalued.

5. Freedom (autonomy) for domestic monetary policy: The absence of an exchange rate target allows short term interest rates to be set to meet domestic macroeconomic objectives such as stabilizing growth or controlling inflation. The Bank of England has enjoyed the autonomy that a floating exchange rate gives since it was made independent in May 1997.

6. Floating exchange rates are not always volatile exchange rates - although the sterling exchange rate has been floating, the volatility has not been that great. Businesses have learnt to cope with modest fluctuations – helped by having a flexible labour market.

The case for fixed exchange rates

1. Trade and Investment: Currency stability can help to promote trade and investment because of lower currency risk

2. Some flexibility permitted: Some adjustment to the fixed currency parity is possible if the economic case becomes unstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement can be reached with other countries). That said, countries with fixed exchange rates are often reluctant to make parity adjustments – these decisions are often see as politically damaging.

3. Reductions in the costs of currency hedging: Because we can never predict what will happen to the market value of a currency, many businesses hedge against this volatility by buying the currency they need in the forward currency markets. With fixed exchange rates, businesses have to spend less on currency hedging if they know that the currency will hold its value in the foreign exchange markets (hedging involves risk)

4. Disciplines on domestic producers: A stable (fixed) currency acts as a discipline on producers to keep their costs and prices down and may lead to greater pressure for exporters to raise labour productivity and focus more resources on research and innovation. In the long run, with a fixed exchange rate, one country’s inflation must fall into line with another (and thus put substantial competitive pressures on prices and real wages)

5. Reinforcing gains in comparative advantage: If one country has a fixed exchange rate with another, then differences in relative unit labour costs will quite easily be reflected in changes in the rate of growth of exports and imports. Consider the example of China and the United States. Most estimates indicate that the Chinese currency is undervalued against the dollar. This makes Chinese products cheaper than they would otherwise be and has led to a surge in import penetration from China into the US economy. This has led to numerous calls from US manufacturers for the Chinese to be persuaded to switch to a floating exchange rate or to adjust their currency by appreciating against the dollar. China recently announced that they would allow more market forces to determine the value of the Yuan.

Exchange rates and mathematical calculations (HL only)

Calculating the value of one currency in terms of another currency.

You may be asked to make various calculations relating to exchange rates and changes in exchange rates:

E.g. The US dollar is currently trading against the Euro at a rate of US$1 = €0.8. What is the rate for €1 in US$?

To change an exchange rate around, we simply take the reciprocal of the existing rate.

So, if US$1 = €0.8, then €1 = US$1.25 (1/0.8)

The table below shows the value of the Euro against five other currencies. Fill in column 3 to express the value of one unit of each of the currencies in Euros.

Plotting demand and supply curves for a currency from linear functions and identifying the equilibrium exchange rate.

You may be asked to identify the equilibrium exchange rate using linear demand and supply functions. This is no different from finding the equilibrium price in a demand and supply question.

Example

Country X has a currency known as the “Pesho‟. The country is involved in international trade and the Pesho is a 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 – 400E

QS = -400 + 400E

Where E is the exchange rate of the Pesho in terms of the US dollar

Structure to follow

Make a table to show the demand schedule and supply schedule for the Pesho, when exchange rates are $0, $1, $2, $3, $4 and $5.

Using the axes above:

ii. Draw a diagram to show the demand curve and supply curves that represent the demand and supply schedules that you have made.

iii. Illustrate the exchange rate.

iv. Using simultaneous equations, calculate the exchange rate.

Now let us assume that the demand function for the Pesho changes to:

QD = 3600 – 400P

v. Explain two factors that might have caused the change in the demand function.

vi. Make a new table to show the demand schedule for the new demand function, when exchange rates are $0, $1, $2, $3, $4 and $5.

vii. Add the demand curve that represents the new schedule to the diagram that you drew in 2.

viii. Illustrate the new equilibrium exchange rate.

ix. Explain the likely effect that the change in the exchange rate will have upon the demand for exports and imports in Country X.

Calculating the price of a good in different currencies, using exchange rates.

You may be asked to make various calculations relating to exchange rates and the prices of goods in different countries:

E.g.

i. If US$1 = €0.8, what would be the cost in Euros of a good that was selling for US$75?

If a good is selling for US$75, then its cost in Euros will be 75 x €0.8 = €60.

ii. If the exchange rate changes from US$1 = €0.8 to US$1 = €0.9, explain what would happen to the Euro price of an American-manufactured dress shirt that was being exported to Europe from the USA at a cost of US$150.

With the original exchange rate of US$1 = €0.8, the dress shirt would cost €120 (150 x €0.8). With the new exchange rate, the value of the Euro has depreciated. It now costs more Euros to buy the same amount of dollars, and so the price of the dress shirt increases to €135 (150 x €0.9).

Question 1

The table below shows the exchange rate between the Euro and five other currencies:

If a large beer costs €4 in Vienna, then what would be the cost in each of the currencies above?

Question 2

The table below shows the exchange rate between the Euro and five other currencies at an interval of 6 months:

For each of the currencies above:

i. Calculate the cost of a €25 phone card in each time period – January and July.

ii. Using figures, explain whether the Euro has got weaker or stronger against the currency.