Economics | Exchange rates

Unit 4.5: Exchange Rates – The Price of Money

Hello Economists! Welcome to the chapter on Exchange Rates. This is a critical topic in "The Global Economy" unit because it explains how countries transact with each other. Don't worry if this seems tricky at first; an exchange rate is simply the price of one currency expressed in terms of another.

Think of it this way: If you travel from the US to Europe, you need to "buy" Euros using your Dollars. The exchange rate tells you how many Euros you get for one Dollar. This price has huge implications for trade, investment, and national economic stability!

1. Defining and Expressing Exchange Rates

1.1 What is an Exchange Rate?

The Exchange Rate (ER) is the price of one currency in terms of another currency.

• Example 1 (Direct Quotation): \(1 \text{ USD} = 0.95 \text{ EUR}\)
• Example 2 (Indirect Quotation): \(1 \text{ EUR} = 1.05 \text{ USD}\)

Key Terminology Check:

• Bilateral Exchange Rate: The rate between two specific currencies (e.g., USD/JPY).
• Effective Exchange Rate (EER) or Trade-Weighted Index: A measure of the value of a currency against a weighted average of the currencies of its major trading partners. This gives a broader, more accurate view of its overall strength.

2. Determining Floating Exchange Rates (Syllabus Focus)

When an exchange rate is floating, its value is determined purely by the market forces of demand and supply for that currency in the foreign exchange market (forex).

2.1 The Foreign Exchange Market (Forex)

In the forex market, the currency you are examining (let's use the US Dollar, USD) is the "good" being traded.

1. The Demand for a Currency (e.g., USD):
Demand comes from anyone who needs USD to pay for something denominated in USD.

• Foreigners buying US Exports (Goods and Services).
• Foreign Tourism to the US.
• Foreign Financial Investment (purchasing US stocks or bonds).
• Foreign Foreign Direct Investment (FDI) (building factories in the US).
• Speculators believing the USD will rise in value.

2. The Supply of a Currency (e.g., USD):
Supply comes from anyone who holds USD and wishes to sell them to obtain a foreign currency.

• US citizens buying Imports (Goods and Services).
• US citizens traveling Abroad.
• US citizens engaging in financial or direct investment Abroad.
• Speculators believing the USD will fall in value.

2.2 Factors that Shift Demand and Supply

A change in the exchange rate (movement along the curve) is different from a factor that shifts the entire curve (change in demand/supply).

Here are the main reasons why the Demand or Supply curves shift, thus changing the equilibrium exchange rate:

1. Changes in Demand for Exports/Imports (Trade):

• If US goods become more popular abroad (e.g., due to higher quality or lower price relative to other countries), foreign demand for US exports rises. They need more USD to buy these goods. → Demand for USD shifts Right.

2. Changes in Interest Rates (Capital Flows):

• If the US Central Bank (the Fed) raises interest rates relative to Europe, US assets (bonds, savings accounts) become more attractive. Foreign investors will move capital into the US to earn higher returns. They must first convert their currency into USD. → Demand for USD shifts Right.

3. Inflation Rates (Purchasing Power):

• If US inflation is higher than Europe's, US goods become relatively more expensive. US citizens will buy more imports (increasing the Supply of USD) and foreigners will buy fewer US exports (decreasing the Demand for USD). → Supply shifts Right, Demand shifts Left.

4. Speculation:

• If speculators believe the USD is about to strengthen (appreciate), they will buy USD now to sell later for profit. → Demand for USD shifts Right. Speculation is often the fastest and most volatile factor.

3. Appreciation and Depreciation

A change in the floating exchange rate is referred to as appreciation or depreciation.

3.1 Defining Appreciation and Depreciation

• Appreciation: An increase in the value of a currency relative to others under a floating exchange rate system.

  Example: If the rate changes from \(1 \text{ USD} = 0.90 \text{ EUR}\) to \(1 \text{ USD} = 1.00 \text{ EUR}\), the USD has appreciated. One dollar now buys more foreign currency.

• Depreciation: A decrease in the value of a currency relative to others under a floating exchange rate system.

  Example: If the rate changes from \(1 \text{ USD} = 1.00 \text{ EUR}\) to \(1 \text{ USD} = 0.90 \text{ EUR}\), the USD has depreciated. One dollar now buys less foreign currency.

Memory Aid: If your currency appreciates, you feel richer when you travel abroad because your money goes further!

4. Exchange Rate Systems

Not all currencies float freely. Governments and central banks often choose different methods to manage their currency's value.

4.1 Floating Exchange Rate System

As discussed above, the value is determined entirely by market S&D forces.

Advantages:

• Automatic Adjustment: If a country runs a persistent trade deficit (Imports > Exports), its currency automatically depreciates, making its exports cheaper and imports dearer, thus correcting the imbalance.
• Monetary Policy Independence: The central bank is free to set interest rates to control domestic inflation or unemployment, without worrying about stabilizing the exchange rate.

Disadvantages:

• Volatility/Uncertainty: Daily fluctuations make planning difficult for firms engaging in international trade or investment, potentially discouraging FDI.

4.2 Fixed Exchange Rate System

The government or central bank sets a specific official rate (the "peg") and promises to maintain it.

Maintaining the Peg:

If market demand for the currency falls, the central bank must intervene to prevent depreciation.

• Buying its own currency: The central bank uses its foreign currency reserves (e.g., USD, EUR) to buy up its own currency in the forex market, increasing demand back to the target level.
• Raising Interest Rates: This attracts capital flows, increasing market demand for the currency. (However, this can conflict with domestic goals, like fighting a recession).

Key Fixed System Terms:

• Devaluation: A deliberate lowering of the official fixed rate by the government/central bank. (Similar effect to depreciation, but intentional).
• Revaluation: A deliberate raising of the official fixed rate by the government/central bank. (Similar effect to appreciation, but intentional).

Advantages of Fixed Rates:

• Certainty and Stability: Removes exchange rate risk, encouraging long-term trade and investment.
• Reduced Speculation: Since the rate is guaranteed, speculation is less likely (unless the peg is clearly unsustainable).

Disadvantages of Fixed Rates:

• Need for Reserves: Requires the central bank to hold large amounts of foreign currency reserves to intervene frequently.
• Loss of Policy Independence: Monetary policy must be aimed at maintaining the peg, sacrificing domestic goals (like fighting inflation or unemployment).

4.3 Managed Exchange Rate System (Managed Float)

This is the most common system. It is essentially a floating rate where the central bank occasionally intervenes (e.g., buys or sells currency, or changes interest rates) to prevent sudden, undesirable fluctuations that could hurt the economy.

Did you know? Many major global currencies, including the USD, EUR, and JPY, operate under a managed float system. Governments generally accept market determination but reserve the right to stabilize markets during crises (hence the nickname "Dirty Float").

5. Impacts of Exchange Rate Changes

Changes in the exchange rate have profound effects on the domestic economy, particularly on trade and inflation.

5.1 Impact of an Appreciation (A Stronger Currency)

When a currency appreciates, it becomes more expensive for foreigners and cheaper for locals.

• Impact on Exports (X): Foreign buyers need more of their currency to buy our goods. Our exports become relatively more expensive. → X falls.
• Impact on Imports (M): Local buyers need less of our currency to buy foreign goods. Imports become relatively cheaper. → M rises.
• Trade Balance (X-M): Usually worsens (moves toward a deficit).
• Inflation: Reduced. Cheaper imports reduce the cost of imported raw materials and final consumer goods (less imported inflation).
• FDI: Can decrease, as it is more expensive for foreigners to buy assets (factories, land) in the appreciating country.

Memory Aid: SPICED (for a Strong Pound, Imports Cheap, Exports Dear)

5.2 Impact of a Depreciation (A Weaker Currency)

When a currency depreciates, it becomes cheaper for foreigners and more expensive for locals.

• Impact on Exports (X): Our goods are cheaper for foreigners. → X rises.
• Impact on Imports (M): Foreign goods are more expensive for locals. → M falls.
• Trade Balance (X-M): Usually improves (moves toward a surplus). This is a policy goal for many countries trying to boost aggregate demand.
• Inflation: Increased. More expensive imports raise costs for producers (cost-push inflation) and raise prices for consumers (imported inflation).
• FDI: Can increase, as it is cheaper for foreigners to buy assets in the depreciating country.

5.3 The Marshall-Lerner Condition and the J-Curve Effect (HL Extension)

Don't worry if this seems tricky at first—this concept is critical for higher-level analysis!

We assume that a depreciation improves the trade balance (X-M). But does it? This depends entirely on the price elasticity of demand (PED) for imports and exports.

The Marshall-Lerner Condition (MLC):
A currency depreciation (or devaluation) will improve the trade balance ONLY IF the sum of the Price Elasticities of Demand for exports (\(PED_X\)) and the Price Elasticities of Demand for imports (\(PED_M\)) is greater than 1.
$$|PED_X| + |PED_M| > 1$$

The J-Curve Effect:
The J-Curve effect shows that immediately following a depreciation, the trade balance often worsens before it eventually improves.

1. Short Run (The Vertical Stick of the J): In the immediate short run, PED for both exports and imports is likely to be inelastic (people are locked into contracts, orders are already placed). Prices change first, but volumes haven't responded yet. Since imports are now more expensive, the total value of imports rises, making the deficit worse.
2. Long Run (The Sweep of the J): Over time (6-18 months), consumers and firms adjust. They switch to cheaper domestically produced goods (Imports fall) and foreigners increase their orders of the now-cheaper exports. PED becomes elastic, the MLC holds, and the trade balance improves dramatically.

The visual graph of the trade balance over time looks like the letter 'J'.