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Exchange Rates

Floating Exchange Rate
Under a floating exchange rate the value of the currency is determined by the markets and is hence governed by demand and supply. Individuals, firms and central banks buy and sell currency on a daily basis, if demand is high for a currency then the price (in terms of another currency) will rise and the currency is said to be strong. On the other hand if the supply of the currency is high (lots of people selling) then the currency will fall and will be considered weak. A strong currency makes imports cheap (and hence more goods are likely to be imported) whereas a weak currency generally makes exports more competitive and hence increases the volume exported.

We can see a demand-supply graph for the currency to the left, the intersect of the demand and supply curves is the equilibrium exchange rate. The demand curve is downward sloping because if the £ is weak then British goods and services are relatively cheap and so demand is high, conversely if the £ is strong then British goods and services are relatively expensive and so demand is low. The supply curve is upward sloping as if the pound is strong then the supply will be strong as British residents can buy more of a foreign currency for their £ and hence will buy foreign goods, services and assets, supplying £s in order to buy the foreign currency. Conversely if the £ is weak then foreign goods will be more expensive and so fewer £s will be supplied in order to purchase foreign currency.

If the exchange rate is in equilibrium (which it will of course be if the exchange rate is floating, where the supply of £s meets the demand)then the components of the balance of payments will balance. Demand and supply can shift as a result of perceived competitiveness or speculation.

In the long run the value of the currency is determined by the performance and competitiveness of the economy, however in the short run the exchange rate can fluctuate greatly. This is mainly due to the flow of hot money (which can flow freely as a result of the abolition of capital controls) whereby foreign investors send their money across the Globe in order to earn interest and make money, as this represents such a large proportion of the demand and supply of a currency it considerably affects the rate of exchange.

An advantage of a floating exchange rate is that it automatically adjusts to ensure that the balance of payments is balanced. It also allows the central bank/government to focus on domestic economic policy and allows it to set interest rates for this purpose as oppose to maintaining an exchange rate.

Fixed Exchange Rate
Under a fixed exchange rate a countries currency is fixed/pegged against another (normally the dollar due to its prominence) and the central bank is committed to keeping this rate. Occasionally the value at which the currency is fixed at can be changed in order to re-calibrate the rate if it seen to be out-of-line. Since 1992 Britain has maintained a floating exchange rate, however prior to this we fixed our exchange rate against other currencies. Between 1950-1967 Sterling was set at $2.80, this was changed in ’67 to reflect changes in competitiveness.
Under a fixed exchange rate regime the rate is set by the government, and this may not correspond with the equilibrium. As this is unlikely to be the equilibrium then there may be excess demand or supply for this currency, in order for the balance of payments to balance (if there is excess supply of a currency it is because residents are purchasing foreign goods, if there is excess demand it is is because foreign residents are trying to purchase from the country) the government/central bank has to intervene. Intervention can take place by either selling or buying foreign exchange reserves. If there was excess supply of a currency (because residents wanted to purchase foreign currency) then the central bank would intervene by selling reserves and purchasing the domestic currency. 
Exchange rate stability is achieved but this is at the cost of domestic stability. A fixed exchange rate also allows importers and exporters to plan for the future for effectively, however the fixed exchange rate can still change over time (although not on regular basis).
Semi-Fixed Exchange Rate
A semi-fixed exchange rate is when an exchange rate has a target by the government but is permitted to fluctuate within a certain band. Exchange rate stability still takes priority over domestic economic stability and the central bank may intervene, manipulating foreign exchange reserves in order to ensure that the currency remains within the permitted bands.
Demand and Supply for a Currency
Demand for a currency is derived from the desire of foreigners for exports, foreign investment flows into the UK (FDI and hot money), speculation and official purchasing by the central banks of nations. An outward shift in the demand for a currency will cause it to appreciate.
Supply for a currency is derived from the design for imports, investment flows out of the UK (to countries with better rates of return), the domestic central bank activity and speculation. 
Interest rates – have a large effect on exchange rates due to the flow of hot money looking for decent returns. Higher interest rates are likely to lead to an appreciation (rightward shift in demand) of the currency. Conversely a fall in rates is likely to lead to a leftward shift in demand for a currency. In the short run interest rates can be used by central banks to maintain a fixed exchange rate regime.
Economic Growth – the exchange rate is likely to alter in response to growth in the country. If a coutnry is growing quickly then investors and firms may wish to ‘get a slice of the action’ and invest in the country. If a country is creating economic growth through exporting then its currency will fall.
Inflation – is likely to lead to a fall in the exchange rate, this is because inflation makes a country less competitive on the World stage. Inflation makes demand for exports fall whilst demand for imports rises, this leads to a fall in the exchange rate which can make a country more competitive.
Long Term Prospects– countries which have good look term prospects and have a solid base for economic growth are likely to have higher exchange rates. 
Speculation – Speculation now contributes a large part in the fluctuations of the rate of exchange. Factors such as political stability, future expectations, commodity prices and the global economic cycle all contribute to changes in demand and supply for a currency.
Exchange Rate Stability or Domestic Economic Stability
It is impossible for the central bank/government to maintain both exchange rate stability and domestic economic control simultaneously. If the central bank wants to control exchange rates it does so at the expense of being able to control aggregate demand, conversely if it wants to control aggregate demand it must let the exchange rate float. The rationale behind this will now be explained.
The graph to the left shows the equilibrium exchange rate (intersect of demand and supply) and the exchange rate the government wishes for; e1. If the central bank was to focus on maintaining e1 then it would have to either cause a shift in demand for Sterling or sell foreign reserves to quench the excess supply of Sterling. This selling of foreign reserves cannot go on indefinitely as they are a finite reserve, therefore the central bank would be wise to try and cause a rightward shift in demand for Sterling. One way in which it could do this is by raising interest rates in the UK. There would be increased demand for Sterling as hot money would be flowing into the country to take advantage of these high interest rates (providing they are higher than in other countries). This could result in the demand curve shifting rightwards to D2. This therefore means that the central bank has achieved an exchange rate of e1 and it doesn't have to sell foreign reserves to maintain this. However by raising interest rates aggregate demand will fall as consumers will look to save money rather than spend it and they find it more expensive to borrow, similarly businesses may make a higher return saving there money than investing it and they will also find it more expensive to borrow. Therefore by maintaining an exchange rate of e1 the central bank has led to a fall in aggregate demand which may result in lower GDP.
If we look at it from the angle of the central bank trying to control aggregate demand we come to the same conclusion. In order to boost AD and the economy the central bank may lower interest rates, this shifts demand for the currency leftwards (as less hot money will be flowing in). Therefore if it wanted to maintain e1 it would have to sell foreign reserves, eventually it would run out and the exchange rate would fall back to its market equilibrium point. Therefore if a central bank wants to be able to control aggregate demand it must have a floating exchange rate.
The reason a government/central bank would conduct a devaluation is to improve competitiveness. A devaluation causes the currency to depreciate; that is fall in value, therefore exports should become more competitive for foreign consumers and imports more expensive. We would therefore assume that demand for exports would rise and demand for imports would fall, ceteris paribus. However this all depends on the elasticities of demand for imports and exports.
There is also the case that a devaluation wont improve the balance of payments if the elasticity of supply of exports is inelastic. The elasticity of supply for exports is dependent on a few things; mainly the availability of spare capacity. If there is not enough spare capacity (factories, labour and other resources) then suppliers wont be able to increase production to meet the increase in demand for exports and there wont be an increase (or a very large on) in exports. Similarly there may be large time lags before production can be increased. Also if elasticity of supply is inelastic then there may not be sufficient supply to produce import substitutes, if domestic producers cant manufacture the goods and services that were previously imported then consumers will have to continue to purchase these goods from abroad. This would mean that the value imported wouldn't fall, instead inflation would rise as a result of this devaluation (which makes imports more expensive).
The change in the surplus on the current account will therefore worsen in the short run after a devaluation (because of these inelasticities and time lags) but in the long run should lead to an improvement or even a surplus. This is known as the J-curve effect and is shown on the graph. The devaluation occurs at T1 which pushes the current account into a further deficit, after a period of time domestic firms can expand their output in order to meet the demand for exports and so the current account can move into surplus at time T2.
A devaluation may not lead to an improvement in the current account if demand for exports is price inelastic. This means that the demand for imports isn't affected by changes in price, and therefore a devaluation wouldn’t lead to a large change in demand for exports. The Marshall Lerner condition states that a devaluation will have a positive effect on the current account only if the sum of the elasticities of demand for exports and imports is less than negative 1 (if you ignore the negative then the condition is fulfilled if the constant is greater than 1). 
Purchasing Power Parity
The purchasing power parity is a theory that exchange rates should, in the long run, be determined by the inflation rates in different countries, providing the countries are operating under a floating exchange regime. The reason for this is that the exchange rates are determined by supply and demand for goods (hot money also comes into it, but we will discuss this effect in a moment). The PPP theory states that a basket of goods should cost the same amount in different countries once the exchange rate is taken into account. For example if a basket of goods cost £100 in the UK and $150 in the US then the exchange rate between Britain and the US should be £1:$1.50, if the PPP theory is correct. The reason behind this is that if the exchange rate didn't equal £1:$1.50, say it equaled £1:$1.30 then British citizens would purchase goods from America as the basket of goods which cost £100 would only cost £77 if imported from America. This increase in demand for American goods would affect the exchange rate and would move it back into equilibrium.
Therefore in the long run we would expect the PPP theory to hold true and hence the only thing driving the exchange rates would be the differing inflation rates in countries (this is fundamentally due to the reason explained above about the different prices of the basket of goods). However in the short run the theory doesn’t hold true for a number of reasons. Firstly we have said that if the exchange rate wasn't in the long run equilibrium (where the price of the basket of goods in both countries is not equal in terms of post-exchange rate value) then consumers would import and exports goods from abroad, thus placing the exchange rate back into equilibrium. This may not happen for a few reasons; the goods may be perishable and therefore not able to be transported, services and goods may not be transferable for other reasons, there are transports costs to take into account and differing tastes across the world may mean that consumers would wish to import/export goods.
Secondly the flow of hot money and speculation affects the rate of exchange in the short run and may mean it doesn't equal its long run equilibrium.
The UKs exchange rate
The table below shows the differing exchange rate regimes the UK has adopted since the Second World War:
Fixed exchange rate (devaluation in 1948 and 1967)
Managed Floating
Shadowing the DeutcheMark
Managed Floating
European Exchange Rate Mechanism
Floating exchange rate


Page last updated on 15/04/14