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14.

1 Freely foating exchange rates


EXCHANGE RATES
Constant fow of money in/out of countries because residents have transactions.
Intl transactions use diferent currencies (foreign exchange).
Demand for foreign currencies generates supply of domestic currency (and vice versa).
Exchange rates relate value of one currency to another.
In a freely foating exchange rate system (abbreviated in this guide as FFERS), the market
determines the exchange rates. In a diagram, the price is expressed in terms of the other currency.
CHANGES IN EXCHANGE RATES
Appreciation - increase in the value of a currency in a FFERS.
From diagram above: increase in demand for $ or decrease in supply of $
Depreciation - decrease in value of a currency in a FFERS.
From diagram above: decrease in demand for $ or increase in supply of $
1 EXCHANGE RATES & THE BALANCE OF PAYMENTS
ECONOMICS SL
EXCHANGE RATES & BALANCE OF PAYMENTS
CAUSES OF EXCHANGE RATE CHANGES*
Increase in demand for a countrys export: appreciation
Increase in countrys demand for imports: depreciation
A countrys interest rate and currency value changes in the same direction
Higher infation in a country relative to other countries: depreciation
Increase in foreign investment: appreciation
A countrys relative income level and currency value change in opposite directions
Widespread expectation of appreciation will contribute to appreciation
Expectations of depreciation will contribute to depreciation
If the central bank buys a foreign currency: depreciation because it supplies domestic currency
If the central bank sells a foreign currency: appreciation because it demands foreign currency
CETERIS PARIBUS
EXCHANGE RATE EVALUATIONS
Infation
Cost-push: A depreciation makes imports more expensive. Production costs increases which
can shift the LRAS leftwards. The more inelastic the demand of the input, the greater the
infation. Currency appreciation lowers infationary pressures.
Demand-pull: A depreciation makes exports cheaper, increasing net exports (XM). Whether
there is an infation will depend on where the economy is in the business cycle.
Employment
Depreciation can increase AD which can decrease cyclical unemployment and cause a temp.
decrease in natural unemployment, but with infationary pressures.
Appreciation will create a recessionary gap and cause cyclical unemployment or increase it.
Economic growth
Depreciation: Cause AD increase (short-term beneft) but with infation. Can cause increases in
potential output
Appreciation: Dampens GDP growth but may have indirect growth by making imports
cheaper.
Current account balance
Depreciation: Cause imports to fall and increases exports. Can cause trade defcit to shrink.
Appreciation: Increases trade defcit.
Foreign debt
Depreciation: causes foreign currency debt value to increase
A problem faced by developing country because as their currency depreciates, they have a
larger debt burden.
14.2 Government intervention
FIXED EXCHANGED RATE
Fixed exchange rate system - exchange rates are fxed by the central bank and does not
respond to supply/demand changes. Govt intervention is used to maintain this fxed rate.
2 EXCHANGE RATES & THE BALANCE OF PAYMENTS
METHODS TO MAINTAIN FIXED RATES
Ofcial reserves
If there is an excess supply of a currency, the central bank can sell foreign reserves to buy the
excess. If there is an excess demand, the central bank can buy foreign currency.
If there is an excess supply and a downward pressure, the central bank will no longer be able to
sell reserves.
When there is upward pressure, the central bank can just sell domestic currency.
Interest rates
By increasing interest rates, it will attract investments and increase the demand for the
domestic currency. It may involve contractionary policy, though.
Borrowing from abroad
Loans will be converted into the domestic currency which will increase the demand, but there
are borrowing costs.
Eforts to limit imports
Limiting imports can reduce supply of domestic currency. This may cause retaliation.
Exchange controls
Exchange controls - restrictions imposed on the government on the quantity of foreign
exchange that can be bought by domestic residents. Restricts outfows of funds. Resource
allocation.
FIXED EXCHANGED RATE CHANGING
Devaluation - when the government changes the fxed rate to a lower value because it is too high
to be maintained through intervention.
Revaluation - when the government fxes a currency at a higher value
MANAGED EXCHANGE RATES
Managed exchange rates (managed foat) combines both foating and fxed exchange rate
systems, though it leans towards the foat side.
Exchange rates usually foat to their market levels, but central banks intervene to stabilize them
from fuctuations.
Some developing nations peg their currency to the US dollar to foat with it. Pegged currencies
are fxed in relation to a currency and foat in relation to other currencies.
This helps price stability for many developing nations.
CONSEQUENCES
Overvalued currency - currency with value higher than equilibrium market value
Imports become cheaper - often wanted to speed up industrialization
Exports become more expensive - afects domestic exporters and worsens current account
balance.
Domestic producers have to compete with low-priced imports
Undervalued currency - currency with low value relative to free market value
Exports less expensive - used to expand exports
Imports more expensive
3 EXCHANGE RATES & THE BALANCE OF PAYMENTS
Undervalued currencies are considered unfair and are referred as a dirty foat.
14.4 The balance of payments
BALANCE OF PAYMENTS
The balance of payments is a record of all transactions between the residents of a country and
the residents of other countries.
Credits - payments for other countries; debits - payments to other countries; defcit - more debits
than credits (negative balance); surplus - more credits than debits (positive balance)
Credits create a foreign demand of a countrys currency, and debits create a supply of the
currency.
The IB follows a certain format for the balance of payments:
Current Account Current Account Current Account
1 Exports of goods Balance of trade in goods - subtract imports
from exports.
2 Imports of goods
Balance of trade in goods - subtract imports
from exports.
Balance of trade in goods (1+2) Balance of trade in goods (1+2)
Balance of trade in goods - subtract imports
from exports.
3 Exports of services Same as above, but with services.
4 Imports of services
Same as above, but with services.
Balance of trade in services (3+4) Balance of trade in services (3+4)
Same as above, but with services.
Balance of trade in goods and services (1+2+3+4) Balance of trade in goods and services (1+2+3+4) Also called trade balance or balance of trade;
value of total exports minus imports. The most
important part of the current account.
5 Income Infows of interest, rents, and wages into a
country minus outfows. Income fowing into a
country is credit; and income fowing out of a
country is debit.
6 Current transfers Infow of transfers such as gifts, foreign aid,
and pensions minus outfows
Balance on current account (1+2+3+4+5+6) Balance on current account (1+2+3+4+5+6) Balance on current account (1+2+3+4+5+6)
Capital Account Capital Account Capital Account
7 Capital transfers Infows minus outfows of things like debt
forgiveness, insurance claims, ad investment
grants
8 Transactions in non-produced/fnancial
assets
Purchase of non-produced assets, such as
mineral rights, fshing rights, airspace, etc.
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Balance on capital account (7+8) Balance on capital account (7+8) Balance on capital account (7+8)
Financial Account Financial Account Financial Account
9 Direct investment Investment in physical capital undertaken by
multinational corporations. (Also known as
foreign direct investment)
10 Portfolio investment Financial investments (stocks and bonds).
Borrowing from foreign lenders appears as
credits
11 Reserve assets Foreign currency reserves that the central bank
can buy/sell to afect countrys currency.
Balance on fnancial account (9+10+11) Balance on fnancial account (9+10+11) Balance on fnancial account (9+10+11)
12 Errors and omissions Transactions are hard to record precisely. Since
credits should equal debits, the error and
omissions balances it out.
Balance (1+...+12) Balance (1+...+12) Balance (1+...+12)
The sum of everything is zero; the credits balance the debits.
current account + (capital account + fnancial account + errors/omissions) = 0
CURRENT ACCOUNT AND FINANCIAL ACCOUNT
If imports > exports, there is a defcit in the trade balance, which makes it likely for there to be a
current account defcit.
If there is a current account defcit, there is a fnancial account surplus, which provides it with the
exchange needed to pay for the excess imports.
A current account surplus means a country consumes less, the country has more foreign exchange
that is used to buy assets and other stuf which results in a fnancial account defcit.
IMBALANCE
A balance of payments defcit/surplus means there is a defcit/surplus in the combined balance of
payments excluding central bank intervention. In a defcit, the central bank can buy up excess
currency to balance the payments.
14.5 The balance of payments and exchange rates
BALANCING DEFICITS WITH SURPLUSES (FREELY FLOATING)
If there is a defcit/surplus in the current account, market forces create a/n downward/upward
pressure on the exchange rate. The exchange rates automatically create a balance.
BALANCING DEFICITS WITH SURPLUSES (MANAGED FLOAT)
The central bank of a country buys and sells currencies to balance the balance of payments.
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BALANCING DEFICITS WITH SURPLUSES (FIXED)
Policies that fx the exchange rate maintain the balance of payments.
COMPARING AND CONTRASTING EXCHANGE RATE SYSTEMS
Fixed exchange rates Floating exchange rates
Degree of
certainty for
stakeholders
High degree of certainty.
People can plan more. International
trade favored - easy to calculate
exchange rates.
Higher uncertainty.
Stakeholders unsure of future value.
Abrupt changes can cause serious
problems and crises. Currency
speculation destabilizing.
Role of foreign
currency reserves
Maintain fxed exchange rate.
Sell reserves if defcit. Problem when
not enough reserves.
Not necessary.
No need for intervention. Market
force does it.
Ease of
adjustment
No easy methods.
Hard to handle large shocks or large
defcits.
Automatic adjustment.
Appreciation and depreciation
eliminates surpluses and defcits.
Flexibility ofered
to policy-makers
No fexibility.
To maintain fxed rate, government
needs to pursue specifc policies.
Greater fexibility.
Domestic policies dont have to
respond to BoP problems.
EVALUATION: MANAGED FLOAT
Supporters: Ofers fexibility to pursue policies that the economy needs. Also allows government to
prevent large fuctuations.
Critics: Not good enough to deal with large fuctuations; not successful in eliminating trade
imbalances; allows dirty foats
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