4.1.8 Exchange rates – Edexcel Economics A notes

An exchange rate is the price of one currency in terms of another currency.

An example exchange rate for the pound is 1 British Pound = 1.15 US Dollars (as of writing in October 2022). You can find trends for exchange rates and up to date exchange rates here.

A “weak” currency typically means the currency has a relatively low value compared to its historical values (the opposite is true for a “strong” currency)

Contents

Types of exchange rate system

Exchange rates, roughly speaking, tell us how much purchasing power the currency has when buying items from abroad.

There are three main types of exchange rate system:

• Floating
  • A floating exchange is where market forces (supply and demand) determine the exchange rate.
  • The UK and the US currently have floating exchange rates.
• Fixed
  • The government or central bank sets a constant exchange rate.
  • Saudi Arabia has a fixed exchange rate system
• Managed
  • The exchange rate is allowed to vary within certain limits.

Interventions in currency markets by central banks, such as interest rate changes or the buying/selling of foreign currency, allow them to maintain a fixed or managed exchange rate.

How exchange rates can change

Just like with prices of goods and services, the price of a currency in terms of another, the exchange rate, can change over time.

• In a fixed exchange rate system
  • A fall in the value of the currency is called a “devaluation“.
  • A rise in the currency value is called a “revaluation“.
  • Decisions about devaluation and revaluation are made by the central bank or government.
• In a floating exchange rate system:
  • A fall in the value of the currency is called a “depreciation“.
  • A rise in the currency value is called an “appreciation“.
  • Whether a currency appreciates or depreciates is determined by market forces (supply and demand).

Examples of depreciations include:

• Following the Brexit vote, that is the decision to leave the European Union, the British Pound depreciated by about 10%.
• Following Kwasi Kwarteng’s mini-budget announcements, the British Pound depreciated to its lowest level against the US Dollar since 1985.

How exchange rates are determined in floating systems

Just like supply and demand can determine the price of any regular good, supply and demand can also determine the floating exchange rate. 

Who demands currency? Those who buy exports or invest from abroad into the domestic economy.

Who supplies currency? Those who need to swap their domestic currency for foreign currency to buy something from abroad. For example importers, domestic residents investing abroad, governments borrowing in foreign currency and so on.

Central banks play a role in currency markets too. They can buy or sell currencies in exchange for another, influencing supply and/or demand.

Here is a diagram of the currency market for the pound for example:

What determines the supply of and demand for currency? Here are some key factors:

• Interest rate domestically relative to other countries.
  • If the domestic interest rate increases relative to interest rates abroad, this means higher returns for international savers in the domestic economy.
  • So these savers move their money into the domestic economy (“hot money inflows”).
  • These savers need to demand the domestic currency to buy domestic assets / to save in a domestic bank, so there is higher demand for the domestic currency, so the currency appreciates.
• Higher inflation relative to other countries.
  • If inflation is higher domestically relative to other countries, export competitiveness decreases, reducing export demand and export value if export demand is sufficiently elastic.
  • This reduces currency demand leading to depreciation.
• High productivity growth relative to other countries.
  • High relative productivity growth is likely to reduce inflation relative to other countries, increasing export competitiveness, export demand and hence currency demand.
• Economic growth rates relative to other countries.
  • Higher economic growth may necessitate increased interest rates to control inflation. Higher interest rates may increase demand for the domestic currency due to hot money inflows as above. So the currency appreciates.
• Current account deficit / surplus.
  • If a country has a current account deficit, this means there could be low export demand relative to import demand, which means reduced demand for the currency, so the currency depreciates.
• Net investment flows.
  • If there are increased investment inflows into the economy from abroad, this increases demand for the currency.
• Central bank selling or buying foreign currency.
  • Say the central bank sells foreign currency in exchange for demanding domestic currency. This boosts the demand for domestic currency and leads to an appreciation. This is one way in which central banks can control the exchange rate in a fixed or managed exchange rate regime.
• Risk of government debt default.
  • If investors believe a government is likely to default, investors sell domestic bonds and in doing so reduce their demand for the currency needed to sell bonds (or increase supply of currency).
  • This means a depreciation in the value of the currency. 
• Expectations about future exchange rates (“speculation”).
  • If traders think the currency is likely to appreciate in the future, traders may buy currency today in order to make a profit.
  • That increases demand for the currency today and may lead to an appreciation today. 

Note that exchange rates are by definition relative (price of one currency in terms of another), several of these factors are relative to other countries.

For example if globally inflation is high, then this will not influence the exchange rate. But if inflation rises in some countries relative to inflation elsewhere, this will influence exchange rates. 

How can a government intervene in currency markets

In managed or fixed exchange rate regimes, the government or central bank is likely to intervene to control the exchange rate.

Governments may try to reduce fluctuations in the exchange rate to create certainty for businesses.

• If businesses can know what the exchange rate will be in the future, they can more accurately predict their revenues and costs from cross-border activities.
• This leads to higher business confidence and higher investment.

However a key drawback of fixed or managed exchange rates is the central bank may have to use monetary policy to achieve its exchange rate objectives. This can lead to tradeoffs with other macroeconomic objectives such as sustained economic growth and low, stable inflation.

There are two ways in which central banks can intervene in currency markets:

• Foreign currency transactions:
  • Suppose a central bank sells foreign currency and buys domestic currency in exchange.
  • This increases demand for domestic currency, so demand shifts right.
  • This leads to an increase in the value of the currency (or prevents the value of the currency from falling).
• Changes in interest rates:
  • If the domestic interest rate increases relative to interest rates abroad, this means higher returns for international savers in the domestic economy.
  • So these savers move their money into the domestic economy (“hot money inflows”).
  • These savers need to demand the domestic currency to buy domestic assets / to save in a domestic bank, so there is higher demand for the domestic currency, so the currency appreciates.

An example of a rise in interest rates was the Bank of England raising interest rates to 12% in 1992 as part of the Exchange Rate Mechanism (ERM), a sort of managed exchange rate system.

• Speculators were betting on the UK leaving the ERM and the value of the pound therefore falling below the lower bound of the ERM regime.
• The purpose of raising interest rates was to defend the managed exchange rate system against speculators, by keeping the exchange rate within the ranges specified by the ERM.
• However raising interest rates to 12% increases borrowing costs and saving rewards, reducing aggregate demand. This could lead to a downturn.
• To prevent a downturn, the UK was forced out of the ERM.

What are the effects of a depreciation / devaluation?

What are the effects of a fall in the value of the currency? Is this a good thing or a bad thing?

The likely effects of a fall in the value of the currency are:

1. Net trade (X-M) increases, shifting aggregate demand to the right.
2. Foreign direct investment (FDI) increases.
3. There are increased costs for importers such as firms who import their inputs.

1) Net trade increases

A weaker currency means imports are dearer and exports cheaper (The opposite of the acronym SPICED = stronger pound, imports cheaper, exports dearer). This decreases import demand and increases export demand. This means higher total value of net exports, so net exports rise. Aggregate demand rises so real GDP grows. This can also generate multiplier effects.

Marshall Lerner condition

But consider the “Marshall Lerner” condition. It states that the effects of a depreciation depend on the price elasticities of demand for exports and imports. Specifically if the PED of exports and the PED of imports sum to one or more in absolute value, then a depreciation improves the net trade position (value of exports minus value of imports).

In other words, if net exports are sufficiently responsive (elastic) to changes in price / exchange rate, only then will the value of net exports rise in response to a depreciation.

While the volume of net exports is always likely to rise, it is less clear whether the total value of net exports will rise.

The J curve

Also consider the J-curve. The J-curve shows how the response of net trade to a depreciation varies in the short run versus the long run. 

• In the short run, firms and consumers are locked into contracts and generally less responsive to changes in exchange rate. This means a depreciation leads to little change in demand, the Marshall Lerner condition does not hold. So net trade falls.
• In the long run, firms and consumers can be more responsive to exchange rate changes. For example consumers can break out of contracts or have noticed the price change and can find substitutes. So the Marshall Lerner condition holds. So net trade rises following a depreciation.

The diagram shows the “J-curve”: the effect of depreciation on net trade in the short run and long run:

2) Foreign direct investment rises

Foreign direct (inward) investment may rise. Investing in a domestic factory from abroad is now cheaper, reducing the upfront costs of any foreign direct inward investment, so FDI increases into the domestic economy. Higher investment increases both aggregate demand and productive capacity (LRAS).

But this depends where investment goes. If the investment goes into buying up existing housing stock for example, rather than investing in productive assets such as factory building, this raises house prices and increases wealth inequality between those who have houses and those who do not.

3) Increased costs for firms, consumers and government

A depreciation makes imports more expensive.

This increases business costs for firms importing inputs. Firms may have inputs from abroad such as raw materials or capital equipment. A depreciation raises import costs and so the short-run aggregate supply may shift left.

For these firms, employment may decrease. This could lead to slower economic growth, in contrast to the effects of higher FDI and higher net trade.

Note this depends on how reliant firms are on imports. If firms do not rely on imports much, then they won’t need to buy imports and can find substitutes. This may vary from industry to industry and over time. For example, over time it might be easier to find cheaper substitutes from domestic companies. 

There will also be increased costs for consumers that buy imports. In general because a depreciation may increase aggregate demand and decrease aggregate supply, it is likely to lead to higher inflation.

There may also be increased government borrowing costs when borrowing from foreign sources. This means there is a greater opportunity cost from any government borrowing – the government may have to give up more spending or raise taxes further, now or in the future, to cover increased borrowing.

Cause of depreciation

A critical point is the cause of the fall of the value of the currency matters. If the depreciation is because of a fall in the economy’s growth rate. This suggests the depreciation may reflect expectations of weakened economic performance and reduced confidence from business, consumers and investors.

Note the opposite effects would apply in the case of an appreciation / revaluation.

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