IB Economics/International Economics/Exchange rates

History of Exchange Rate Systems

• For several centuries the developed world operated under a fixed exchange rate system based on the gold standard. The system worked well until WW1 and the rapid changes occurring due to industrialization.
• After the depression in the 1930s many systems were tried, but the developed world chose to switch back to a fixed exchange rate system after W.W.II.
• This was called the Bretton Woods system and included the creation of the IMF (International Monetary Fund).
• This system was finally terminated in 1973 but the IMF survived. What followed was a system called the adjustable peg which gave way to a short period during which rates were floating under a flexible exchange rate system.
• This has been followed in more recent times by a managed float system.

Modern Exchange Rate systems

• The Euro exchange rate is the value of the Euro in terms of another currency.
• The exchange rate is the amount of foreign currency paid to obtain a unit of the home currency (this is the definition used by the IB)
• If the exchange rate rises, the home currency appreciates, more of the foreign currency is needed in order to purchase the home currency.
• If the exchange rate falls, the home currency depreciates, less of the foreign currency is needed to purchase the home currency.
• Except for the US$, the Euro € and the Japanese ¥, most currencies are only acceptable within the borders of the home country. Thus exporters must eventually receive payment for the goods that they export in terms of the currency of their own country.

• A trade weighted exchange rate index measures the value of the Euro in terms of a basket of currencies which are weighted by the proportion of trade between those countries and Europe.
• The effective exchange rate examines how much trade Europe has with the other country and the extent to which Europe competes with these other countries in terms of trade.
• The real exchange rate takes into account the effects of inflation. If the Euro falls by 5% against the Yen but there is 5% inflation in Europe, the real exchange rate is assumed to be unchanged.

• If Europeans sell software and the Japanese sell cars:
  • Europeans who want to import Japanese cars will need Japanese ¥, and they provide the demand for Japanese ¥ and the supply of Euros.
  • Japanese who want to buy European software need Euros and they provide the demand for Euros and the supply of Japanese ¥.

4.6.1 Fixed Exchange Rates

• Under the fixed exchange rate system rates are fixed at some value and the central bank intervenes to ensure it stays at that agreed upon rate:
  • For centuries the standard was gold
  • Some countries fixed their exchange rates to a currency like the British pound which was convertible into gold.

• From 1946 to 1973, most countries pegged or fixed their currencies to the US dollar.
  • In the face of short term fluctuations, the central banks of each country would intervene in the market and buy and sell US$.
  • As long as the central bank worked around equilibrium, then on average it would buy about as much as it sold and the policy did not lead to changes in foreign currency reserves.
  • More recently governments of smaller countries have fixed their currency to a ‘key’ currency such as the dollars, Yen or Euros with periodic adjustments.

• If there is a fixed or adjustable peg system, and the demand for foreign currency shifts out (from Do to D1) because greater domestic inflation has led to an increase in the demand for imports and a fall in the demand for exports:
  • There will be pressure on the domestic currency to depreciate (exchange rate rises from A to B).

• If there is a permanent switch away from the agreed on rate, the central bank will be faced with constantly buying or selling to maintain the old rate.
• If there is more inflation in the domestic economy than in the foreign, the exchange rate should be rising or the domestic currency should depreciate.
  • With flexible exchange rates, the domestic currency would do exactly that. But this is not permitted under the fixed exchange rate system.

Current Account Adjustments

• The govt. imposes tariffs or quotas on imports, or exchange controls or it could subsidize exports:
  • This leads to a fall in the demand for the foreign currency from D1 back to Do (B back to A)
  • It may lead to retaliation from other countries especially under GATT.

• The govt. can subsidize exports:
  • This leads to an increase in demand for exports which means the supply of foreign currency shifts out from So to S1 and we move from point B to C
  • It may lead to countervailing duties from other countries.

Capital Account Adjustments

Foreign Exchange Reserves

• Foreign reserves are often held in the form of US$ with only small amounts held in ¥ and the Mark.
• Each member country of the IMF is assigned a quota of (SDRs), rather like a bank account or a type of currency issued by the IMF (International Monetary Fund). .
  • SDRs can only be used to cope with balance of payments problems.
  • Central banks are reluctant to see the system expand because most govts. have shown irresponsibility when it comes to controlling the money supply.
  • Private acceptance of SDRs has been almost non-existent indicating the tremendous influence of the US$.

• Effectively the central bank in the US, called the Federal Reserve Board, is the central bank for the world.
  • There have been calls for a return to the gold standard, but there is a shortage of gold which would lead to further crises.

• Most central banks keep SDRs, US$, some gold, some ¥, and some Euros
• With downward pressure on the exchange rate, and if the country holds foreign exchange reserves, the govt. can tell the central bank to buy domestic currency:
  • Supply of foreign currency shifts right (from So to S1 in above diagram) which brings the exchange rate back down to the original level (from B to C).

• The govt. can tell the Central Bank to increase interest rates (Ms contracts):
  • This leads to increased capital inflows which means that the supply of foreign currency shifts out from So to S1 (move from point B to C).
  • Domestic citizens stop buying foreign money market instruments, and demand shifts left (move from point C to X)
  • Effect on the domestic economy:
• Domestic prices fall: S shifts right, D shifts left: exports rise and imports fall.
• This may lead to a recession in the domestic economy: D shifts left, imports fall.

• If these policies do not work, the govt. will tell the Central Bank to devalue the currency which may lead to competitive devaluations by other countries.

4.6.2 Floating Exchange Rates

• Under the flexible exchange rate system, rates are allowed to float.
  • The purchasing power parity theory assumes floating exchange rates adjust until a unit of currency can buy the same basket of goods and services as a unit of another currency.
  • Currencies are allowed to float and govt. intervenes periodically to influence the price but does not set the price. The currencies are kept within some limits.

• If the exchange rate is denoted as the number of Yen required to purchase a Euro. If it is below equilibrium: there will be excess demand for European Euros

• • Traders who need Euros will start bidding up the price:
  • As the supply curve is upward sloping, the quantity supplied of Euros will rise. The extent of the increase will depend on the elasticity of supply.
  • As the demand curve is downward sloping, the quantity demanded of Euros will fall.
  • The extent of the fall will depend on the elasticity of demand.

• As the exchange rate rises:
  • Exports of software start to fall as it becomes relatively more expensive
  • Imports of Japanese cars will rise as they become relatively cheaper.
• The two effects will finally lead to supply equal to demand in equilibrium.

• If the exchange rate is above equilibrium:
  • There will be an excess supply of Euros
  • Japanese cars look relatively cheaper so Europeans start offering more Euros for Yen and the price of Euros will start to depreciate in value.
  • As the supply curve is positively sloped, fewer Euros are offered as the value of the Euro depreciates. The more elastic the supply, the greater the impact on quantity supplied.
  • As the demand curve is negatively sloped, the lower value of the Euro starts to make European software look cheaper and more will be demanded. The more elastic demand, the greater the impact on quantity demanded.
  • The two effects will finally lead to supply equal to demand in equilibrium.

Shifts in Demand & Supply

• Europeans demand Yen to buy goods and services from Japan, and to invest if the return on investment is greater in Japan.
• If Europeans want more Japanese goods and services or if they want to invest more in Japan, the supply of Euros will shift to the right. If the Japanese demand for Euros does not increase, then the exchange rate depreciates.
• If Japanese want more European software or if they want to invest in European securities, the demand for Euros shifts to the right and the exchange rate will appreciate.
• The most common causes of shifts: some affect one rather than both demand and supply (denoted in brackets):

ROI or interest rate effect (two sided):

• If return on investment or the interest rate increases in Japan, or if currency speculators believe the value of the Yen will rise in the future:
  • The supply of Euros will shift to the right. More Euros will be offered for sale.
  • The Japanese will be less interested in investing in Europe. Fewer Euros will be demanded.
  • The outward shift in supply and inward shift in demand leads to a depreciation of the Euro.

Income effect (one sided):

• If the income in Japan rises, the demand for Euros will shift out, more Yen will be offered for Euros, and the Euro will increase in value

Price inflation (two sided):

• If there is inflation in Europe but not in Japan, Japanese cars will appear to be relatively cheaper, and more cars will be sold in Europe, more Euros will be offered for sale for Yen.
  • The supply of Euros will shift out, and the Euro will depreciate in value.
  • At the same time, European software will be relatively more expensive in Japan, so the demand for Euros will shift in to the left.
  • The outward shift in supply and the inward shift in demand leads to a depreciation in the exchange rate.
• If both countries have the same amount of inflation, the two sets of shifts offset each other.
• The country experiencing a more rapid rate of inflation will also experience a steady depreciation of its currency.

Growth or productivity effect (two sided):

• Rather similar to the price inflation, only in this example it is costs which are falling in the country with the higher growth rate or more rapid increase in productivity. If labour productivity rises faster in Europe then goods look relatively cheaper in Europe:
  • The demand for Euros will shift to the right.
  • The supply of Euros shifts in.
  • This leads to an increase in the value of the Euro.

4.6.3 Managed Exchange Rates

• The managed float is basically a flexible exchange rate system in which rates are permitted to float, but the central bank intervenes on a regular basis to keep the rate within some agreed upon limits.
• Govt. can influence exchange rates, usually through the Central Bank by:
  • Buying and selling both domestic and foreign currency
  • Altering interest rates in order to influence short term capital flows
  • Altering return on investment through tax policies in order to influence long term capital flows.
• Rather than managing a single currency, for several years the EU has attempted fixed exchange rates amongst its member countries but a managed external float as a block against the dollar and the Yen.
  • This broke down in the fall of 1992 and was replaced in 1999 by the European Monetary Union which consists of 11 member countries.

• If interest rates rise in Canada, investors from Britain will buy Can$ money market instruments until the appreciation in the value of the Can$ which results is just equal to the differential in the interest rates.

• The expected future depreciation of the Can$ is just enough to bring Canadian interest rates back down to the international equivalent.
  • If interest rates are 5% higher in Canada, investors will keep on investing until the exchange rate has fallen by 5% (Can$ has appreciated by 5%).
  • The extra 5% interest earned is enough to offset the 5% future depreciation of the Can$.
  • The appreciation puts export and import competing industries at a competitive disadvantage.

4.6.4 Depreciation vs Devaluation; Appreciation vs Revaluation

• Under a floating exchange rate system, the exchange rate:
  • Depreciates whenever it falls in value against other currencies:
• Less foreign currency is needed to purchase a unit of domestic currency
  • Appreciates whenever if rises in value against other currencies:
• More foreign currency is required to purchase a unit of domestic currency.

• Under a fixed or adjustable peg system, rates are set every day by the central bank but are periodically adjusted:
  • If the Central Bank devalues the currency it is equivalent to a depreciation in the currency or an increase in the exchange rate:
• It costs more domestic currency to buy foreign currency.
  • If the Central Bank revalues the currency it is the equivalent of an appreciation of the currency or a fall in the exchange rate:
• It costs less domestic currency to buy foreign currency.

4.6.5 Effects on Exchange Rates

Trade Flows: Appreciation of the Euro

Software Market

• In the figure, Deur and Seur represent the domestic supply and demand for software. The no trade point of equilibrium is O with no exports.
• Deur +Japa represents the domestic European demand plus the Japanese demand for European software. Total European production is Qa of which Qda is consumed in Europe and Xa is exported to Japan.
• If the Euro appreciates, the foreign price of European software will rise:
  • Japanese demand will fall to Japb
  • Exports will fall to Xb
  • Price will fall from Pa to Pb.
  • Domestic consumption rises from Qda to Qdb.
  • Exports decrease to Xb.

Car Market

• In the figure, Deur and Seur represent the domestic supply and demand for cars. The no trade point of equilibrium is O with no imports.
• Seur +Japa represents the domestic European supply of cars plus the Japanese supply. Total European consumption is Qa of which Qda is produced in Europe and Ma is imported from Japan.
• If the Euro appreciates, less Euros must be paid to obtain the required amount of Japanese ¥. The European price of Japanese cars will fall:
  • The supply curve shifts out from Seur +Japa to Seur +Jap b.
  • Domestic production of cars falls from Qda to Qdb.
  • Imports of Japanese cars rise to Mb.

Trade Flows: Depreciation of the Euro

Software Market

• In the figure, Deur and Seur represent the domestic supply and demand for software. The no trade point of equilibrium is O with no exports.
• Deur +Japa represents the domestic European demand plus the Japanese demand for European software. Total European production is Qa of which Qda is consumed in Europe and Xa is exported to Japan.
• If the Euro depreciates, the foreign price of European software will fall:
  • Japanese demand will rise to Japb
  • Exports will rise to Xb
  • Price will rise from Pa to Pb.
  • Domestic consumption falls from Qda to Qdb.
  • Exports increase to Xb.

Car Market

• In the figure, Deur and Seur represent the domestic supply and demand for cars. The no trade point of equilibrium is O with no imports.
• Seur +Japa represents the domestic European supply of cars plus the Japanese supply. Total European consumption is Qa of which Qda is produced in Europe and Ma is imported from Japan.
• If the Euro depreciates, more Euros must be paid to obtain the required amount of Japanese ¥. The European price of Japanese cars will rise:
  • The supply curve shifts in from Seur +Japa to Seur +Jap b.
  • Domestic production of cars rises from Qda to Qdb.
  • Imports of Japanese cars fall to Mb.

Capital Flows & Interest Rate Changes

• In addition to software, the Japanese may be interested in investing in Europe.
  • If they buy securities they offer Japanese ¥ to buy Euros to pay for them, an outward shift of the demand curve.
  • This leads to capital inflows into Europe and an appreciation of the Euro.
• If Europeans decide they want to buy more Japanese stocks, they will offer Euros (equivalent to an outward shift in the supply curve for Euros).
  • This leads to capital outflows from Europe and a depreciation of the Euro.

• Interest rates (OCRR): a major reason for short term capital movements is differences in interest rates.
  • If interest rates are higher in Japan, Europeans with short term funds will buy short term money market instruments in Japan. As they do so the foreign exchange rate falls leading to a depreciation of the Euros.
  • To stop the depreciation of the Euros the Central Bank may decide to increase interest rates.

• Speculation about exchange rates can also lead to short term capital movements:
  • If the Euro is expected to appreciate, Japanese investors will buy European money market instruments in anticipation.
  • The increase in the supply of Japanese ¥, equivalent to an increase in the demand for Euros will force the exchange rate up and lead to an appreciation of the Euro. This is an example of self realizing expectations.

• ROI: long term capital movements are more related to expectations about profit opportunities than to future movements in exchange rates.
  • If return on investment is higher in Europe, then money will flow out of Japan into Europe.
  • If rates of return are consistently lower in Europe compared to Japan because productivity rises more slowly for a number of reasons, then there will be a slow but steady erosion in the value of the Euro.
  • If return on investment is the same in both countries but investors expect the Euro to appreciate in the future, this may lead to greater long term investment.
• This case is much less likely as it is very difficult to predict exchange rate movements over the long term. Investors are much more sensitive to differences in ROI.
• If the exchange rate is expected to fluctuate greatly in the future, investors are much less likely to invest for fear of potential loss.

4.6.6 Advantages and Disadvantages of Fixed & Floating Rates

Fixed Exchange Rate System

Advantages

• Of particular importance is the uncertainty of production costs in different locations for TNCs:
  • Most have adopted a system of flexible production allocation between plants.
  • This is complicated by the volatility of exchange rates between different countries.
  • What appears to be a least cost country location for production may turn out to be the most expensive if there are major changes in currency values.
• Fixed exchange rates can create much greater stability. Indeed, whenever we enter a period of floating exchange rates with much volatility, global dispersion of production and trade tends to fall.
• Most smaller countries have adopted a system of pegging their exchange rates close to major ones such as the dollar, Euro or Yen. This reduces uncertainty for TNCs and fosters FDI.
• Fiscal policy tends to be stronger:
  • If the govt. is closing a recessionary gap they will shift AD out to the right by borrowing
  • The rise in interest rates needed to finance the deficit stimulates an inflow of capital moving the capital account toward a surplus.
  • At the same time, rising aggregate demand increases imports which moves the current account toward deficit.
  • If the former is larger than the latter, the whole balance of payments will move toward surplus.
  • To stop the exchange rate from falling (appreciation of the domestic currency), the central bank intervenes and buys foreign currency from the commercial banks with Euros.
  • This increases the money supply and increases aggregate demand.

Disadvantages

• Reserves are needed to offset short term fluctuations.
  • Under the gold standard it was found there were not enough reserves to do the adjusting.
  • The US dollar worked quite well until it became unstable.

• A fixed exchange rate system cannot adjust to long term trends.
  • If inflation rates are different amongst countries, or there are fundamental shifts in the supplies and demands for certain goods and services either because of differences in growth rates or because of major structural changes such as technological breakthroughs, then the rates must be permitted to change.
  • Over a decade the drift away from the old equilibrium can be quite substantial.

• Over time as equilibrium rates drift away from the fixed rate, there is more and more intense speculation as investors try to buy currencies which are expected to be revalued and sell currencies which are expected to be devalued.
  • This drains foreign reserves even more quickly and forces a major adjustment in the value of the currency.
  • This is what eventually destroyed the Bretton Woods system.

• Because of its fixed exchange nature, the adjustable peg system may affect the domestic economy adversely as domestic policies must be adjusted to maintain external equilibrium.
• Monetary policy is weakened. If there is a recessionary gap and interest rates are lowered to shift AD out:
  • Investment increases domestically and aggregate demand shifts out
  • Higher interest rates lead to capital outflows and the capital account moves toward deficit.
  • At the same time, with rising aggregate demand, imports increase and the trade balance also moves toward deficit.
  • To maintain the fixed exchange rate, the central bank buys domestic currency. Euros leave the commercial banks and enter official reserves at the Central Bank reducing the money supply and offsetting the original policy

The Floating or Managed Float Exchange Rate System

Advantages

• The greatest advantage is that adjustments needed to achieve external equilibrium impact only indirectly on the domestic economy.
  • Under a fixed exchange rate system, if there is downward pressure on the currency and reserves of foreign exchange are exhausted, a recession must be induced in order to reduce imports and boost exports.
  • With flexible exchange rates, downward pressure on the currency leads to depreciation with a subsequent fall in imports and rise in exports without having to induce a domestic recession.

• Monetary policy tends to be stronger:
  • If the govt. wants to close an inflationary gap, raising interest rates will cause AD to shift in and lead to capital inflows.
  • This will lead to appreciation, exports fall and imports rise leading to a further inward shift in AD.

Disadvantages

• Different govts. try to set their exchange rates at levels which are inconsistent with each other.
  • If central banks try to force their view, there is chaos in exchange markets.

• Countries may become involved in rounds of competitive devaluations in order to capture a competitive advantage.
  • There has been considerable pressure by the US on Japan to force an appreciation of the Yen to make Japanese goods less competitive in the US.
  • This has simply accelerated the Japanese program of transplanting production to other countries to avoid the US border disputes over Japanese made goods.

• It was expected that speculators would stabilize rates close to their PPP normal exchange rate equivalents.
  • In fact, speculators seem no better at predicting than anyone else and there have been some destabilizing speculations take place.

• Exchange rates have been over and under shooting their PPP normal exchange rate equivalent often because of interest rate policies and the movement of short term capital.
  • When there has been overshooting, the result has been disruption in production because of the severe competitive pressures.

• Fiscal policy tends to be weaker.
  • Govt runs a surplus budget to close an inflationary gap
  • With less crowding out, interest rates fall, capital flows out
  • The currency depreciates, exports rise and imports fall shifting AD out.

4.6.7 Advantages and Disadvantages of Single Currencies/Monetary Integration

Single Currency

Advantages

• The nation state retains full control over monetary policy with the right to alter interest rates and money supply to suit the economic circumstances.

Disadvantages

• It can act as a depressant to both trade and FDI due to the uncertainties associated with future currency values.
• Most smaller countries have linked their currencies through some sort of managed float to a larger currency such as the dollar, Yen or Euro:
  • This confers the benefits of stability without limiting their ability to control monetary policy
  • Nevertheless, freedom to adjust monetary policy may be curtailed because of the need to adjust interest rates to prevent volatility in exchange rate movements.

Monetary Integration

• Monetary integration occurs when countries fix their currencies against each other but let the group of currencies float against all other currencies. This is referred to as a currency block.
  • Only if all members agree that there is a fundamental mis-alignment of currencies can one country make adjustments in its monetary policy.

• Within the European Monetary Union (EMU) control over monetary policy has been surrendered to the European Central Bank which gives it great influence over the economies of individual member states.
  • EU members have already agreed not to impose tariffs amongst members.
  • With a common currency they cannot adjust by changing the exchange rate or interest rates:

Advantages

• Reduced costs and uncertainties associated with having to deal with many separate currencies within a single market and the overall stability this is intended to produce.

Disadvantages

• Individual states are unable to use monetary policy as a stabilization tool during times of economic crisis.
• The fact that Denmark, Sweden and the UK have stayed outside the group is a major source of uncertainty.
• The most recent problem is how to integrate the new members of the EU. It may lead to a core of states which are fully integrated economically and financially surrounded by various groups of countries with different degrees of integration.

4.6.8 Purchasing Power Parity Theory

• Under a floating system one of the major influences is the purchasing power parity (what the normal exchange rate should be equal to).
  • If a representative basket of goods costs £12 in Britain but Can$20 then the Canadian PPP for the British pound is equal to
• Can$20/£12 = 1.67
  • Converting the British pound equivalent to Can$ is equal to:
• £12*1.67 = Can$20.

• The PPP rate adjusts for the relative changes in the two countries' price levels. If the Can$ price of the basket of goods rises to Can$25, then the PPP (normal exchange rate equivalent) will rise to
  • Can$25/£12 = 2.08.
  • This is similar to an increase in the exchange rate or a depreciation of the Can$.

• Thus the PPP (normal exchange rate equivalent) keeps the relative price of the two nation's goods constant when measured in the same currency.
  • As long as the exchange rate remains equal to the PPP rate, the competitive position of the two nations' producers will not have changed.
  • Deviations from the PPP can be substantial in the short run, but over the long run exchange rates tend toward the PPP.
  • It was assumed under the flexible exchange rate system that as speculators could calculate the PPP, they would work to keep exchange rates equivalent to their PPP:
• Experience has shown that speculators have tended to overshoot or undershoot the correct PPP.
• One of the main reasons for this has been the influence of interest rates on flows of short term capital.