Exchange Rates

Long term deficits in the balance of payments

lead to decline in the value of currencies.

These days’ movements of exchange rates

especially short term are dominated by
International Capital flows rather than trade,
therefore countries with a current account deficit
may actually see the exchange rates rise due to
inflows on capital account of ‘Hot Money’.
Governments may allow exchange rates to ‘freely
float’ or have them ‘fixed’.

“ An exchange rate is the price at which the

currency of our country is exchanged for the
currency of another country in the foreign
exchange market. “

The demand for a currency at any given time

reflects the amount of currency that individuals
or businesses wish to buy.
“Currency Assets” are net stock of
financial assets dominated in US
dollars held outside the US Federal
reserve and Public Sector.
 Transaction Effect
• When a currency is bought or sold there is
a transaction cost, dealers charge
commission. By holding stocks of
currencies costs are illuminated.
• When currencies rise in value, demand
falls for currency to purchase exports,
growth in flow of imports and the demand
for foreign currency.
 Capital Gains effect
Anticipating foreign exchange movements
allows capital gains through speculation
through ‘Hot Money’.
 Important considerations affecting
the demand for dollars include:
• The volume of dollar payments reflecting the size of US
GDP.
• The value of the dollar.
• The interest rate on dollar denominated assets
compared with interest rates on assets from other non
dollar based currencies.
• The supply of dollars in foreign exchange markets also
affected by the gov’ts budget deficits or surplus and
central banks policy on buying and selling foreign
currency assets.
• Gov’ts finance deficits by issuing bonds in its own
currency.
• Central gov’ts influence currency values
by buying and selling assets in the
currency. If it wants to depress exchange
rates it will sell its currency and buy
foreign exchange or increase the value by
buying currency using foreign exchange
reserves.
 Purchasing Power Parity theory
• Under a floating exchange rate, the exchange
rate of one currency against another will adjust
to ensure prices for identical goods in the two
countries are the same.
• In practice exchange rates affected by a
multitude of factors:
• Relative prices
• Foreign investment
• Speculation in foreign exchange markets
• Central bank intervention
 Floating exchange rates
“ Under a floating exchange rate system, a
country’s exchange rate is determined
solely by the demand for and supply of its
currency (or currency denominated
assets) in the foreign exchange markets.”
 Fixed exchange rates
“A gov’t may pursue a policy of keeping the
external value of its currency fixed at a
stable rate by having its central bank
intervene in the foreign exchange market.”
 The Gold Standard
• Lasted until 1930s currency fixed to the price of
gold based on holding gold in reserve. Trade
financed by gold shipments and internal money
supply broadly determined by amount of gold
held in reserve.
• When exports exceeded imports more gold
flowed in than out, internal money supply rose
which led to pressure on prices which led to
exports becoming less competitive until
equilibrium found again.
 Bretton Woods
• From WWII- 1970s
• Following the collapse of the Gold Standard
countries attempted to gain a competitive
advantage by devaluing their exchange rates,
making the exports cheaper and imports more
expensive. Intended to boost employment
prospects, commonly referred to as ‘begger my
neighbour policy’.
• All agreed to fix exchange rates against the
dollar which was assigned a fixed value against
gold ($35 per troy ounce for official transaction
purposes)
• Not entirely fixed as allowed for 1% differential until
1971, supported by the INF based in Washington. Gov’ts
expected to intervene to maintain parity backed up by
IMF actions.
• Countries were also expected to correct balance of
payments disequilibria by appropriate domestic fiscal
and monetary policies.
• Sterling devalued twice under Breton Woods:1949 from
$4.03-$2.80 and 1967 to $2.40.
• Eventually brought down by a lack of international
liquidity.
• 1948 world reserves of gold could finance 48 weeks of
exports but only 14 by the mid 1970s. Falling confidence
in the dollar when in 1971 Smithsonian agreement
officially devalued the dollar against gold from $35-$38
per troy ounce.
 Managed Exchange Rates
“Exchange rates are determined in the main by the
conditions of demand and supply but central
banks intervene from time to time to stabilise the
rates or influence them in some way.”
• Dirty Floating (Managed)- Gov’t discretion as to
when and how to intervene through the foreign
exchange market.
• Joint floating- European Snake system in 1972
allowed a 2% band against Deutschmark and
collapsed in 1973.
European Monetary System (1979-
1993)
• Played major role in the development of the single
market. Until 1993 currencies measured against ECU
within a 2.25% band. The Lire, Pesata and later Sterling
had wider margins of 6%. Known as the European
Exchange rate Mechanism (ERM)
• UK did not join until 1990, two years later sterling crisis
led to the abandonment of the system.
• 1999, 11 of the 15 EU member states joined the Euro
making the ECU and ERM redundant.