what are free floating exchnage rates?
government allows the exchange rate to be determined purley by market forces and no attempt of the central bank to infleunce the external value of the exchnage rate
eg: UK, US, EU ,AUS, Mexico
what is a managed floating exchange rate?
- central bank gives freedom for market exchange rates on a day to day basis (determined by supply and demand), however the central bank may intervene ocassaionally
- currency becomes a key target of monetary polciy
eg indian rupees
what are fixed exchange rates?
central bank fixes the official currency value
* adjusted with devaluation and revaluation
central bank must hold enough foreign exchnage reserves
draw a diagram for the following conditions on the GBP/USD
* fall in value of exports
* rise in spending on imports
* increased intrest rates
what is the distinction between
* appreciation and revaluation
both are an increase in the value of an exchnage rate but revaluaution occurs in a fixed system and appreciation in managed
what are the factors that cause changes in (floating) exchnage rates?
- intrest rates and hot money
- trade balance (import and exports)
- net investment flows
- speculation
demand for currency is derived demand
what are “expenditure switching effects”?
change in pattern of consumption and production by encouraging domestically produced goods instead of imports and making exports more competitive internationally
what are the advanatges of of a free floating exchange rate?
explain the J curve effect
- in the short term a currency depreciation may not necessarily improve the current account deficit
- this is because, PEDs for exports and imports are likley to be inelastic in the short term
- initially the quantity of imports will remain steady because many contracts for imported goods are already signed
- it takes times for export businesses to increase their sales following a fall in price
- earnings from selling exports may not intially be sufficent to compensate for the higher total spending on imports
- the trade balance (X-M) may therefore initially worsen
what is the marshal lerner condition?
- states that the depreciation/ devaluation will lead to a net improvement in the trade balance, provided that the sum of PED of imports + sum PED of exports is greater than 1
Within a managed exchange rate, what are the ways in which the currency is intervened by central bank?
depreciation as example
- direct intervention: selling domestic currency and buying foreign currency, increasing foreign currency reserves
- intrest rates: cut intrest rates, leads to outflow of hot money
- others: quantitative easing
- increasing corporation taxes- discourage investors from buying currency
need high foreign currency reserves, conflict macrojectives,little affec
KAA paragraph of benefits of free floating exchange rates
current account
- A key benefit of a free-floating exchange rate is its ability to adjust to imbalances in the current account, such as a deficit, through expenditure switching effects.
- If a country experiences a fall in export demand, leading to a current account deficit, the reduced demand for its currency causes a depreciation. For example, during the 2008 financial crisis, the British pound depreciated significantly as the UK’s trade balance worsened.
- This depreciation makes exports cheaper and imports more expensive, encouraging domestic and foreign consumers to switch their spending towards domestically produced goods. helping to correct the current account deficit over time. For example, after the depreciation of the pound in 2008, UK exports of manufactured goods and services saw a noticeable increase, contributing to a gradual improvement in the trade balance.
EV:
* according to the Marshall Lerner condition, this only holds if the sum of PED of exports and imports>1, if less then then a depreciation may not be beneficial to the current account deficit.
* there can be a time lag before the full effects are felt, as seen in the ** J-curve effect**, where the trade balance may initially worsen before improving.
define competitive depreciation/ devaluation
competitive devaluations occur when a country deliberately intervenes to drive down the value of their currency to provide a competitive boost to demand in their export industries
depreciations are natural by market forces
how might a currency depreciation affect competitiveness?
- A depreciation is a fall in the external value of a currency inside a floating exchange rate system
- Consider for example a depreciation of the UK £ against the Euro
- As a result UK exporters can reduce the foreign prie of goods and services sold overseas
- This makes UK exports realtivley cheaper in overseas markets, improving price competition
- In addition to this the price of UK imports will also increase, as £! buys fewer euros
- A rise in import prices will make domestic producers in the UK more competitive relative to overseas producers
what are the effects of competitive devaluation/ depreciation?
- cost push inflation
- improved trade balance
- increased employment
- improved current account balance
- encourages trade retaliation through protectionsim like tarrifs
EV:
* hard to hold foreign currency reserves required
* are major trading partners in recession, then this doesn’t impact
what is effect of exchange rate on FDI?
A depreciation of the domestic currency can make a country more attractive for FDI, as foreign investors can acquire assets, labor, and resources at a lower cost in their own currency. This reduces the initial investment cost and increases the potential return on investment, particularly in export-oriented industries. For example, if the pound sterling depreciates against the US dollar, UK-based assets become cheaper for American investors, potentially boosting FDI into the UK. Additionally, a weaker currency can enhance the competitiveness of domestic goods in international markets, making the country a more attractive destination for firms looking to establish production bases for exports.
However, exchange rate volatility and sustained depreciation can also deter FDI. Sharp or unpredictable fluctuations in exchange rates increase risks for foreign investors, as they may face higher costs for imported inputs or reduced profitability when repatriating earnings. For instance, if a foreign investor expects further depreciation of the host country’s currency, they may delay or cancel investment plans to avoid potential losses. Moreover, a weak currency may signal underlying economic instability, such as high inflation or poor fiscal management, which can erode investor confidence. Therefore, while a controlled depreciation may attract FDI in the short term, long-term stability and a favorable economic environment are crucial for sustaining foreign investment.
Explain two ways in which a central bank can acuse a currency depreciation
chains of analysis
- Attempts by a central bank to cause a currency depreciation happens in a managed floating exchange rate system. A depreciation is a drop in the external value.
- One policy is to cut interest rates. This is designed to cause an outflow of hot money from the banking system and an increase in currency flowing overseas seeking a better return.
- Another intervention would be for the Central Bank to go directly into the foreign exchange market and sell your country’s own currency and buy foreign currencies.
- This again leads to an increased market supply of the domestic currency and a fall in the exchange rate. One effect would be a rise in foreign currency reserves.
for fixed: the central bank will intervene to prevent depreciation, not
