objectives Explain how ER is determined in floating ER system. Reasons causing fall in ER – depreciation Reasons c

1. objectives Explain how ER is determined in floating ER system. Reasons causing fall in ER – depreciation Reasons causing rise in ER - appreciation

2. Three types of ER systems : Floating Exchange Rate Fixed Exchange Rate Managed Floating

3. Floating Exchange Rates: • Price determined only by demand and supply of the currency – no government intervention • Fixed Exchange Rates: • The value of a currency fixed in relation to an anchor currency – not allowed to fluctuate • Dirty Floating or Managed Exchange Rate:– rate influenced by government via central bank around a preferred rate

5. Floating ER System • The ER is allowed to find its own level in the market. • Floating ER is determined by equating the forces of dd & ss of that country’s currency. • no intervention by govt.

6. $ / £ exchange rate and £ exchange rate index: 1976-2003 $ / £ fig

8. Floating ER System • DD for £ • The lower the ER of £, the cheaper the UK goods, the more people buy their goods, therefore the higher the dd for a currency • The DD curve for £ is __________ sloping.

9. Determination of the rate of exchange 2.20 • Downward Sloping • from Left to Right • Rate Lower, • Quantity Higher 2.00 1.80 $ price of £ 1.60 1.40 DD by USA 1.20 1.00 Q of £ fig 0

10. Floating ER System • SS of £ • The higher the ER of £, the more UK residents want to sell £ (to buy the cheaper American goods or to invest in US as it is now cheaper) • Therefore ss curve is __________ sloping.

11. Determination of the rate of exchange Upward Sloping From left to right -Rates Increase -Quantity Increase SS by UK (price) $=f £ Q of £ fig

12. Determination of the rate of exchange 2.20 S by UK Determined by British demand for US goods 2.00 1.80 $ price of £ 1.60 Determined by US demand for British goods 1.40 1.20 D by USA 1.00 Q of £ 0 fig

13. b a QS QD ER disequlibrium S by UK (price) $=f £ D by USA Q of £ fig

14. ER disequilibrium a)Excess SS of £ • If ER = $1.80, there will be an excess ss or surplus of £ of QdQs amount. • Banks wishing to make money by exchanging currency, would have to lower the ER in order to encourage a greater dd for £ & reduce the excess ss. • They will continue lowering the rate until dd = ss

15. c d QD QS ER disequlibrium S by UK (price) $=f £ D by USA Q of £ fig

16. ER disequilibrium a)Excess dd of £ • If ER = $1.40, there will be an excess __ or ________of £ of _____ amount. • Banks wishing to make money by exchanging currency, would have to raise the ER in order to encourage a greater ss of £ & reduce the excess dd. • They will continue raising the rate until dd = ss

17. Changes in ER • The equilibrium ER will not change unless the conditions of dd or ss changes, thus shifting the dd or ss curve to the left or right.

18. Currency Depreciation Currency Depreciation • A fall in exchange rate of one currency in terms of another. • means the £ buys less US$ • eg US$2 = £1 to US$1 = £1 • caused by • i) a fall in demand for the £ or • ii) an increase in ss of the £

19. Factors causing ER to change

20. 1)Changes in prices of domestic goods vs. foreign goods E.g. if UK's inflation rate is higher than abroad, UK exports will become more expensive, X will __ • The dd of £ will __ , dd curve shift left. • At the same time, imports will become cheaper, • M __ • The ss of £ will __ - ss curve shifts right. • Result -  ER i.e. DEPRECIATION

21. 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0 Floating exchange rates: movement to a new equilibrium S1 $ = £ D1 Q of £ fig

22. 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0 movement to a new equilibrium -depreciation S1 S2 $/ £ D1 D2 Q of £ fig

23. 2) Changes in relative Interest Rates • Changes in IR causes changes in short term capital flows. • Funds may be transferred from country to country to secure the highest rate of return. •  IR  inflow of hot money  DD for currency  ER - APPRECIATION

24. movement to a new equilibrium -appreciation $ = £1 1.80 S 1.60 1.40 1.20 1.00 D1 0.80 D 0.60 0 Quantity of £

25. 3 ) Changes in Current Account CA surplus  X -  dd for X  dd for £ •  M -  dd for M   ss of £ • __ ER CA deficit  X -  dd for X   dd for £  M -  dd for M ssof £ • __ ER

26. 4) Changes in relative investment prospects If investment prospects become higher abroad than UK, perhaps due to better economic conditions overseas or because of impending recession in UK, then DD for £ will __ & SS of £ will __

27. 5) Changes in relative incomes • If UK’s AD/NY, DD for M __, ss of £ __  ER___ • If UK’s AD/NY, DD for M __, ss of £ __  ER___

28. 6)Speculation • If speculators including importers & exporters etc think that the ER is about to fall they will ____ £ now. • Therefore ss of £ __ • At the same time, people requiring £ will wait until the rate has fallen before they purchase them. • Therefore dd for £ __ • Result: ___ ER

29. Terms of Trade improves SOL improves X is expensive – X M is cheaper - M  CA worsens (if dd for X n M r elastic) Terms of Trade deteriorates SOL worsens imported inflation M is expensive - M X is cheaper - X CA improves (if dd for X n M r elastic) Effects of Currency Appreciation Effects of Currency Depreciation