Exchange rates

Exchange rates

1. DEFINITION

   • Rate at which one currency trades against another on a foreign exchange.

2. KEYWORDS

   • Exchange rate index- measure of a currency against a trade-weighted basket of currencies.
   • Real exchange rate- when exchange rates are adjusted for effects of inflation.
   • Floating exchange rates- value of currency is determined by market forces.
     • Advantages- exchange rate adjusts to balance of payments. Policyc makers have freedom to change exchange rates depending on specific macroeconomic objectives.
   • Fixed exchange rates- government keeps value of currency at a certain level compared to other currencies
     • Advantages- firms export prices will be more stable. Firms can plan ahead and invest for the future.

3. FACTORS INFLUENCING EXCHANGE RATE

   • Interest rates- higher interest rates encourages saving in a country so the demand for a currency will appreciate.
   • Inflation- the higher value of currency makes exports more expensive so the currency depreciates.
   • Growth in economy- Investments(FDI)

4. BENEFITS AND COSTS OF APPRECIATING CURRENCY

   • BENEFITS- Potential efficiency gains for domestic producers
   • BENEFITS- Cheaper imports= higher standard of living
   • BENEFITS- Lowers Demand Pull inflation and lowers Cost push inflation, i.e. AD & AS have Shift left
   • COST- Higher Current Account Deficit
   • COST- Lower employment for exporting based firms

5. GOVERNMENT INTERVENTION

   • Interest Rate- IR Increase = Appreciation IR Decrease =Depreciation
   • Buy domestic currency and sell foreign reserves = depreciation Vice versa for appreciation

6. BENEFITS OF DEPRECIATION

   • Fall in exchange rates can stimulate demand for exports when economy is in recession.
   • Balance of trade will improve as sales increase.
   • Provides a competitive boost to an economy

7. LIMITS OF CURRENCY DEPRECIATION

   • Demand pull and Cost push inflation increase
   • Increases cost of imports

8. The J-Curve

9. MARSHALL-LERNER CONDITION

   • A devaluation in the currency will only improve the balance of payments if the sum of demand elasticity for imports and exports is greater than one!

10. HYBRID EXCHANGE RATES

    • A mixture of fixed and floating exchange rates.

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