Importance of Exchange Rate Systems - Term Paper Example

April 14, Exchange and Markets Every country has its own policy objectives regarding their macro-economic aims. There were some aims of the internal policy objectives and some which were external policy objectives. Internal objectives include low unemployment, low inflation and economic growth. External objectives are with respect to the rest of the world like avoiding balance of payments deficit, preventing exchange rate fluctuations, and maintaining a positive balance of international trade. It is not always that all of the above aims can be maintained simultaneously. It is very difficult to maintain these macro-economic objectives and at times they are even in conflict of each other. (Sloman, 670) Exchange rates fluctuations are a major reason for balance of payment fluctuations. Before we understand the system of exchange rates we need to understand the method of balance of payments. Balance of payments means a record of all transactions made between one particular country and all other countries during a specified period of time (www.investopedia.com). BOP compares the dollar difference of the amount of exports and imports, which includes all financial exports and imports. A negative balance of payments means that more money is flowing out of the country than coming in, and a positive BOP means that more money is coming into the country. Balance of Payment can be said as a huge accounts book for the country. It also acts as an indicator of political and economic stability. A positive BOP may mean that the country’s functioning is going in a positive direction with foreign investment and funds coming in and limited resources in the form of cash going out. What are nominal exchange rates? Nominal exchange rate is simply the rate at which one currency is exchanged for other. This may mean for example it is quoted that one dollar is equal to 0.6 of a pound sterling. This may mean that the nominal exchange rate of a dollar to the pound is $1= 0.6 pound. Changes in the nominal exchange rates between two countries will have an effect on all the transaction prices of goods bought and sold between those two countries. This means that it is extremely important for these rates to be stables as these are bilateral rates (Bamford et al, 115). In a free market the exchange rate is determined by the market forces of demand and supply. This is quite similar to the determination of all other prices because where the supply and demand curves meet that is the market rate of the currency. For this lets consider the market price of Euros against dollars. The demand for euro will be a downward sloping demand curve. This is because when the price of euro is high in terms of US dollar, then the euro zone goods and services are expensive to US customers. This means that they will have to may more dollars in exchange for euros. This will result in a low demand for euro zone goods and services in the US. Thus few pounds are demanded on the foreign exchange market. As the value of the euro falls against the dollar US customers are able to get more pounds thereby increasing the demand of pounds on the foreign exchange market (Bamford et al, 117). The supply curve of Euro is upward sloping. When the Euro is low against the Dollar, then US goods are expensive in the Euro Zone and as a result less Euros are supplied in the market to buy US goods. On the other hand if the value of the Euro rises then US goods will become cheaper allowing more people in the Euro zone to buy these goods and rising the supply of Euros. Where these demand and supply curves meet the market exchange rate of Euro against Dollar is determined as shorn in the diagram below. ( Diagram taken from Determination of Exchange Rates, http://media.wiley.com/product_data/excerpt/73/EHEP0006/EHEP000673-2.pdf). At all prices above the equilibrium exchange rate the Euros supplied will be greater than the Euros demanded and vice versa. Any changes in the supply or demand of a currency will result in a depreciation or appreciation of the exchange rate. Depriciation of the exchange rate can be brought about by a variety of reasons. For example there is a fall in the demand for Euro. The fall can be caused by a veriety of changes. The fall can be due to a reduction in the damand for Euro Zone goods and services. In this way less amount of Euros will be demanded for payments and the demand for Euros will fall. This will cause a depriciation of the currency. Another reason could be the reduction in the foreign investment in the Euro Zone. A reason behind this could be lower interest rates in the Euro Zone which will prevent the foreign direct investment from entering here. Appreciation of the exchange rate can occur due to a decrease in the supply of dollar. This shift in supply curve can be the result of a decrease in the amount of goods and services imported in the country which causes the reduction in the supply of money (Bamford et al, 117,118). There are a number of reasons which can brink about changes in exchange rates and it is these factors which cause the variations. The reason which is important is the relative inflation rates. Lets suppose that the supply of dollars increases more than or relative to its demand. This excess growth in the money supply will cause inflation in the United States, because the more cash that is available the more people will spend. This means that U.S. prices will begin to rise relative to prices of goods and services in Euro Zone. Euro Zone consumers are likely to buy fewer U.S. products as they are now expensive compared to local products. As a result, they begin switching to Euroland substitutes, leading to a decrease in the amount of Euros supplied at every exchange rate. The result is a leftward shift in the Euro supply curve to as shown in diagram below. Similarly, higher prices in the United States will lead American consumersports for U.S. products, resulting in an increase in the demand for euros as depicted by outward shift of the demand schedule. In effect, both Americans and residents of Euroland are searching for the best deals worldwide and will switch their purchases accordingly as the of U.S. goods change relative to prices in Euroland. Hence, a higher rate of inflation in the United States than in Euroland will simultaneously increase Euroland exports to the United States and reduce U.S. exports to Euroland.A new equilibrium rate results. In other words, a higher rate of inflation in the United States than in Europe will lead to a depreciation of the dollar relative to the euro or, equivalently, to an appreciation of the euro relative to the dollar. In general, a nation running a relatively high rate of inflation will find its currency declining in value relative to the currencies of countries with lower inflation rates. This relationship is known as purchasing power parity (PPP). (Determination of Exchange Rates, http://media.wiley.com/product_data/excerpt/73/EHEP0006/EHEP000673-2.pdf). The diagram is taken from Determination of Exchange Rates, http://media.wiley.com/product_data/excerpt/73/EHEP0006/EHEP000673-2.pdf). Exchange rate fluctuations can also cause a change in the rate of inflation. As mentioned earlier that not all macro-economic objectives can be fulfilled as per one’s need. This is an excellent example of the conflict of interests. Thus, exchange rates can affect inflations rates through many ways. There can be a change in the price of goods because exchange rates have a direct impact on the Consumer Price Index. An appreciation of the exchange rate for example can reduce the price of the other goods which are imports. This however, also depends on the elasticties of the goods in discussion. There can also be a change in the price of international commodities. For example coal and gold these days are still traded in Dollars. So an appreciation in the currency with respect to dollars will reduce the price of these commodities. On the other hand a depriciation will result in the rise in prices of these goods. Credit: http://tutor2u.net/economics/revision-notes/a2-macro-exchange-rate.html The above diagrams further elaborate the effect of exchange rates on inflation rates. Exchange Rate Systems There are two major types of exchange rate systems: floating exchange rate system and fixed exchange rate system respectively. The floating exchange rate system means that there is no involvement of the central bank in the mainenance of the exchange rate of the country. On the other hand fixed exchange rate system means that there is a huge involvement of the central bank in the managing of the exchange rate. There are regular debates on which system is better. The main arguments for adopting a floating exchange rate system are as follows: There is a reduced need for currency reserves. There is no exchange rate target so there is little requirement for the central bank of that country to hold large scale reserves of gold and foreign currencies. This allows the central banks for some leverage. Huge reserves and interference are extremely difficult to manage. The floating exchange rates can be a useful as a macro-economic indicator. The fluctuations can not only be a good indicator but also a tool. For example depreciation should provide a boost to net export demand and therefore stimulate growth in the economy. However, the assumption which is significant here is that the gains from a lower exchange rate are not dissolved in higher wage claims or export prices. The countries inside the Euro Zone for example might be hoping for a more competitive exchange rate as a means of creating an injection of demand into their slow-growing economies. Floating exchange rates also offer a degree of adjustment when the balance of payments is in fundamental disequilibrium which means that we are either facing excessive growth or continuous downfall. A large trade deficit puts downward pressure on the exchange rate which should help the export sector and control demand for imports because they become relatively expensive. This helps the economy and stimulates an auto mode. Due to the floating exchange rate system there is an increased reduction in the amount of speculation which takes place in the economy. The absence of an explicit exchange rate target reduces the risk of currency speculation. This target is used by speculators for their own benefits. Often, currency market speculators target an exchange rate target that they believe to be fundamentally over or undervalued. If the exchange rate is not fixed and fluctuating it removes one of the macro-economic objectives of the government. The absence of an exchange rate target allows short term interest rates to be set to meet domestic macroeconomic objectives such as stabilising growth or controlling inflation. The are no longer bothered of managing the fixed rate of exchange by maintaining the inflows and out flows. The Bank of England has enjoyed the autonomy that a floating exchange rate gives since it was made independent in May 1997. Despite the fact that it is claimed that fixed exchange rate systems are volatile this may not be the true scenario. Although the sterling exchange rate has been floating, the volatility has not been that great. Businesses and speculators have learnt to cope with modest fluctuations – helped by having a flexible labour market and meeting their own objectives. The main arguments for adopting a fixed exchange rate system are as follows: The fixed exchange rate system is very beneficial for trade and investment.Currency stability can help to promote trade and investment because of lower currency risk as even if there are appreciations or depriciations the government takes the necessary steps. The system allows some deal of flexibility. Some adjustment to the fixed currency parity is possible if the economic case becomes unstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement can be reached with other countries). That said, countries with fixed exchange rates are often reluctant to make parity adjustments – because of the reason that these are considered as critical. Because we can never predict what will happen to the market value of a currency, many businesses hedge against this volatility by buying the currency they need in the forward currency markets. With fixed exchange rates, businesses have to spend less on currency hedging if they know that the currency will hold its value in the foreign exchange markets (hedging involves risk) (Riley, 2006) A stable (fixed) currency acts as a discipline on producers to keep their costs and prices down and may lead to greater pressure for exporters to raise labour productivity and focus more resources on research and innovation. In the long run, with a fixed exchange rate, one country’s inflation must fall into line with another (and thus put substantial competitive pressures on prices and real wages). Conclusion Therefore exchange rate systems are an important tool and component of the macro-economic system. We live in a world where the effects in one area affects the other as we have seen in the South Asia crisis in the 1990s and the world recession in the last couple of years. Exchange rates are extremely important as far as macro-economic objectives are concerned. Though they may not be primary concern for the governments they are extremely significant for balance of payments and the economic position of the country. Though it has been a lon lasting debate now each and every country goes for the floating exchange rate but the government does interfere at times. References Bamford, Colin, et al. AS Level and A Level Economics, Cambridge, Cambridge University Press, 2004 Print Determination of Exchange Rates, http://media.wiley.com/product_data/excerpt/73/EHEP0006/EHEP000673-2.pdf). Riley, Geoff, 2006, http://tutor2u.net/economics/revision-notes/a2-macro-exchange-rate.html Sloman, John, Economics, 6th edition, Collins 2006, Print http://www.investopedia.com/terms/b/bop.asp Read More