Exchange Rate Regime for UK - Essay Example

Exchange Rate Regime for UK Name: Institution: Exchange rate regime is a means through which a sovereign country manages its own currency in relation to other foreign currencies in the foreign exchange sector. There are various types of exchange rate regimes but the most common ones are the pegged exchange regime, floating exchange rate regimes, and managed float exchange rate regimes. The history of exchange rate regime is long and interesting. Before I discuss about history of exchange rate for the USA, I will first explain how it evolved on a general scale. The choice of the exchange rate traditionally was between fixed exchange rates and specie standards on one side and floating and fiat money on the other side. Fiat money and floating money were deemed a departure from monetary and fiscal stability policy and was only to be allowed during the periods of war and other forms of emergency. Before the Second World War, the return of the Gold standard was temporary, succumbing at the Great Depression. The eventual use of the gold standard system was followed by massive use of floating rates. This perception was later followed by the Bretton Woods flexible peg in 1944. Countries were supposed to carry out currency arrangements combining the pegged exchange rate regime and fixed exchange rate regime. The reference currency was to be the US dollar. Pegged exchange regime is where the central bank of a particular country is controlled or fixed by the central bank so that it cannot deviate from the target value. It is normally used in the stabilization of currency value against a specific currency in which it is pegged to. The main importance of this type of exchange rate regime is that it enables trade between two or more countries to be predictable. The disadvantage of this exchange rate regime; however is that it cannot be used to automatically adjust the deficits in the balance of trade. The use of monetary policies cannot be used easily to regulate the monetary policy using this type of exchange rate regime (Yeung et. al., 1998). In the pegged exchange rate system, the central bank, which acts on the government’s behalf, intervenes so that the rate of exchange of currency stays near the fixed value. The sterling pound, for example, was allowed to fluctuate at arrange of plus or minus 6% of the fixed value of DM 2.95. Floating exchange rate regime, also common referred to as fluctuating exchange rate regimes a type of exchange rate regime where the currency’ of a particular nations allowed to consistently fluctuate in value as dictated by the foreign exchange market. This type of exchange rate regime is more preferred than the fixed one. Since this exchange rate regime adjusts automatically, it will enable a country to reduce the effects of exchange shocks and external business cycles. It also reduces the effects of balance of payment deficits. They are also preferred for their enhanced certainty and stability. The floating exchange rate regime enhances foreign exchange volatility. This usually affects the developing countries so much because they have a financial sector which high liability dollarization, strong balanace sheet effects and high financial fragility. The constant debate of trying to get the trade off between fixed and floating exchange rate regimes is explained under Mundell- Fleming model. It argues that a country cannot be able to maintain free capital movement, fixed exchange rate, and independent monetary policy simultaneously. It can opt for the two, and leave the other one to the effects of market forces. In case of extreme depreciation or appreciation of a currency, what usually happens is that the central bank intervenes to make the currency stable. This is done through using the managed float system. The central bank will allow a currency rate to float between lower and upper bound. This policy may be in form of buying and selling large lots to offer resistance. The exchange rate regime of the UK dates back to the Bretton woods conference, though there were some, other forms of exchange rate policies that were in existence before then. I am giving a brief summary of the exchange rate policies from 1944 on wards. Bretton Woods’s system was the first formal policy of monetary policies to be implemented by the UK and other countries. The main feature of the Bretton Woods system was that each member state was supposed to adopt a certain monetary policy that kept the exchange rate by fixing its home currency to the dollar. However, in 1975, the US officially terminated the conversion of its currency to gold.Bretton Woods system was ended and the US dollar became the fiat currency, which was backed by the government promises. The event was coined ‘Nixon Shock’ and it created a condition whereby the US dollar fully becomes the reference currency and a reserve currency for all the member states. With the Bretton Woods system, member countries were supposed to be committed in maintaining the value of their currencies near a stipulated par value. From the periods 1949-1967, the par value was fixed at one sterling equivalent to 2.80 dollars. The exchange rate range was kept at $2.78-$2.82. During 1960’s the value of sterling deteriorated because of the ever-poor competitiveness of the currency due to UK wages rising faster and higher than WE do prices and wages. There was also a balance of payment crises, with the government reports indicating current account deficit from 1964-1967. Since 1992, UK has highly regarded the floating exchange rate as the best type of exchange rate regime. Under the floating exchange rate regime, the value of the currency can be found by forces of market demand and supply. In 1971, the value of the sterling depreciated against all major currencies. The reasons for depreciation were high oil prices, rapid demand expansion, and rising inflation. In 1972, UK tightened its monetary policy, bringing down inflation by 25%. Unemployment rate stopped rising, the price of oil reduced and the balance of payment figures became pleasing. This will lead to the eventual rise in the value of the sterling. UK’s monetary policy is the one for floating exchange regime ad also the inflation forecast targeting. The floating exchange rate regime enables the Bank of England the ability to effectively use the efficient monetary policy to control inflation. The members of Monetary Policy Committee have endorsed that this exchange rates effective for monetary policy if only it has effects on inflation forecasts. The value of UK pound is always rated high as compared with the values of other currencies. This implies that its value of output (natural resources, manufactured goods and services) are more valuable in the foreign markets than those of other countries. When the devaluation of a currency takes effect, balance of payment crisis occurs. The purchasing power parity goes down, there will be less imports and the value of the country’s products will be lower than expected. Exchange rates can be modified to deviate fro their equilibrium state. In order to encourage UK exports, devaluation of the currency will be effected in order to encourage importers to buy more UK exports. To reduce the effects of inflation, the sterling pound rates will be increased. Since the Bank of England usually does not target the exchange rate, the MPC takes care of the exchange rates. MPC prefer usually high exchange rates as they lower the prices of imports and reduces the effects of inflationary pressure on the UK’s economy. What MPC needs to take into consideration however, is that they need to take care of competitiveness of UK exports in foreign markets since if the exchange rates rises too high the amount of exports will decrease since the sterling pound would have become expensive to importers. When the Bank of England buys some currency in circulation in order to increase its reserves, the amount of the currency in circulation reduces, making its supply come down, hence increasing its price or value. When this happens, inflation, rate reduces and the people’s purchasing power comes down. Lowering of exchange rates will have the various effects in the UK commodity market. First, it raises the aggregate demand of the UK exports. Secondly, it results to a rise in national output or the GDP. This is because increased value of exports will translate to money income inflows, which is an injection to an economy. Lowering the exchange rates will also create jobs, as great demand of the country’s exports will lead to expansion of production capacities, which require more people to be employed. Assuming that the demand of the UK exports is price elastic, the devaluation of the pound will result in the improvements of balance of payment. Raising the exchange rates can reduce excessive aggregate demand, which prevents the country’s resources from being overexploited, keep inflation lower and lose of jobs since less is demanded of UK exports. The Purchasing Power Parity (PPP) for UK in 2010 was approximately $2.173 trillion. The GDP at PPP shows the value of all the goods and services produced in the country and valued at the prevailing US prices. The UK’s PPP is by far the highest in the world due to the value of its currency and the quality and quantity of its exports. UK’s exports are demanded all over the world and this implies that it has a competitive edge over other advanced economies like USA, Germany, Japan, and France. UK’S economy is the sixth largest in the world when nominal GDP is used and the seventh largest when PPP is used. The essence of PPP is that a unit of a sterling pound should be able to purchase the same basket of goods in one particular country as the equivalent of a given foreign currency, at the existing exchange rate. It means it can be able to purchase in a particular foreign country, so as to ensure parity in terms of purchasing power of the currency in the two countries. The idea of PPP usually holds for foreign trade due to Law of One Price. It states that the price of a good trade internationally should be similar anywhere world wide immediately the price is expressed in form of common currency (Gillespie, 2007). The PPP for UK from 2006 onwards shows that it had been increasing consistently. This implies that the price for a basket of commodities in the UK was a bit lower due to currency devaluation. Currency devaluation resulted in more exports since the price of the sterling pound in the foreign exchange market is now lower. Compared to the US, the exports of UK in these stated periods were higher. Therefore, it shows that PPP increases when the country devalues its currency under the floating exchange rate regime. UK’s interest rate parity is somehow closely related to rates of countries like USA, Germany, and Japan. However, investors usually prefer UK because this is where most assets dominated by different currencies are found. This means that investing in UK is less risky than other countries. The investors will therefore analyze the existing exchange rates and if it is favorable to carry out their investment. In a mixed economy like this of UK, the relationship between interest rates and the existing exchange rates is stronger and direct than relationship between exchange rates and money supply. Since capital movement around the world now days is flexible, it means that the expected rates of returns on those assets would be the same. In addition, since most assets are dominated in different currencies, it will be insufficient to compare the interest rates. Considering exchange rates is very important, as it will help investor to know which country has favorable exchange rates against their home currency. The reason here is, if an investor from the UK invests in US, and the value of the dollar depreciates by 5% compared to the sterling, the investor will incur a loss of 5%. This will be netted from the prevailing US rates in order to determine the amount of return the investor got by holding the funds in the States (Bagman et al, 2002). The determining factor of how usable IRP is the presence of the forwards market .Forwards market provides useful information for determining the anticipated change in exchange rates. The sterling’s forward premium indicates the amount by which the sterling is supposed to appreciate. Therefore, the type of interest parity UK uses is known as covered interest rate parity. The implication here is that the interest rate got from investing abroad must be equal to interest rates prevailing in the UK plus the sterling’s forward premium (Lee, 2011). When the foreign exchange market is working efficiently, the forward exchange rate will have to be the same as investor’s expected value of their returns in a period less than 3 months. For example, if on March, the sterling’s forward price is $1.54, and suppose that the investors anticipate the value of sterling to be $ 1.50 come June it would imply that if the investor had sold sterling on the market, he will anticipate some gain. This also suggests that when the currency is devalued, investors will be attracted since they will be able to make profit (Macdonald, 1988). For most periods, sterling has been selling at a discount compared to the dollar. Since inflation rate, In the UK has been higher than in the USA, sterling has been depreciating as it is reflected by the forward discount (Hendricks, 2010). References Arthur, S. (1995). Understanding Purchasing Power Parity. New York: Cengage Publishers. Bigman, D. and Taya, T. (2002), Floating exchange rates and the state of world trade and payments. London: Beard Books. Gillespie, A. (2007). Foundations of Economics. London: Oxford University Press. Hendrik, B. (2010). 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