Understanding Currency Exchange Rates and Economic Systems
Types of Exchange Rates
Nominal Exchange Rates
The nominal value is simply the price of one currency in terms of another. Changes in the nominal exchange rate of one country’s currency with that of another will affect the transaction price of goods and services bought and sold between these two countries. (Inflation is not taken into account so they are not REAL VALUES)
Trade Weighted Index
It measures the value of a currency against a basket of currencies of other countries which are weighed according to their relative importance.
e.g., the exchange rate between two countries such as USA and UK won’t be as much as the one of UK and Colombia.
So the exchange rate depends on the trade between the countries
Real Exchange Rate
It takes inflation into account.
e.g. if the pound falls by 3% against the dollar, but there is 3% of inflation in the USA, then the real exchange doesn’t change, (even though it actually has) (It is balanced again)
The Determination of Exchange Rates
The buying and selling of foreign exchange takes place on the foreign exchange market. This evolves into a supply and demand graph for currencies.
e.g.
If a resident in the UK wants to buy a Spanish product the process is:
Pounds supplied into the market – Demand for Euros in the market – UK resident buying the product with Euros
The demand of a currency will increase if:…
- The goods and services of that country are demanded more, e.g: the quality improves, foreign incomes increase or they are relatively cheaper, (more tourism)
- The interest rate increases, because there will be a greater desire to save in the UK to earn higher rates in return.
- People think that the value of the currency will rise in the future, therefore they buy money now
The Determination of the Equilibrium Exchange Rate in a Free Market
The value of an exchange rate is determined solely by the forces of demand and supply.
-As an example let’s say that we are talking about the demand and supply of pounds in reference to the US dollar.
-If the price of the pound is very high, then British goods and services are expensive to US consumers- which have to pay lots of dollars to gain pounds. And it means that it is also high for British citizens as well if they want to buy British products. This has two consequences.
-The demand for pounds will decrease because the US citizens won’t want to buy UK products
-The supply of pounds onto the foreign exchange market will be high, because many British citizens will want to change the pounds to other currencies where it is cheaper to buy products.
The opposite situation will occur if the price of the pound was low. There would be high demand and low supply in the foreign exchange market.
Causes of Changes in the Equilibrium Exchange Rate
Any change in supply or demand for a currency will cause a depreciation or appreciation in the exchange rate. (market for pounds)
A Depreciation in the Exchange Rate
A depreciation in the exchange rate can occur. It occurs when the demand for the pound falls (shifts to the left). It could be caused by:
A Reduction in the Number of UK Goods and Services Sold Abroad.
These could be a consequence of an increase in prices of UK goods due to inflation inside the country. Moreover, if the prices are higher now in the UK, it is obvious that less countries abroad, are going to be willing to demand pounds to buy UK goods and services.
A Reduction in the Number of International Investors Who Wish to Place Their Funds in the UK Economy.
This might be because interest rates in the UK are lower, and would give a poor return to the investors.
An Appreciation in the Exchange Rate
An appreciation in the exchange rate can occur. Here there has been a decrease in the supply of the pound. This could be caused by:
A Decrease in the Number of Foreign Goods and Services Imported to the US.
To buy products abroad, UK citizens have to supply pounds to receive money in the form of other currencies. Moreover if the UK citizens don’t want to import from abroad, due to a better domestic price (or to a rise in the price of foreign goods), then there will be less supply of pounds onto the foreign exchange market.
A Decrease in the Number of US Investors Who Want to Place Their Funds in Foreign Economies.
Again, in this case, if interest rates abroad fall, then investors will prefer to invest in the UK rather than in foreign countries.
Effects and Consequences of Changing Exchange Rates in the Economy.
If there is a change in the value of a country’s currency, then the transactions in the international market will also be affected. The effects would be:
A depreciation will mean that the price of imports will rise and the price of exports will fall.
An appreciation will mean that the price of imports will fall and the price of exports will rise
The Impact of a Depreciation
As explained before, a balance of payments deficit (more imports than exports) or (more investments made in foreign countries than in the own country) will cause a depreciation in a country’s currency, which will mean that import prices will rise. Consequences:
- Domestic manufacturers will be more competitive
- Imported manufacturers are more expensive
- Increase in demand for domestic products
- Increase in demand for factors of production (including labour)
- Unemployment falls
- If labour becomes scarce (no unemployment), employees will require higher wages
- Higher wages will be passed on to consumers as higher prices
- Inflationary pressure occurs because of excessive demand for domestic products
- Imported raw materials will become expensive
- Manufacturers pay more and pass it on to consumers (again higher prices)
A depreciation also means that export prices will fall. Consequences:
- Increase in demand for that country’s products
- Inflationary because of competing with other firms
Overall, the balance of payments will change from deficit to surplus.
The Impact of an Appreciation
A balance of payments surplus (more exports than imports which means that there is no supply of pounds and the prices has gone up) will cause an appreciation in that country’s exchange rate. This will have a number of consequences.
- Import prices will fall
- Export prices will rise
- Domestic consumers switch to imported goods
- Foreign consumers prefer domestic goods rather than the UK’s
- Overall decline in demand
- Unemployment (domestic firms have no demand)
Balance of payment surplus is replaced by a balance of payment deficit.
Exchange Rate Systems
Governments can decide to have a floating exchange system. This means that the rate of exchange of a currency is decided by the demand and supply of it.
An alternative approach is the government to intervene. The degree of intervention can vary:
Managed exchange system: Value of currency mostly decided by market forces, but the government takes action to influence the rate.
Fixed or pegged exchange systems: Far more than intervention. Government declares a central value and intervenes to maintain the value.
Floating Exchange Rate Systems
Advantages
- The exchange rate automatically adjusts so that supply equals demand- this can eliminate balance of payments deficit or surpluses.
- There is no need for central bank to keep foreign reserves.
- The government can pursue its own domestic policies.
- It prevents imported inflation
Disadvantages
- It causes instability, which reduces investment and trade
- It can lead to inflation
- Governments are not forced to control their economies and do not face any pressure.
Fixed and Managed Exchange Rates
The government intervenes to maintain the exchange rate
If the price of currency is going to fall = Government increases demand by buying its own currency or increasing interest rates.
If the price of a currency is about to increase= Government may sell its own currency or lower interest rates
Advantages
- Provide stability- encourages investment and trade.
- They act as a constraint (restricción) on domestic inflation.
Disadvantages
- A government must have sufficient reserves.
- The government may undertake policies that are bad for the domestic economy (in order to stabilize the exchange rate.
2 (a) Explain the functions of an economic system.
An economic system is the means by which a country answers the basic economic problem.
Limited resources and unlimited wants result in scarcity and choices have to be made. The
system allows the questions of what?, how?, and for whom? to be answered. It arranges for
resources to be employed to meet demands and for producers and consumers to be
satisfied. This may be done by the price system, state planning or a mixture of the two.
(b) Discuss possible reasons why mixed economic systems have replaced most of the former planned economic systems.
Planned economies are based on state control and direction while a mixed economy uses
the market system supported by appropriate government intervention. Recent history
illustrates the failure of the planned economy to raise living standards and perform as well as
mixed economies. Mixed economies proved more efficient, more innovative, more flexible
and provided greater choice and higher living standards. Planned economies were unable to
coordinate economic decision making, lacked incentives, lacked quality control, were slow to
change and caused considerable environmental damage. Despite the attempts of planned
economies to provide citizens with security and a minimum standard of living, the advantages
of the mixed economy were more highly valued.
2 (a) Explain the role that a government must fulfil in a mixed economy.
A mixed economy is based on private ownership, the profit motive, demand and supply etc. with a role for the government. The role is to provide the environment in which the market can operate successfully. This includes ensuring law and order, national defence, property
rights and the provision of public goods and desirable merit goods. It intervenes with taxes, subsidies etc. to influence the behaviour of the private sector and markets and achieve a better allocation of resources.
(b) Discuss the accuracy of the definition of public and merit goods as ‘goods that must be provided by the government’.
Public goods are non-rival and non-excludable such as street lighting. Merit goods are goods underprovided by the market system. The consumers lack full information of the consequences of non-consumption. This might include healthcare and pension provision. Although the government provides public goods because it is not possible for the market due to free riders, merit goods are supplied to a greater or lesser extent by private providers. The government also provides other goods and services which are neither public nor merit goods. The definition fits public better than merit goods but is inadequate in itself.
2 (a) Explain how resources are allocated in a free market system.
A free market system relies on demand and supply without government intervention. Resources are the factors of production. Consumer and producer behaviour results in demand and supply changes leading to price changes. Higher prices, profits and rewards draw more resources to that use. Price falls do the opposite.
(b) Discuss how the market system might be influenced by government intervention to provide appropriate quantities of goods and services.
Markets may fail by under-provision, over-provision or non-provision of goods and services. This relates to merit goods, demerit goods and public goods. The government can undertake state provision, subsidisation, taxation and product bans and regulation. Each method can be judged by its cost, effectiveness and side effects. State provision will make the goods available but may be costly and inefficient. Subsidisation will reduce the cost of the good but will interfere with the market mechanism and be a burden to taxpayers. Taxation regulates consumption and raises revenue but imposes burdens on producers and consumers. Bans and regulation prevent production but may lose some benefits and create unemployment and enforcement costs.