10.2 Exchange Rates

Exchange rates are the price of one currency in terms of another. They come in three main flavors: floating, fixed, and managed float. Each system has its pros and cons, affecting a country's economic stability, trade relationships, and monetary policy goals.

Exchange rates are influenced by various factors, both economic and non-economic. Interest rates, inflation, current account balances, and government debt levels all play a role. Political stability, economic performance, and market sentiment also impact currency values. These factors can cause significant fluctuations in exchange rates.

Exchange rates and systems

Definition and types of exchange rates

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• An exchange rate represents the price of one currency in terms of another currency
• Indicates how much of one currency can be exchanged for a unit of another currency (US dollar to euro)
• The three main types of exchange rate systems are:
  • Floating exchange rates: Currency values determined by supply and demand in the foreign exchange market without government intervention
  • Fixed exchange rates: Government or central bank sets and maintains the official exchange rate by actively buying or selling its currency (Chinese yuan pegged to US dollar)
  • Managed float exchange rates: Exchange rate largely determined by market forces, but central bank may intervene to influence the rate and prevent excessive fluctuations (Singapore dollar)
• Countries choose their exchange rate system based on factors such as economic stability, trade relationships, and monetary policy goals

Factors influencing exchange rate choice

• Economic stability: Countries with stable economies may prefer fixed or managed exchange rates to minimize currency fluctuations
• Trade relationships: Countries with strong trade ties may opt for fixed or managed exchange rates to facilitate trade and reduce exchange rate risk
• Monetary policy goals: Countries seeking to maintain independent monetary policy may prefer floating exchange rates
• Historical and political factors: Past experiences and political considerations can influence a country's choice of exchange rate system (Eurozone countries adopting the euro)

Factors influencing exchange rates

Economic factors

• Interest rate differentials: Higher interest rates attract foreign capital, increasing demand for the domestic currency and causing appreciation
• Inflation rate differentials: Countries with consistently lower inflation rates typically see currency appreciation relative to countries with higher inflation
• Current account deficits or surpluses: A current account deficit implies a country is spending more on imports than earning from exports, leading to currency depreciation
• Government debt levels: High public debt may lead to currency depreciation due to concerns about the government's ability to repay obligations (Greece during the European debt crisis)

Non-economic factors

• Political stability: Countries with stable political environments tend to have stronger currencies
• Economic performance: Strong economic growth and positive economic indicators support currency appreciation
• Speculation and market sentiment: Investors buying or selling currencies based on expectations of future exchange rate movements can cause short-term fluctuations
• Geopolitical events: Political tensions, wars, or natural disasters can impact currency values (Swiss franc appreciation during global uncertainties)

Exchange rate fluctuations and impact

Impact on international trade

• Relative prices of exports and imports: Currency appreciation makes exports more expensive for foreign buyers, potentially reducing demand, while making imports cheaper (Japanese yen appreciation affecting export competitiveness)
• Export competitiveness: Currency depreciation can make exports more competitive in international markets as they become cheaper for foreign buyers, potentially increasing export volumes and improving trade balance
• Exchange rate volatility: Increases uncertainty and risk associated with international trade, leading to higher costs for businesses engaged in international transactions due to hedging needs

Impact on investment and corporations

• Foreign direct investment (FDI) decisions: Weak currency in the host country may attract FDI as foreign investors can acquire assets at a lower cost, but excessive volatility may deter FDI due to increased uncertainty
• Multinational corporations: Value of foreign assets, liabilities, and foreign-earned profits impacted by exchange rate movements when translated back into the company's home currency (US multinational companies affected by dollar strength)

Central banks and exchange rate management

Intervention in foreign exchange markets

• Foreign exchange intervention: Central banks buy or sell currencies to influence exchange rates
  • Prevent excessive appreciation or depreciation of the domestic currency to mitigate adverse economic effects
  • Sterilized intervention: Offsetting the impact on the domestic money supply
  • Unsterilized intervention: Allowing the money supply to change
• Maintaining fixed exchange rates: Central banks are responsible for maintaining the fixed rate by standing ready to buy or sell the domestic currency at the predetermined rate

Monetary policy and reserves

• Monetary policy tools: Central banks use interest rates to indirectly influence exchange rates (raising rates attracts foreign capital, leading to currency appreciation)
• Foreign exchange reserves: Central banks hold reserves to manage exchange rates and protect against currency crises, enabling intervention to defend the domestic currency when necessary (China's large foreign exchange reserves)
• Effectiveness of intervention: Debated, as intervention can be costly and may not always achieve desired outcomes, particularly in the long run or when market forces are strong