7.3 Exchange rates and currency policies

Exchange rates and currency policies play a crucial role in international trade and global business. They determine how much one currency is worth compared to another, affecting everything from trade balances to investment flows between countries.

Central banks use various tools to manage exchange rates, including direct intervention and interest rate adjustments. These policies can have far-reaching effects on a nation's economic competitiveness, inflation rates, and overall financial stability in the global marketplace.

Exchange Rate Systems

Fixed vs. Floating Exchange Rates

Top images from around the web for Fixed vs. Floating Exchange Rates

• 

  File:Mundell Fleming Model (fiscal policy under fixed exchange rates).png - Wikimedia Commons View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Exchange Rate Policies | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  File:Mundell Fleming Model (fiscal policy under fixed exchange rates).png - Wikimedia Commons View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

1 of 3

Top images from around the web for Fixed vs. Floating Exchange Rates

• 

  File:Mundell Fleming Model (fiscal policy under fixed exchange rates).png - Wikimedia Commons View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

• 

  Exchange Rate Policies | OpenStax Macroeconomics 2e View original

  Is this image relevant?

• 

  File:Mundell Fleming Model (fiscal policy under fixed exchange rates).png - Wikimedia Commons View original

  Is this image relevant?

• 

  Exchange-Rate Policies | Macroeconomics View original

  Is this image relevant?

1 of 3

• Fixed exchange rate system pegs currency value to another currency or basket of currencies
  • Central bank maintains set rate by buying or selling reserves
  • Provides stability and predictability for international trade and investment
  • Can lead to balance of payments problems if rate becomes misaligned with economic fundamentals
• Floating exchange rate allows currency value to fluctuate based on supply and demand in forex markets
  • Reflects economic conditions more accurately
  • Requires less government intervention
  • Can experience higher volatility and uncertainty for businesses

Central Bank Intervention in Currency Markets

• Central banks intervene in foreign exchange markets to influence currency values
• Methods of intervention include:
  • Direct buying or selling of foreign currency reserves
  • Adjusting interest rates to attract or discourage foreign investment
  • Implementing capital controls to restrict currency flows
• Goals of intervention vary:
  • Stabilize excessive short-term fluctuations
  • Maintain a target exchange rate range (managed float)
  • Accumulate foreign exchange reserves

Currency Value Changes

Factors Influencing Currency Values

• Currency devaluation involves deliberately lowering a currency's value
  • Often used to boost exports and reduce trade deficits
  • Can lead to inflation and reduced purchasing power for citizens
• Currency appreciation occurs when a currency's value increases relative to others
  • Results from strong economic performance, higher interest rates, or increased demand
  • Can make exports less competitive but increase purchasing power for imports
• Economic factors affecting currency values include:
  • Interest rate differentials between countries
  • Inflation rates and expectations
  • Political stability and economic policies
  • Trade balances and capital flows

Purchasing Power Parity and Exchange Rates

• Purchasing power parity (PPP) theory suggests exchange rates should equalize the purchasing power of different currencies
• PPP calculation compares the cost of a standard basket of goods across countries
• Formula: $PPP = Price of basket in Country A / Price of basket in Country B$
• Used to compare living standards and adjust for price level differences
• Deviations from PPP can indicate over- or undervalued currencies
• Big Mac Index serves as a simplified PPP measure using McDonald's Big Mac prices globally

Foreign Exchange

Structure and Function of Forex Markets

• Foreign exchange (forex) market facilitates currency conversion and international trade
  • Largest financial market globally, with daily trading volume exceeding $6 trillion
  • Operates 24 hours a day, five days a week across major financial centers
• Key participants in forex markets include:
  • Commercial and investment banks
  • Central banks
  • Multinational corporations
  • Hedge funds and other institutional investors
  • Retail traders and speculators
• Exchange rates quoted as currency pairs (EUR/USD, GBP/JPY)
  • Base currency listed first, quote currency second
  • Exchange rate represents units of quote currency per one unit of base currency

Managing Exchange Rate Risk

• Exchange rate risk arises from potential losses due to currency fluctuations
• Hedging strategies to mitigate forex risk:
  • Forward contracts lock in future exchange rates
  • Currency options provide right but not obligation to exchange at predetermined rate
  • Currency swaps involve exchanging principal and interest payments in different currencies
• Companies can also use operational hedging techniques:
  • Diversifying operations across multiple currency zones
  • Matching revenues and costs in same currencies when possible
  • Adjusting pricing strategies to offset currency movements

Currency Manipulation and International Trade

• Currency manipulation occurs when countries artificially influence exchange rates
  • Often aims to gain unfair trade advantages by keeping currency undervalued
• Methods of currency manipulation include:
  • Large-scale intervention in forex markets
  • Implementing strict capital controls
  • Maintaining excessively large foreign exchange reserves
• Impacts of currency manipulation:
  • Distorts global trade balances
  • Can lead to retaliation and trade disputes between nations
  • Potentially violates international agreements (IMF rules, G20 commitments)
• Addressing currency manipulation requires international cooperation and monitoring
  • IMF surveillance of exchange rate policies
  • Bilateral and multilateral trade negotiations
  • Potential use of countervailing duties or other trade remedies