Global Economic Issues.

Exchange Rate Systems

Exchange Rate Systems

An Exchange Rate System is any system which determines the conditions under which one currency can be exchanged for another.

Types of Exchange Rate System

We can consider three main types: 1) Free or Floating. 2) Managed or controlled. 3) Fixed.

Free or Floating

Under this system the value of a currency simply reflects the markets determination of the value based on supply and demand. If we assume only pounds and dollars in the world and a lot of traders want pounds and few want dollars then a lot of dollars will be put onto the market in order to swap for pounds so the value of the pound in terms of dollars will increase.

Free or Floating (2)

In a floating exchange rate system, the value of a currency is determined, without central bank intervention, by the forces of demand and supply in foreign currency markets.

Free or Floating (3)

The advantages of this system are mostly gained by the government. The government does not have to worry about the exchange rate it reflects supply and demand. In theory, movements of the exchange rate will cause import and export prices to change and as a result (given elasticity of demand) imports and exports will increase or decrease.

Free or Floating (4)

So if we assume again only two currencies the pound and the dollar: If demand for pounds increased (because Americans had increased their imports from the U.K. and had to pay for them) then Americans will put a lot of dollars onto the market to pay for the pounds they want. The pound : dollar rate increases and so something costing 100 in the U.K. and which sold for $200 in the USA might now sell for $300 if the pound : dollar rate went up to 1 = $3.

Free or Floating (5)

Because of the changes in the exchange rate, and given an assumption of elasticity of demand for imports and exports, then eventually under a free or floating exchange rate system the value of imports and exports will tend to even out if exports are doing well the pound : dollar rate will change, British exports become dearer and so demand falls. (At the same time as the pound : dollar rate changes more dollars to the pound the price of imports will fall and so we might expect imports to increase in value).

Free or Floating (6)

So the advantage of a system of free or floating exchange rates is that, in theory, the government does not have to worry about the Balance of Payments - the account of the UKs trading with the rest of the world. As stated on the previous slide, changes in the exchange rate mean that provided that the demand for imports and exports in price elastic, if we have a deficit on the B of P now more imports than exports by value then the exchange rate changes, exports become cheaper, imports dearer and the deficit is reduced/abolished.

Free or Floating (6)

The big disadvantage of Free or Floating exchange rates is that an exporter or importer can lose out if they sign a contract to be paid at a certain exchange rate and the rate changes between signing the contract and the payment. The change may not be to the advantage of the trader. If the pound : dollar rate is 1 = $2 and I sign a contract to sell something at $400 then I expect to receive 200. If the rate changes to 1 = $2.10 then I will still get the $400 but it will be worth only 190.47. my profit has probably been wiped out.

Managed or Controlled (1)

With a managed or controlled or dirty system, the price of a currency is determined by market forces, but occasionally central banks will intervene using their reserves to steady the price of the currency so the price varies around a central band that the government thinks is desirable.

Managed or Controlled (2)

Under this system the exchange rate is allowed to vary between certain parameters so the government might try to keep the pound : dollar rate to between 1 = $2 + or 10 cents. If the market causes the rate to increase to 1 = $2.10 and the government (or the Bank of England) thinks that the rate is going to increase more, then the authorities will put more pounds on the market to reduce its value.

Managed or Controlled (3)

The advantage of this system is that business men and women have an idea of the exchange rate they may be faced with when they try to exchange the revenue from international trade try to exchange the foreign currency into their own currency. Some of the exchange rate risk of trade is reduced.

Managed or Controlled (4)

The disadvantage of this system was that governments had to constantly monitor the exchange rate and had to use reserves of foreign currency to intervene to smooth out changes in the value of the national currency.

Managed or Controlled (5)

Sometimes they would use changes in interest rates to help keep a currencys preferred value increasing interest rates if the exchange rate was falling and reducing interest rates if the exchange rate was rising. But this meant that interest rates reflected the concern over the exchange rate and not other concerns such as the level of investment in the economy or the amount of saving.

Fixed System (1)

A Fixed Exchange rate System is one where a currency has fixed value against another currency or commodity.

This system existed for most of the time from the late 1940s to the early 1970s. Most major currencies had fixed values against each other.

Fixed System (2)

So the pound : dollar rate would be the same, month in month out. The rate actually changed in 1949 and 1967 but otherwise importers and exporters would always know the exchange rate they had to use.

Fixed System (3)

An example of a Fixed System was the Gold Standard which was an exchange rate system under which currencies could be converted into gold at a fixed rate, hence providing a relative price between each currency. The Fixed system that existed for most of the worlds important currencies from late 1940s to early 1970s was one in which $35 was linked to an ounce of gold.

Fixed System (4)

The big advantage of a fixed system was this idea of certainty for importers and exporters as to how much they would receive or have to pay for goods sold or bought.
The big disadvantage was that governments had to intervene even more than in the managed system to keep the currency stable. Government macroeconomic policy was often just about keeping the exchange rate steady.