The exchange rate of a currency is the price of that currency in terms of other currencies. If each country has its own currency and international trade is to take place an exchange of currencies needs to occur. When a UK resident buys goods from France, these must be paid for in euros. The individual will probably purchase euros from a bank in exchange for sterling in order to carry out the transaction. There must therefore be an exchange rate between sterling and euros. Likewise there will be exchange rates between sterling and all other currencies.Basically, there are two types of exchange rate: the floating exchange rate; and the fixed exchange rate. There are also hybrid exchange rate systems which combine the characteristics of the two main types.The floating exchange rate A floating exchange rate is one that is determined within a free market, where there is no government intervention, and the exchange rate is free to fluctuate according to market conditions. The exchange rate is determined by the demand for and the supply of the currency in question. As far as sterling is concerned, the demand for the currency comes from exports that is, overseas residents buying pounds either to buy British goods and services or for investment purposes. The supply of pounds comes from imports that is, UK residents who are buying foreign currencies to purchase goods and services or for investment purposes and who are therefore at the same time supplying pounds to the market.The market for sterling can then be drawn using simple demand and supply diagrams. In Figure, the price axis shows the price of £1 in terms of US dollars and the quantity axis shows the quantity of pounds being bought and sold. The equilibrium exchange rate is determined by the intersection of demand and supply at £1 = $2. As this is a totally free market, if any of the conditions in the market change the exchange rate will also change.
The demand for and supply of sterling, and therefore the exchange rate, is affected by:
Changes in the balance of payments
Figure shows the effect on the exchange rate of changes in the balance of payments.The original demand curve is DD and the original supply curve is SS. At the equilibrium exchange rate of £1 = $2 the demand for pounds is equal to the supply of pounds. In other words, if the demand for pounds comes from exports and the supply of pounds comes from imports, imports and exports are equal and the balance of payments is in equilibrium. Now it is assumed that a balance of payments deficit appears, caused by the level of imports rising while the level of exports stays the same. If exports remain the same there will be no change in the demand curve for pounds. As imports rise there will be a rise in the supply of pounds to the market; the supply curve moves to the right to S1S1. At the old exchange rate of £1= $2, there is now excess supply of pounds, and as this is a free market there will be downward pressure on the value of the pound until equilibrium is re-established at the new lower exchange rate of £1 = $1. At this exchange rate the demand for pounds is again equal to the increased supply of pounds and the balance between imports and exports is re-established.How does this happen? When the value of the pound falls two things happen: the price of imports rises and the price of exports falls. Thus the level of imports falls and the level of exports rises and the deficit is eradicated. A simple numerical example illustrates this point: At old exchange rate £1 = $2:An American car which costs $20 000 in USA costs £10 000 in UK.A British car which costs £10 000 in UK costs $20 000 in USA. If the exchange rate falls to £1 = $1:The American car still costs $20 000 in USA but now costs £20 000 in UK.The British car still costs £10 000 in UK but now costs $10 000 in USA.Therefore a depreciation in the exchange rate has made imports dearer (theAmerican car) and exports cheaper (the British car). Thus a fall in the value of the pound helps to re-establish equilibrium in the balance of payments. In the case of a surplus on the balance of payments, the exchange rate will rise, making exports more expensive and imports cheaper and thereby re-establishing equilibrium in the balance of payments. You should test your understanding of the working of the foreign exchange markets by working through what happens if a surplus develops.
A fall in the value of the pound in a free market is called a ‘depreciation’ in the value of the pound, a rise in its value is called an ‘appreciation’.
Changes in investment flows
In Figure, the original equilibrium exchange rate is £1 = $2. If there is an increase in the level of investment in the UK from overseas, there will be an increase in the demand for pounds. The demand curve moves to the right (toD1D1), and the exchange rate rises to £1 = $2.5.
The effect of speculation
If the exchange rate of sterling is expected to rise, speculators will buy sterling in order to make a capital gain by selling the currency later at a higher exchange rate. There will be an increase in the demand for pounds and the exchange rate will rise. If the exchange rate is expected to fall, speculators will sell sterling in order to avoid a capital loss, there will be an increase in the supply of sterling and therefore a fall in the exchange rate. Illustrate these changes yourself using demand and supply diagrams.The important thing about speculation is that it tends to be self-fulfilling. If enough people believe that the exchange rate is going to rise and act accordingly, the exchange rate will rise.The main advantage of the floating exchange rate is the automatic mechanism it provides to overcome a balance of payments deficit or surplus. Theoretically, if a deficit develops, the exchange rate will fall and the balance of payments is brought back into equilibrium. The opposite occurs in the case of a surplus. Of course in reality it does not work as smoothly or as quickly as the theory suggests. A depreciation is supposed to work as demonstrated in Figure.
There are, however, a number of problems which may occur to prevent this self correcting mechanism working properly. First, if in the United Kingdom the goods which are imported are necessities that cannot be produced at home, then even if their price goes up as a result of a depreciation, they will continue to be demanded. Thus, not only will the balance of payments deficit not be automatically rectified, another economic problem will result, that of inflation. The United Kingdom will continue to buy the imported goods at the new higher price. A second problem occurs on the other side of the equation. It is assumed above that, as the price of exports falls, more exports are sold. This presupposes that in the United Kingdom the capacity is there to meet this increased demand, but this may not be the case, especially if the economy is fully employed already or if the export-producing industries are not in a healthy enough state to produce more.
These problems give rise to what is called the ‘J-curve effect’. A fall in the exchange rate may well lead to a deterioration in the balance of payments in the short term, until domestic production can be increased to meet the extra demand for exports and as substitutes for imported goods. Once this can be done there will be an improvement in the balance of payments, hence the J-curve effect pictured in Figure. The effect of a fall in the exchange rate is limited and the curve levels off after a certain time period. The depreciation in the value of the pound seen when Britain left the ERM did not have an immediate effect on the balance of payments and many argued that this was due to the J-curve effect.
One big disadvantage of the floating exchange rate is that it introduces uncertainty into the market, and for firms that operate internationally, this is another variable which needs to be considered when planning. Moreover, since the possibility of speculation exists with the floating exchange rate, this can be destabilizing and unsettling to markets, something which businesses do not welcome.
The fixed exchange rate
The fixed exchange rate is one that is fixed and maintained by the government. An exchange rate can be fixed in terms of other currencies, gold or a basket of other currencies. In order to maintain a fixed exchange rate the government has actively to intervene in the market, either buying or selling currencies.Figure shows the action needed by the UK authorities in the case of downward pressure on the value of the pound. The exchange rate is fixed at £1 = $2, and the government wants to maintain that rate. If a balance of payments deficit develops, brought about by an increase in imports, exports remaining the same, there will be excess supply of pounds at the fixed exchange rate. In a free market the value of the pound would fall until the excess supply had disappeared. However, this is not a free market, and the government must buy up the excess supply of pounds in order to maintain the exchange rate at £1 = $2. Thus the demand curve moves to the right and the exchange rate has been maintained at the same level.Alternatively if there is excess demand for pounds, the government has to supply pounds to the market in order to maintain the fixed exchange rate. A prime advantage of a fixed exchange rate is that there is less uncertainty in the market; everyone knows what the exchange rate will be in a year’s time, and long term planning is made easier. It also reduces the likelihood of speculation in the foreign exchange markets. One serious disadvantage, however, is that there is no longer an automatic mechanism for rectifying any balance of payments problems as there is in the case of the floating exchange rate and this means that government intervention is necessary not just to support the exchange rate, but also to overcome any balance of payments problems. Added to this, a fixed exchange rate is not sustainable in the case of persistent deficits or surpluses. In the event of a surplus, the government must supply pounds to the market and if the surplus persists then eventually the government will exhaust its reserves and might well have to revalue the pound (i.e. increase the exchange rate of the pound). In the case of a persistent deficit, the size of the government’s reserves will be increasing over time and the government may have to devalue the pound to correct the problem.There are, then, advantages and disadvantages to both types of exchange rate and there have been hybrid exchange rate systems which serve to combine the advantages of both systems. In such an exchange rate system the exchange rate is basically fixed but is allowed to fluctuate by a small amount either side of the central value. The Exchange Rate Mechanism (ERM) of the European Union was an example of this. When the United Kingdom entered the ERM the exchange rate was fixed against other member currencies but allowed to vary by 6 per cent either side of the central value before action was needed.Over the years the United Kingdom has had a variety of different types of exchange rate. Before the First World War and for some time between the wars, the exchange rate was fixed in terms of gold the gold standard. From the Second WorldWar until 1972, the United Kingdom was part of the Bretton Woods system of fixed exchange rates, where the pound was fixed in terms of dollars. Then from 1972 to 1990, there was a floating exchange rate. In 1990, however, Britain joined theExchange Rate Mechanism of the European Union, which was again a fixed exchange rate. In September 1992, the pound left the ERM and was allowed to float once more.The Exchange Rate Mechanism In October 1990, the United Kingdom joined the ERM, which was a system of fixed exchange rates. The currencies within the ERM were fixed against the European currency unit (ECU) and were therefore fixed against one another. Exchange rates were allowed to fluctuate by a small percentage around their par values. The ECU was a weighted basket of EU currencies, designed to act as a unit of account and eventually as an international currency.The essence of the ERM was that it provided a means of stabilizing the exchange rates of participating member states. If the pound, for instance, strayed too far from its central rate the Bank of England and other central banks of ERM members would buy or sell currencies in order to stabilize the exchange rate. Each member held reserves in the European Co-operation Fund in order to settle debts between countries, and these funds could be used to stabilize currencies. Another thing that could be done to help an ailing currency was to change the domestic rate of interest.If the pound’s exchange rate fell towards its lower limit, an increase in the rate of interest would make the United Kingdom a more attractive place for investors and therefore increase the demand for pounds. If both of these approaches failed, there could be a realignment of the currencies within the ERM. This happened from time to time, but such realignments were against the spirit of the fixed exchange rate, and countries were expected to avoid this if possible.
Britain’s reasons for entering the ERM in 1990 were as follows:
Figure shows the fluctuations in sterling’s exchange rate after joining the ERM.
The exchange rate of the pound was much more stable while the UK was a member of the ERM, but sterling ran into problems in mid-1992, mainly as a result of speculation against the pound. The Bank of England intervened in the market but was unable to stop the fall in the value of the currency. An increase in interest rates was announced but then withdrawn very quickly because of political pressures and the effect such a move would have on UK industry in the midst of recession. In the end the pound was suspended from the ERM and allowed to float, and subsequently fell in value sharply.
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