Flexible Exchange RatesThis is a featured page

Flexible Exchange Rates - Welker's Wikinomics Page Flexible Exchange Rates - Welker's Wikinomics Page
Flexible Exchange Rates - Welker's Wikinomics Page Flexible Exchange Rates - Welker's Wikinomics Page

2 Pure types of exchange rates systems:
  • Flexible/floating exchange rate system: demand and supply determine exchange rates with no government intervention
  • Fixed exchange rate system: government determines exchange rates and makes necessary adjustments to maintain these rates

Depreciation and appreciation:
  • exchange rate is determined by market forces and can change daily like stock and bond prices.
    • the dollar depreciated relative to the pound = when the dollar price of pound rises; $2 for €1 --> $4 for €1
    • the dollar appreciated relative to the pound = when the dollar price of pound falls;$2 for €1 --> $1 for €1

Determinants of exchange rates:

Generalizations:
-if the demand for a nation's currency increases, currency will appreciate (if demand decrease, currency will depreciate)
-if supply of nation's currency increases, currency will depreciate (if supply decreases, currency will appreciate)
-if nation's currency appreciates, foreign currency depreciates relative to it
1. Changes in Tastes
  • Any change in consumer tastes or preferences for the products of a foreign country may alter the demand for the nation's currency and change its exchange rate.
  • Ex: If technological advances in U.S. wireless phones make them more attractive to British consumers and businesses, then the British will supply more pounds in the exhcange market in order to purchase more U.S. wireless phones. This increase in supply will depreciate the pound.
2. Relative Income Changes
  • A nation's currency is likely to depreciate if its growth of national income is more rapid than that of other countries.
  • A country's imports vary directly with its income level.
    • Ex: Germans receive more income (richer) and will buy more foreign goods since those countries incomes are now relatively less compared to Germany.
3. Relative Price-Level Change
  • Changes in the relative price levels of two nations may change the demand and supply of currencies and alter the exchange rate between the two nations' currencies
  • The purchasing-power-parity theory holds that exchange rates equate the purchasing power of various currencies. When a good becomes more expensive, after going through an exchange rate translation, the good will appear on the international market as relatively more expensive
  • Higher price level depreciates a currency (lower price level appreciates it)
4. Speculation
  • If investors believe the value of a currency is about to fall, demand will fall for that currency and supply will increase as speculators sell that currency before its value falls. This will cause depreciation of that currency.
  • If investors believe the value of a currency is about to rise, demand will increase, supply will decrease as people want to hold on to that currency.
5. Relative Interest Rates
  • Changes in relative interest rates between two countries may alter their exchange rate
  • When country ABC has higher interest rates, investors are more reluctant to invest; therefore, forgoing their currency and demand more of ABC's currency
  • Higher interest rate = appreciation (lower interest rate = depreciation)
    • People put their money in foreign banks where interest rate is higher, appreciating their currency

*The way to remember determinants of exchange rates: TIPSI

Flexible rates and the balance of payments:
Flexible Exchange Rates - Welker's Wikinomics Page

Disadvantages of flexible exchange rates:
  • create uncertainty on international markets, reducing levels of FDI as investors find it hard to assess the level of return and risk
  • May fluctuate too much
  • floating rates do not always self-adjust to eliminate current account deficits due to political and social factors
  • worsen existing levels of inflation:
    • high inflation in US --> reduce demand for US products abroad --> reduce demand for $ --> $ weakens --> imports more expensive for Americans --> inflation!





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Robert.Wang
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