For several centuries the developed world operated under a fixed exchange rate system based on the gold standard. The system worked well until WW1 and the rapid changes occurring due to industrialization.
After the depression in the 1930s many systems were tried, but the developed world chose to switch back to a fixed exchange rate system after W.W.II.
This was called the Bretton Woods system and included the creation of the IMF (International Monetary Fund).
This system was finally terminated in 1973 but the IMF survived. What followed was a system called the adjustable peg which gave way to a short period during which rates were floating under a flexible exchange rate system.
This has been followed in more recent times by a managed float system.
The Euro exchange rate is the value of the Euro in terms of another currency.
The exchange rate is the amount of foreign currency paid to obtain a unit of the home currency (this is the definition used by the IB)
If the exchange rate rises, the home currency appreciates, more of the foreign currency is needed in order to purchase the home currency.
If the exchange rate falls, the home currency depreciates, less of the foreign currency is needed to purchase the home currency.
Except for the US$, the Euro € and the Japanese ¥, most currencies are only acceptable within the borders of the home country. Thus exporters must eventually receive payment for the goods that they export in terms of the currency of their own country.
A trade weighted exchange rate index measures the value of the Euro in terms of a basket of currencies which are weighted by the proportion of trade between those countries and Europe.
The effective exchange rate examines how much trade Europe has with the other country and the extent to which Europe competes with these other countries in terms of trade.
The real exchange rate takes into account the effects of inflation. If the Euro falls by 5% against the Yen but there is 5% inflation in Europe, the real exchange rate is assumed to be unchanged.
If Europeans sell software and the Japanese sell cars:
Europeans who want to import Japanese cars will need Japanese ¥, and they provide the demand for Japanese ¥ and the supply of Euros.
Japanese who want to buy European software need Euros and they provide the demand for Euros and the supply of Japanese ¥.
Under the fixed exchange rate system rates are fixed at some value and the central bank intervenes to ensure it stays at that agreed upon rate:
For centuries the standard was gold
Some countries fixed their exchange rates to a currency like the British pound which was convertible into gold.
From 1946 to 1973, most countries pegged or fixed their currencies to the US dollar.
In the face of short term fluctuations, the central banks of each country would intervene in the market and buy and sell US$.
As long as the central bank worked around equilibrium, then on average it would buy about as much as it sold and the policy did not lead to changes in foreign currency reserves.
More recently governments of smaller countries have fixed their currency to a ‘key’ currency such as the dollars, Yen or Euros with periodic adjustments.
If there is a fixed or adjustable peg system, and the demand for foreign currency shifts out (from Do to D1) because greater domestic inflation has led to an increase in the demand for imports and a fall in the demand for exports:
There will be pressure on the domestic currency to depreciate (exchange rate rises from A to B).
If there is a permanent switch away from the agreed on rate, the central bank will be faced with constantly buying or selling to maintain the old rate.
If there is more inflation in the domestic economy than in the foreign, the exchange rate should be rising or the domestic currency should depreciate.
With flexible exchange rates, the domestic currency would do exactly that. But this is not permitted under the fixed exchange rate system.
Under the flexible exchange rate system, rates are allowed to float.
The purchasing power parity theory assumes floating exchange rates adjust until a unit of currency can buy the same basket of goods and services as a unit of another currency.
Currencies are allowed to float and govt. intervenes periodically to influence the price but does not set the price. The currencies are kept within some limits.
If the exchange rate is denoted as the number of Yen required to purchase a Euro. If it is below equilibrium: there will be excess demand for European Euros
Traders who need Euros will start bidding up the price:
As the supply curve is upward sloping, the quantity supplied of Euros will rise. The extent of the increase will depend on the elasticity of supply.
As the demand curve is downward sloping, the quantity demanded of Euros will fall.
The extent of the fall will depend on the elasticity of demand.
As the exchange rate rises:
Exports of software start to fall as it becomes relatively more expensive
Imports of Japanese cars will rise as they become relatively cheaper.
The two effects will finally lead to supply equal to demand in equilibrium.
If the exchange rate is above equilibrium:
There will be an excess supply of Euros
Japanese cars look relatively cheaper so Europeans start offering more Euros for Yen and the price of Euros will start to depreciate in value.
As the supply curve is positively sloped, fewer Euros are offered as the value of the Euro depreciates. The more elastic the supply, the greater the impact on quantity supplied.
As the demand curve is negatively sloped, the lower value of the Euro starts to make European software look cheaper and more will be demanded. The more elastic demand, the greater the impact on quantity demanded.
The two effects will finally lead to supply equal to demand in equilibrium.
Europeans demand Yen to buy goods and services from Japan, and to invest if the return on investment is greater in Japan.
If Europeans want more Japanese goods and services or if they want to invest more in Japan, the supply of Euros will shift to the right. If the Japanese demand for Euros does not increase, then the exchange rate depreciates.
If Japanese want more European software or if they want to invest in European securities, the demand for Euros shifts to the right and the exchange rate will appreciate.
The most common causes of shifts: some affect one rather than both demand and supply (denoted in brackets):
Rather similar to the price inflation, only in this example it is costs which are falling in the country with the higher growth rate or more rapid increase in productivity. If labour productivity rises faster in Europe then goods look relatively cheaper in Europe:
The demand for Euros will shift to the right.
The supply of Euros shifts in.
This leads to an increase in the value of the Euro.
The managed float is basically a flexible exchange rate system in which rates are permitted to float, but the central bank intervenes on a regular basis to keep the rate within some agreed upon limits.
Govt. can influence exchange rates, usually through the Central Bank by:
Buying and selling both domestic and foreign currency
Altering interest rates in order to influence short term capital flows
Altering return on investment through tax policies in order to influence long term capital flows.
Rather than managing a single currency, for several years the EU has attempted fixed exchange rates amongst its member countries but a managed external float as a block against the dollar and the Yen.
This broke down in the fall of 1992 and was replaced in 1999 by the European Monetary Union which consists of 11 member countries.
If interest rates rise in Canada, investors from Britain will buy Can$ money market instruments until the appreciation in the value of the Can$ which results is just equal to the differential in the interest rates.
The expected future depreciation of the Can$ is just enough to bring Canadian interest rates back down to the international equivalent.
If interest rates are 5% higher in Canada, investors will keep on investing until the exchange rate has fallen by 5% (Can$ has appreciated by 5%).
The extra 5% interest earned is enough to offset the 5% future depreciation of the Can$.
The appreciation puts export and import competing industries at a competitive disadvantage.
4.6.4 Depreciation vs Devaluation; Appreciation vs Revaluation
Under a floating exchange rate system, the exchange rate:
Depreciates whenever it falls in value against other currencies:
Less foreign currency is needed to purchase a unit of domestic currency
Appreciates whenever if rises in value against other currencies:
More foreign currency is required to purchase a unit of domestic currency.
Under a fixed or adjustable peg system, rates are set every day by the central bank but are periodically adjusted:
If the Central Bank devalues the currency it is equivalent to a depreciation in the currency or an increase in the exchange rate:
It costs more domestic currency to buy foreign currency.
If the Central Bank revalues the currency it is the equivalent of an appreciation of the currency or a fall in the exchange rate:
It costs less domestic currency to buy foreign currency.
In addition to software, the Japanese may be interested in investing in Europe.
If they buy securities they offer Japanese ¥ to buy Euros to pay for them, an outward shift of the demand curve.
This leads to capital inflows into Europe and an appreciation of the Euro.
If Europeans decide they want to buy more Japanese stocks, they will offer Euros (equivalent to an outward shift in the supply curve for Euros).
This leads to capital outflows from Europe and a depreciation of the Euro.
Interest rates (OCRR): a major reason for short term capital movements is differences in interest rates.
If interest rates are higher in Japan, Europeans with short term funds will buy short term money market instruments in Japan. As they do so the foreign exchange rate falls leading to a depreciation of the Euros.
To stop the depreciation of the Euros the Central Bank may decide to increase interest rates.
Speculation about exchange rates can also lead to short term capital movements:
If the Euro is expected to appreciate, Japanese investors will buy European money market instruments in anticipation.
The increase in the supply of Japanese ¥, equivalent to an increase in the demand for Euros will force the exchange rate up and lead to an appreciation of the Euro. This is an example of self realizing expectations.
ROI: long term capital movements are more related to expectations about profit opportunities than to future movements in exchange rates.
If return on investment is higher in Europe, then money will flow out of Japan into Europe.
If rates of return are consistently lower in Europe compared to Japan because productivity rises more slowly for a number of reasons, then there will be a slow but steady erosion in the value of the Euro.
If return on investment is the same in both countries but investors expect the Euro to appreciate in the future, this may lead to greater long term investment.
This case is much less likely as it is very difficult to predict exchange rate movements over the long term. Investors are much more sensitive to differences in ROI.
If the exchange rate is expected to fluctuate greatly in the future, investors are much less likely to invest for fear of potential loss.
4.6.6 Advantages and Disadvantages of Fixed & Floating Rates
Reserves are needed to offset short term fluctuations.
Under the gold standard it was found there were not enough reserves to do the adjusting.
The US dollar worked quite well until it became unstable.
A fixed exchange rate system cannot adjust to long term trends.
If inflation rates are different amongst countries, or there are fundamental shifts in the supplies and demands for certain goods and services either because of differences in growth rates or because of major structural changes such as technological breakthroughs, then the rates must be permitted to change.
Over a decade the drift away from the old equilibrium can be quite substantial.
Over time as equilibrium rates drift away from the fixed rate, there is more and more intense speculation as investors try to buy currencies which are expected to be revalued and sell currencies which are expected to be devalued.
This drains foreign reserves even more quickly and forces a major adjustment in the value of the currency.
This is what eventually destroyed the Bretton Woods system.
Because of its fixed exchange nature, the adjustable peg system may affect the domestic economy adversely as domestic policies must be adjusted to maintain external equilibrium.
Monetary policy is weakened. If there is a recessionary gap and interest rates are lowered to shift AD out:
Investment increases domestically and aggregate demand shifts out
Higher interest rates lead to capital outflows and the capital account moves toward deficit.
At the same time, with rising aggregate demand, imports increase and the trade balance also moves toward deficit.
To maintain the fixed exchange rate, the central bank buys domestic currency. Euros leave the commercial banks and enter official reserves at the Central Bank reducing the money supply and offsetting the original policy
The Floating or Managed Float Exchange Rate System
The greatest advantage is that adjustments needed to achieve external equilibrium impact only indirectly on the domestic economy.
Under a fixed exchange rate system, if there is downward pressure on the currency and reserves of foreign exchange are exhausted, a recession must be induced in order to reduce imports and boost exports.
With flexible exchange rates, downward pressure on the currency leads to depreciation with a subsequent fall in imports and rise in exports without having to induce a domestic recession.
Monetary policy tends to be stronger:
If the govt. wants to close an inflationary gap, raising interest rates will cause AD to shift in and lead to capital inflows.
This will lead to appreciation, exports fall and imports rise leading to a further inward shift in AD.
Individual states are unable to use monetary policy as a stabilization tool during times of economic crisis.
The fact that Denmark, Sweden and the UK have stayed outside the group is a major source of uncertainty.
The most recent problem is how to integrate the new members of the EU. It may lead to a core of states which are fully integrated economically and financially surrounded by various groups of countries with different degrees of integration.