4.1.8 Exchange rates

Chapter 4.1.8: Exchange Rates

Welcome to one of the most exciting and dynamic topics in Theme 4 International Economics: Exchange Rates! Whether you are planning a holiday abroad, buying an imported smartphone, or analysing global trade wars, exchange rates affect everyday life and the entire macroeconomy. Don't worry if this topic feels a bit technical at first—we will break down every mechanism step-by-step so you can ace your Paper 2 and Paper 3 exams.

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1. Understanding Exchange Rate Systems

An exchange rate is simply the price of one currency expressed in terms of another currency (for example, $£1 = \$1.30$). The way an exchange rate is determined depends on the exchange rate system a country chooses to operate.

A. Floating Exchange Rate System

In a pure floating exchange rate system, the value of the currency is determined purely by the free market forces of supply and demand on the foreign exchange (forex) market. There is no official government or central bank target, and the authorities do not intervene to maintain a specific rate.

Example: The UK Pound Sterling ($£$), the US Dollar ($\$$), and the Euro ($€$) operate on floating exchange rate systems.

B. Fixed Exchange Rate System

In a fixed exchange rate system, the government or central bank officially fixes or "pegs" the value of its currency to another currency (such as the US Dollar), a basket of foreign currencies, or a standard such as gold. The central bank commits to buying and selling currencies or altering interest rates to keep the rate at this exact target peg.

C. Managed Exchange Rate System (Managed Float)

In a managed float, the exchange rate is primarily determined by market supply and demand, but the central bank steps in periodically. The central bank may intervene if the currency moves outside preferred upper and lower bands or experiences excessive volatility, steering the currency toward a desired range.

Key Takeaway: Floating systems rely 100% on free markets; fixed systems rely on an official target peg; managed floats let the market decide day-to-day but use central bank intervention when needed.

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2. Distinctions in Currency Movements: Terminology Matters!

Examiners frequently report that students lose marks by mixing up floating and fixed exchange rate terms. Here is the golden rule to keep them straight:

Floating Systems: Market-Driven Changes

• Appreciation: An increase in the value of a currency in terms of another currency, caused purely by market forces (an increase in market demand or a decrease in market supply for the currency).
• Depreciation: A fall in the value of a currency in terms of another currency, caused purely by market forces (a decrease in market demand or an increase in market supply for the currency).

Fixed Systems: Government-Mandated Changes

• Revaluation: A deliberate, administrative upward adjustment of the official pegged exchange rate by a government or central bank.
• Devaluation: A deliberate, administrative downward adjustment of the official pegged exchange rate by a government or central bank.

Examiner Warning: Never write that a floating currency "devalued" or that a government "depreciated" its fixed peg! Use appreciation/depreciation for floating rates and revaluation/devaluation for fixed rates.

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3. Factors Influencing Floating Exchange Rates

In a floating system, anything that alters the demand ($D$) or supply ($S$) of a currency shifts the equilibrium exchange rate on a forex diagram.

Forex Diagram Labelling Tip: Always label the vertical axis as "Price of Currency A in terms of Currency B" (e.g., "Price of $£$ in terms of $\$$") and the horizontal axis as "Quantity of Currency A" (e.g., "Quantity of $£$").

1. Relative Interest Rates & "Hot Money" Flows

When domestic interest rates rise relative to interest rates abroad, international investors move short-term financial capital into domestic banks to earn a higher rate of return. These short-term capital flows are called hot money. To deposit funds into domestic banks, foreign investors must buy the domestic currency, which shifts the demand curve to the right and causes the currency to appreciate.

2. Relative Inflation Rates

If domestic inflation is higher than inflation in competitor countries, domestic goods become relatively more expensive and less price-competitive. Foreign buyers demand fewer exports (reducing demand for the domestic currency), while domestic consumers buy more imports (selling domestic currency to buy foreign currency). This causes the domestic currency to depreciate.

3. Current Account Position (Trade Balance)

A persistent current account deficit means a country spends more on imports than it earns from exports. This results in a net outflow of currency onto the foreign exchange market (increasing supply of domestic currency), putting downward pressure on the currency and causing it to depreciate.

4. Foreign Direct Investment (FDI) & Capital Inflows

When foreign multinational companies invest long-term capital by building factories, buying local businesses, or expanding operations domestically, they must convert foreign currency into domestic currency. This increases demand for the domestic currency, causing an appreciation.

5. Speculation & Market Sentiment

Forex traders buy and sell currencies based on expectations of future events. If speculators expect a central bank to raise interest rates, or believe an economy is strengthening, they will buy the currency today in anticipation of a price rise. This surge in speculative demand causes an immediate appreciation.

6. Quantitative Easing (QE) & Money Supply

When a central bank expands the domestic money supply through policies like Quantitative Easing (QE), the increased supply of liquidity and lower yields on domestic bonds can encourage capital outflows, leading to currency depreciation.

Key Takeaway: High relative interest rates, low relative inflation, trade surpluses, inward FDI, and strong market confidence drive currency appreciation. The opposite conditions drive currency depreciation.

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4. Government Intervention in Foreign Exchange Markets

How does a central bank maintain a fixed exchange rate or manage a floating rate? It uses two primary policy tools:

Tool 1: Foreign Currency Reserves Transactions

• To raise or support currency value: The central bank enters the forex market and buys domestic currency using its stock of foreign currency reserves. This shifts the demand curve for the domestic currency to the right, driving up its value.
• To lower currency value: The central bank sells domestic currency on the open market and accumulates foreign currency reserves. This shifts the supply curve of domestic currency to the right, lowering its value.

Tool 2: Monetary Policy (Interest Rates)

• To appreciate/strengthen currency: The central bank raises interest rates to attract foreign "hot money" inflows.
• To depreciate/weaken currency: The central bank cuts interest rates to encourage capital outflows and discourage hot money inflows.

Key Takeaway: Central banks buy domestic currency or raise interest rates to strengthen the exchange rate; they sell domestic currency or cut interest rates to weaken it.

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5. Competitive Devaluation / Depreciation

Competitive devaluation (in a fixed system) or competitive depreciation (in a managed/floating system) occurs when a country deliberately adopts policies to push down the value of its currency to gain an artificial price advantage for its exports on international markets.

Risks and Consequences of Competitive Devaluation:

1. "Beggar-thy-Neighbour" Retaliation & Currency Wars: A lower currency makes exports cheaper at the expense of trading partners. Trading partners may retaliate by devaluing their own currencies, leading to a race to the bottom where no country gains a lasting competitive advantage.
2. Inflationary Pressures: A weaker currency raises the price of imported raw materials (imported cost-push inflation) and increases aggregate demand (demand-pull inflation).
3. Trade Protectionism: Aggrieved trading partners may respond to currency manipulation by imposing trade barriers such as tariffs and quotas.

Key Takeaway: While competitive depreciation aims to boost export competitiveness, it risks sparking currency wars, import cost inflation, and trade protectionism.

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6. Macroeconomic Impacts of Exchange Rate Changes

To evaluate how exchange rate movements affect the broader economy, use the classic mnemonic rules:

• SPICED: Stronger Pound Imports Cheaper, Exports Dearer (Appreciation)
• WIDEC: Weaker Imports Dearer, Exports Cheaper (Depreciation)

A. Impact on the Current Account & Trade Balance

When a currency depreciates, export prices fall in foreign currency terms, and import prices rise in domestic currency terms. However, does this automatically improve the balance of trade? Not always! We must evaluate two crucial concepts: the Marshall-Lerner Condition and the J-Curve Effect.

1. The Marshall-Lerner Condition

A currency depreciation or devaluation will improve the current account balance only if the sum of the price elasticities of demand for exports ($PED_x$) and imports ($PED_m$) is greater than 1:

$|PED_x| + |PED_m| > 1$

If $|PED_x| + |PED_m| < 1$ (demand is price-inelastic), the higher import prices and lower export prices will actually cause the current account deficit to widen in monetary terms!

2. The J-Curve Effect

The J-Curve effect illustrates why a currency depreciation often worsens the trade balance before improving it:

• In the Short Run: Trade contracts are fixed, and consumers take time to switch habits. Demand for exports and imports is price-inelastic ($|PED_x| + |PED_m| < 1$). Because import prices rise immediately while export earnings remain unchanged, the current account deficit worsens.
• In the Medium-to-Long Run: Consumers and firms adapt, finding domestic substitutes or new international buyers. Demand becomes price-elastic ($|PED_x| + |PED_m| > 1$), causing export volumes to rise significantly and import volumes to drop. The current account improves and moves toward surplus, tracing out the shape of the letter 'J'.

B. Impact on Economic Growth & Employment

Recall the Aggregate Demand formula: $AD = C + I + G + (X - M)$.
A currency depreciation makes exports cheaper and imports dearer. Assuming the Marshall-Lerner condition holds, net exports $(X - M)$ increase. This shifts the $AD$ curve to the right, expanding real GDP and creating derived demand for labour, which reduces cyclical unemployment.

C. Impact on the Rate of Inflation

A weaker exchange rate generates two distinct inflationary pressures:
• Imported Cost-Push Inflation: Domestic firms must pay higher prices for imported raw materials, intermediate components, and essential commodities (e.g., oil priced in $\$$). This shifts the Short-Run Aggregate Supply (SRAS) curve to the left.
• Demand-Pull Inflation: Rising net export demand shifts $AD$ to the right. If the economy is operating near full capacity ($Y_{fe}$), this extra demand creates upward pressure on the general price level.

D. Impact on Foreign Direct Investment (FDI)

• Asset Bargains: A depreciated currency makes domestic assets, commercial property, and infrastructure cheaper for foreign multinational corporations to purchase.
• Volatility Risk: High exchange rate volatility creates uncertainty for foreign investors regarding future profits and repatriation of earnings, which can deter long-term FDI.

Key Takeaway: Currency depreciation boosts $AD$, economic growth, and employment via cheaper exports, but it creates cost-push and demand-pull inflation, and only improves the current account if the Marshall-Lerner condition is met over time (J-Curve).

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7. Quick Review: Common Pitfalls to Avoid in the Exam

1. Don't assume depreciation always improves the current account: Always evaluate using the Marshall-Lerner condition and explain the short-run vs. long-run dynamics with the J-Curve effect.
2. Remember imported component costs: When evaluating domestic exporters, note that many manufacturing firms import raw parts. A weaker currency raises their production costs, dampening their export price competitiveness.
3. Check your terminology: Floating rates = Appreciation / Depreciation. Fixed rates = Revaluation / Devaluation.
4. Label your forex diagram axes properly: Vertical axis = "Price of Currency A in Currency B" (e.g., "Price of $£$ in $\$$"); Horizontal axis = "Quantity of Currency A" (e.g., "Quantity of $£$").

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