exchange rate concepts for econ 4

with the euro dominating the news exchange rate topics look to be a good bet for econ 4 here is a brief overview

regimes (choice of types of exchange rate systems); specialisation and trade leads to the needs to convert domestic prices into international ones and vice versa. currency is in derived demand to trade

float - demand and supply

positive - partial adjustment for trade imbalance

one less thing for monetary authority to worry about when conducting policy

negative - volatility and uncertainty when creating international contracts over time but this may be reduced by hedging with futures to guarentee rates but extra cost involved

fix - peg reduces uncertainty by setting a price over time and can act as an anchor for inflation

• soft peg - price guarentee scheme price is maintained through intervention buying and selling by the central bank plus use of interest rates to influence currency demand
• buffer stock of commodity is international foreign currency reserves and gold used to buy domestic currency to support price

• examples of soft pegs
• UK ERM 1992: where 2.95 peg against Deutsch Mark deemed too high by market, waves of selling forced Bank of England to spend billions and hike interest rates from 10 to 15% in one day in the middle of a recession before giving up and letting the currency float
• Swiss Franc 2011: Swiss Franc fell 10% in one day as Central Bank looked to print and sell its own currency to bring the price down as safe haven status in face of euro crisis had led to a 25% appreciation in real terms
• hard peg- a more sophisticated committment to fix one currency against another achieved in two ways
• currency board: peg currency is held in reserve to back every unit of domestic currency in circulation eg Argentina 1991-2002 1 to 1 against US Dollar.
• dollarization: adoption of another currency completely and removal of domestic currency, the Eurozone is an example of this

Exchange Rate Regimes may exist in a range of intermediate forms that offer the advantages (and disadvantages) of the polar extremes

• dirty float - demand and supply with the odd tweak from a central authority when deemed too high or too low
• acceptable range: ceilings and floors set out highest and lowest values with float between and soft peg intervention when challenging top or bottom
• adjustable peg - soft peg with intermitant movement of fix price to reflect changing market fundamentals
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Exchange Rate movement are key to influencing macro economic performance - growth issues in the sense that (X-M) is a component of AD

• X is total revenue from exports (Px Qx)
• M is total revenue from imports (Pm Qm)

Clearly a fall in the exchange rate (depreciation) will make exports cheaper and imports more expensive but it truth the impact on revenue flows is dependent on the elasticity of demand for exports and imports ie whether the Marshal Lerner Condition applys (combined elasticities for X and M must be greater than 1 for a fall in the exchange rate to have a positive effect on the trade balance).

The J-curve is a graph illustration of the Marshal Lerner Condition in action

Exchange Rates are a great way to combine micro and macro analysis - synoptic styles which lead to high marks use ADAS to analyse employment and inflation impacts - remember a depreciation will lead to pressure on costs as well and injecting competitiveness