Floating exchange rates and factors affecting them

Floating exchange rates fluctuate freely according to market forces, specifically the interaction between demand for and supply of a currency.

Factors that increase demand for a currency

• Rising demand for a country's exports - If foreign buyers want more of a nation's goods or services, they need its currency to make purchases, pushing up demand.
• Increased foreign investment - When overseas investors see opportunities, such as in stocks or property, they buy the local currency to invest, increasing demand.
• Speculation of appreciation - Traders may buy a currency if they expect its value to rise, anticipating profits from selling it later at a higher rate.

Factors that decrease supply of a currency

• Reduced imports - If a country buys fewer foreign goods, less of its currency is supplied to international markets for exchange.
• Decreased overseas investment - When domestic investors cut back on foreign assets, less currency is released into the global market.
• Expectation of appreciation - If people believe the currency will strengthen, they hold onto it rather than supplying it for exchange, reducing overall supply.

Fixed exchange rates, devaluation, and revaluation

Fixed exchange rates are set and maintained by governments or central banks, changing only rarely through official decisions.

Devaluation

Devaluation happens when a government lowers the fixed value of its currency, often to address economic pressures.

Reasons for devaluation:

• Persistent downward market pressure - If market forces continually push the currency's value below the fixed rate, maintaining it becomes unsustainable.
• Risk of exhausting reserves - Central banks may deplete foreign currency reserves while trying to prop up the fixed rate by buying their own currency.
• Avoiding interest rate hikes - Raising rates to attract investors could slow economic growth, so devaluation offers an alternative.
• Improving competitiveness - A lower currency value makes exports cheaper, helping to reduce a current account deficit, stimulate growth, and lower unemployment.

Revaluation

Revaluation occurs when a government raises the fixed value of its currency to counter excessive upward pressures or achieve specific economic goals.

Reasons for revaluation:

• Strong upward market pressure - If demand consistently drives the currency above the fixed rate, revaluation prevents the need for constant intervention.
• Avoiding excessive currency sales - Selling large amounts of the currency to keep it down could inflate the money supply undesirably.
• Controlling inflation - A higher currency value makes imports cheaper, helping to curb rising prices.
• Increasing domestic competition - Cheaper imports pressure local firms to become more efficient and competitive.

The Marshall-Lerner condition and its implications

The Marshall-Lerner condition states that for a currency depreciation to improve a country's trade balance, the sum of the price elasticities of demand for its exports and imports must be greater than 1.

Implications when the Marshall-Lerner condition is met

• Effect of depreciation - A fall in the currency's value reduces a current account deficit.
• Effect of appreciation - A rise in the currency's value reduces a current account surplus.
• Role of elasticity - If the combined price elasticity of demand (PED) is less than 1, appreciation might be more suitable to improve the trade balance.

Worked example - Applying the Marshall-Lerner condition

A country's currency is initially valued at 1 unit = 2 foreign currency units. Domestically, machinery sells for 20 currency units, generating export revenue of 800 from sales abroad. The country imports 50 vehicles at 30 domestic currency units each, with import expenditure of 1,500, creating a trade deficit of 700. After depreciation to a 1:1 ratio, assume PED for exports is 0 (inelastic) and PED for imports is -0.8 (elastic). Calculate the new import expenditure and trade deficit.

Step 1: Identify the values

• Initial export revenue = 800
• Initial import expenditure = 1,500
• Initial deficit = 700
• PED for exports = 0
• PED for imports = -0.8
• Price rise for imports after depreciation = 100% (from 1:2 to 1:1 ratio doubles the domestic price)

Step 2: Calculate export revenue after depreciation

With PED = 0, export revenue remains unchanged at 800 (no change in demand despite price fall).

Step 3: Calculate import expenditure after depreciation

Initial quantity of imports = 50 vehicles.

Price rise = 100%. New price per import = 30 × 2 = 60 domestic units.

Demand for imports falls by 80% (PED of -0.8 × 100% price rise).

New quantity of imports = 50 × (1 - 0.8) = 50 × 0.2 = 10 vehicles.

New import expenditure = 10 vehicles × 60 domestic units/vehicle = 600.

Step 4: Calculate new deficit/surplus

New deficit = 600 (imports) - 800 (exports) = -200 (a surplus of 200).

The initial deficit was 700, which has now become a surplus of 200, demonstrating an improvement in the trade balance as the Marshall-Lerner condition is met.

The J-curve effect and reverse J-curve effect

The J-curve effect describes how a currency depreciation initially worsens a country's current account balance before eventually improving it, due to differences in short-run and long-run elasticities.

The J-curve effect

• Short-run impact - Demand for imports and exports is relatively inelastic immediately after depreciation. This can temporarily increase the deficit.
• Long-run impact - Over time, demand becomes more elastic, potentially turning the deficit into a surplus.

The reverse J-curve effect

The reverse J-curve occurs with currency appreciation, where the current account surplus may initially improve before declining:

• Short-run impact - Inelastic demand means the higher export prices and lower import prices temporarily boost the surplus.
• Long-run impact - As demand becomes elastic, export volumes fall and import volumes rise, reducing the surplus, provided the sum of price elasticities exceeds 1.