Types of exchange rate systems

Exchange rates represent the value of one currency compared to another and can affect areas like economic growth, inflation, and the balance of payments.

Main exchange rate systems

• Fixed exchange rate - The government or central bank sets and maintains a specific value for the currency against another currency or asset.
• Floating exchange rate - The currency's value is determined by market forces of supply and demand, without regular government intervention.
• Hybrid exchange rate - A combination of fixed and floating elements. Examples include:
  • Managed floating, where the rate mostly floats but the government intervenes occasionally, such as during economic shocks.
  • Semi-fixed, where the rate can only vary within a predefined range.
  • Pegged, where the currency is linked to another currency or a group of currencies, with the peg adjustable by the government as needed.

Maintaining a fixed exchange rate

In fixed or certain hybrid systems, a target rate is set. To keep the currency at this level, the government or central bank adjusts interest rates and uses foreign currency reserves to buy or sell the currency, balancing supply and demand.

Ways of measuring exchange rates

Exchange rates can be measured in different ways to provide accurate comparisons between currencies.

Key methods of measurement

• Nominal exchange rate - A straightforward comparison of currency values without adjustments, such as £1 = €1.10.
• Real exchange rate - Adjusts the nominal rate for differences in price levels between countries, using a price index like the consumer prices index (CPI) to reflect actual purchasing power.
• Bilateral exchange rate - Compares just two currencies directly, for example, showing £1 = $1.40.
• Effective exchange rate - Compares a currency against a weighted average of several others, often from major trading partners, to give an overall sense of its value. The weighting is based on trade volumes with each partner.

Purchasing power parity (PPP) uses real exchange rates to calculate a rate based on what currencies can actually buy in different countries.

Factors causing exchange rate fluctuations

Exchange rates can change due to deliberate government actions or market forces. These changes are described using specific terms depending on the system and direction of movement.

Terms for exchange rate changes in fixed systems

• Devaluation - A deliberate reduction in the currency's value by the government, often achieved by selling the currency.
• Revaluation - A deliberate increase in the currency's value, typically by buying the currency.
• Competitive devaluation - When governments intentionally lower their currency's value to make exports more competitive internationally.

Terms for exchange rate changes in floating systems

• Depreciation - A fall in the currency's value due to market forces, though government actions like cutting interest rates can influence it indirectly.
• Appreciation - A rise in the currency's value driven by market conditions.
• Competitive depreciation - Indirect government efforts to reduce the currency's value for better international competitiveness.

Influences on supply and demand in floating systems

Floating exchange rates are shaped by supply and demand shifts. For instance, increased supply of a currency (e.g., from higher imports or selling by investors) can lower its value, while decreased demand (e.g., from lower exports) has a similar effect.

Factors affecting these shifts include:

• Speculation, where traders buy or sell based on expected future changes.
• Government or central bank interventions through buying or selling the currency.
• Relative inflation rates – higher inflation than competitors reduces competitiveness, decreasing demand and increasing supply of the currency.
• Relative interest rates – higher rates attract foreign investment (hot money), boosting demand.
• Economic confidence – strong growth, stability, and political reliability increase demand for the currency.
• Current account balance – A deficit slightly increases supply due to import purchases.

Advantages and disadvantages of fixed and floating exchange rates

Each exchange rate system has benefits and drawbacks, influencing economic stability, trade, and policy flexibility. Hybrid systems blend these characteristics, such as providing more certainty than pure floating but requiring some interest rate control.

Advantages of floating exchange rates

• Reduces the need for large foreign currency reserves, as no constant intervention is required.
• Helps correct balance of payments (BOP) current account deficits if export and import demand is price elastic, as a falling currency boosts exports and cuts imports.
• Allows governments to use monetary policy (e.g., interest rates) for other goals, not just rate maintenance.

Disadvantages of floating exchange rates

• Can lead to volatile changes, complicating business planning.
• Speculation may artificially inflate the rate, harming competitiveness.
• Can cause inflation if import demand is price inelastic.

Advantages of fixed exchange rates

• Reduces speculation unless the rate seems unsustainable.
• Encourages firms to control costs, invest, and improve productivity to stay competitive.
• Provides stability, boosting investment including foreign direct investment (FDI).

Disadvantages of fixed exchange rates

• Speculators may sell the currency if the fixed rate appears unsustainable.
• Limits control over interest rates, as they must support the fixed rate.
• Challenging to sustain long-term without significant reserves.

Economic impacts of exchange rate changes, including the Marshall-Lerner condition and J-curve

Changes in a currency's value affect trade, growth, employment, and inflation. A fall (depreciation or devaluation) makes exports cheaper and imports dearer, potentially increasing export demand and reducing import demand. This can shrink a current account deficit or expand a surplus, but only under certain conditions. A rise (appreciation or revaluation) typically has opposite effects, such as worsening deficits and lowering aggregate demand.

Effects of a currency value fall

• Boosts export competitiveness, increasing demand and potentially leading to economic growth via higher aggregate demand.
• Reduces imports, aiding the current account balance.
• May lower unemployment through job creation from growth.
• Can raise inflation if import demand is price inelastic or cause cost-push inflation from higher import prices.

Effects of a currency value rise

• Makes exports more expensive, potentially reducing demand and aggregate demand, leading to lower output.
• Makes imports cheaper, increasing demand and possibly worsening the current account.
• May increase unemployment due to reduced economic activity.
• The impact on inflation will depend on the price elasticity of demand for imports and for domestic goods.

The Marshall-Lerner condition

A fall in currency value improves the current account only if this condition is met.

$PE{D}_M+PE{D}_X>1$

Where:

• $PE{D}_M$ = Price elasticity of demand for imports
• $PE{D}_X$ = Price elasticity of demand for exports

If the sum exceeds 1, the trade balance improves; otherwise, it may worsen.

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Worked example - Applying the Marshall-Lerner condition

In an economy, the price elasticity of demand for imports is 0.7, and for exports is 0.5. Assess whether a depreciation of the currency would improve the current account balance.

Step 1: Identify the values

• $PE{D}_M$ = 0.7
• $PE{D}_X$ = 0.5

Step 2: Apply the Marshall-Lerner condition

$PE{D}_M+PE{D}_X=0.7+0.5=1.2$

1.2 > 1, so the condition holds.

Step 3: Interpretation

The depreciation would improve the current account balance, as the combined elasticities are greater than 1.

The J-curve effect

Even if the Marshall-Lerner condition holds long-term, a currency fall may initially worsen the current account due to short-run inelastic demand for imports and exports (e.g., time needed to switch suppliers).

Export values drop and import values rise initially, but improve over time as elasticities increase, forming a J-shaped curve on a graph of the current account over time.