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Currency Economics

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This revision presentation is designed for students revising their A2 macroeconomics. It looks at the economics of currency markets and focuses in particular on different exchange rate systems and the debate over fixed versus floating currencies.

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Currency Economics

  1. 1. Exchange Rates EdExcel Economics Unit 4 Macro
  2. 2. Exchange Rates A2 Unit 4 - EdExcel Economics A2 EdExcel Syllabus Specification: Students need to cover the following aspects: Influences on exchange rates • Understand factors influencing exchange rates. • Students should consider the significance of relative interest rates; relative inflation rates; speculation. Changes in exchange rates • Consider the impact of changes in exchange rates. • For example the implications for competitiveness.
  3. 3. Average Daily Turnover in Global FX Markets 1,527 1,239 1,934 3,324 3,981 5,345 0 1000 2000 3000 4000 5000 6000 1998 2001 2004 2007 2010 2013 AveragedailyturnoverinbillionU.S.dollars
  4. 4. Market share of leading foreign exchange currencies 87% 33% 23% 12% 9% 5% 5% 3% 2% 2% 2% 2% 1% 1% 1% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0% U.S. dollar Euro Yen British pound Australian dollar Swiss franc Canadian dollar Mexican peso Chinese yuan New Zealand dollar Swedish krona Russian rubel Hong Kong dollar Norwegian krone Singapore dollar Market share The US dollar dominates currency trades in the world economy. 1. It is the global reserve currency 2. USA is largest economy in the world 3. Majority of commodities are traded in $s The Chinese Yuan will grow in significance as a global currency – but not yet fully convertible and traded in a floating currency system
  5. 5. Classification of Currency Systems (Selected Nations, Source: IMF Dec 2014) Exchange Rate System Exchange rate anchor (where relevant) US Dollar ($) Euro Composite or Other Currency Peg Fixed currency with no separate legal tender Ecuador Zimbabwe Kosovo, San Marino Currency Board System Hong Kong Bulgaria Conventional exchange rate peg (Fixed currency system) Bahrain Qatar Saudi Arabia Denmark Senegal Kuwait Nepal Crawling exchange rate peg (semi-fixed) Jamaica Croatia Botswana China Ethiopia Managed floating currency Kenya, Brazil, Ukraine, South Korea, India, Zambia, South Africa, Thailand, Turkey Free floating exchange rate Australia, Canada, Chile, Japan, Norway, UK, USA, Mexico, Euro Zone
  6. 6. Fixed and Floating Exchange Rates Floating Exchange Rates • The market determines the value of the currency without government / central bank intervention Fixed exchange Rates • Exchange rate is pegged • Occasional realignments e.g. usually a devaluation • Day to day, the external value of the currency is usually stable
  7. 7. Floating Exchange Rates • The strength of currency supply and demand drives the external value of a currency in the markets Currency value set by market forces • Central bank allows currency to find it’s own level No intervention by the central bank • External value of currency is not an intermediate target of macroeconomic policy No target for the exchange rate
  8. 8. Sterling against the US Dollar Sterling depreciation of more than 20% in 2008-09 Floating currencies don’t necessarily have to be volatile currencies! US dollar now appreciating
  9. 9. Sterling against the Euro Sterling falls against the Euro as the global financial crisis hits Sustained appreciation during the “Euro Crisis”
  10. 10. Euro: A Currency Union & a Floating Exchange Rate The nineteen countries in the euro area have a hard peg (a currency union) with other members of the bloc, but the euro itself floats against third currencies such as sterling & the $.
  11. 11. Floating Currencies – the Australian Dollar Depreciation of Australian dollar as global financial crisis took hold Rapid appreciation of Australian dollar – due to booming economy, surge in exports, rising current account surplus and higher interest rates AUS $ now depreciating again – growth slowing as exports hit by Chinese weakness
  12. 12. What factors determine a currency’s value? • In a floating exchange rate system, the external value of a currency is determined by market demand for and supply • Much currency dealing is speculative but trade and investment flows have a key role to play • Factors mentioned in the graphic will usually lead to a currency appreciation (i.e. rising external value) Current account surplus on the balance of payments Strong inward investment inflows + portfolio flows Relatively high policy interest rates Speculative currency demand A Rising Currency
  13. 13. Currency Market Analysis: Higher Interest Rates Value of currency Quantity of currency traded D1 Supply Rise in policy interest rates by central bank Currency more attractive for investors Attracts inflows of short- term hot money Causes outward shift in currency demand Currency appreciates in value in a floating system P2 P1 D2
  14. 14. Currency Market Analysis: A Slump in Exports Value of currency Quantity of currency traded Demand Supply Recession in a trading partner Causes a fall in export sales Worsening of trade balance Inward shift of currency demand Currency will depreciate D2 P1 P2
  15. 15. Economic Effects of a Currency Depreciation This will have an effect on a number of economic indicators Domestic production  Trade deficit  Domestic jobs  Changes in import and export prices will affect demand Import sales will CONTRACT Export sales will EXPAND When the pound depreciates against the US dollar It makes UK import prices RISE It makes UK export prices FALL
  16. 16. Will an Exchange Rate Depreciation improve the BoP? Time period after depreciation Trade surplus Trade deficit Currency depreciation here Trade deficit may grow in initial period after depreciation Net improvement in trade provided certain conditions are met The diagram below shows the “J Curve effect” – it shows the time lags between a falling currency and an improved trade balance
  17. 17. The Marshall Lerner Condition The Marshall Lerner condition states that a depreciation / devaluation of the exchange rate will lead to a net improvement in the trade balance provided that the sum of the price elasticity of demand for exports and imports > 1 Ped for exports Ped for imports Sum of price elasticity Will fall in currency improve the trade balance? Country A 0.4 0.3 0.7 No Country B 1.2 0.7 1.9 Yes Country C 0.8 0.2 1.0 Will leave it unchanged
  18. 18. Evaluating the Effects of a Currency Depreciation In theory a depreciation of the exchange rate provides stimulates aggregate demand and economic growth ....but this depends on.. 1. The length of time lags as consumers and businesses respond 2. The scale of any change in the exchange rate i.e. a 5%, 10%, 20% 3. Whether the change in the currency is short-term or long-term – i.e. is a change in the exchange rate temporary or likely to persist 4. Price elasticity of demand for imports and exports 5. The size of any second-round multiplier and accelerator effects 6. When the currency movement takes place – i.e. Which stage of an economic cycle (recession, recovery etc.) 7. The type of economy (e.g. small developing v large advanced) 8. The degree of openness of the economy to international trade
  19. 19. Managed Floating Exchange Rates • Central bank gives a degree of freedom for market exchange rates on a day-to-day basis Currency usually set by market forces • Buying to support a currency (selling their FX reserves) • Selling to weaken a currency (adding to their FX reserves) • Changes in policy interest rates to affect “hot money flows” Central bank may intervene • Higher exchange rate to control inflationary pressures • “Competitive devaluation” to improve competitiveness Currency becomes a target of policy
  20. 20. Instruments for Managing the Exchange Rate • Changes in interest rates e.g. lower interest rates to depreciate the exchange rate • Causes movements of “hot money” banking flows Changes in monetary policy interest rates • Increase liquidity in the banking system, usually causes outflow of money – depreciation of the exchange rate Quantitative easing • Direct intervention in the market • Buying and selling of domestic / foreign currencies Direct buying / selling in the currency market (intervention) • Taxation of foreign deposits in banks cut the profit from hot money inflows • Controls on the free flow of capital into and out of a country Taxation of overseas currency deposits and capital controls
  21. 21. Stock of Currency Reserves (December 2015) 3,406.11 1,233.21 602.49 368.4 367.96 358.82 356.46 350.38 247.75 177.6 173.68 156.51 155.88 118.46 105.93 79.75 49.27 38.64 25.56 6.03 2.2 0. 500. 1,000. 1,500. 2,000. 2,500. 3,000. 3,500. 4,000. China: Mainland Japan Switzerland Russian Federation Korea, Republic of China: Hong Kong Brazil India Singapore Mexico Germany Thailand United Kingdom United States Indonesia Canada Australia Chile Argentina Greece Ireland International reserves and foreign currency liquidity in selected countries worldwide as of December 2015 (in billion U.S. dollars)
  22. 22. Countries with Managed Exchange Rate Systems Brazilian Real Swiss Franc Japanese Yen Norwegian Krone Ghana - Cedi
  23. 23. The Swiss France against the Euro Swiss maintained a currency fix against the Euro from late 2011 to January 2015 Peg lifted – the Swiss Franc appreciates dramatically against the Euro!
  24. 24. Fixed Exchange Rates • External value is pegged to one or more currencies (known as the anchor currency) Government / central bank fixes currency value • Trade takes place at this official rate • There might be unofficial trades in shadow markets Pegged exchange rate becomes official rate • Occasional realignments may be needed • E.g. a devaluation or revaluation depending on economic circumstances – the currency may have drifted from the fundamental value Adjustable peg
  25. 25. Danish Kroner is fixed against the Euro
  26. 26. Danish Kroner is fixed against the Euro 0.6% movement over the last 5 years
  27. 27. China and the US Dollar – From Fixed to Crawling Peg Fixed exchange rate for over ten years – ended in 2005 China has “managed” the appreciation of the Yuan over the last eleven years
  28. 28. China and the US Dollar – Yuan is now Depreciating Yuan has been depreciating against the US dollar over the last two years. China's central bank has cut rates six times since November 2014 Shock devaluation here! “The expectation of higher US interest rates has contributed to a massive outflow of capital from China, as investors take their money in search of higher and safer returns elsewhere” - Source: Deloitte, March 2016
  29. 29. Floating versus Fixed Exchange Rates Floating Currency • Reduces the need for foreign currency reserves • Freedom to set policy interest rates to meet domestic objectives • May help to prevent imported inflation • Insulation for an economy after an external shock especially for export- dependent countries • Partial automatic correction for a current account deficit • Less risk of speculative attack Fixed Currency • Certainty of currency value gives confidence for inward investment • Reduced costs of currency hedging for businesses • Stability helps to control inflation – it is a discipline on businesses to keep unit labour costs low • Can lead to lower borrowing costs (lower yields on bonds) • Imposes responsibility on government policies • Less speculation if the fixed exchange rate is credible
  30. 30. Floating versus Fixed Exchange Rates Floating Currency • Reduces the need for foreign currency reserves • Freedom to set policy interest rates to meet domestic objectives • May help to prevent imported inflation • Insulation for an economy after an external shock especially for export- dependent countries • Partial automatic correction for a current account deficit • Less risk of speculative attack Fixed Currency • Certainty of currency value gives confidence for inward investment • Reduced costs of currency hedging for businesses • Stability helps to control inflation – it is a discipline on businesses to keep unit labour costs low and drive efficiency • Can lead to lower borrowing costs (lower yields on bonds) • Imposes responsibility on government policies • Less speculation if the fixed exchange rate is credible
  31. 31. Key Arguments: Floating versus Fixed Exchange Rates Fixed rates may be optimal for developing countries wanting to control inflation Export-dependent economies may favour a managed floating rate Struggling "southern" countries inside Euro have experienced deflationary pressures – falling wages and very high unemployment General drift towards managed floating - game theory in action! Not every country has the reserves to influence currency - China does! "Competitive depreciations" when conventional monetary policy fails Choice of currency regime is hugely important for developing countries
  32. 32. Classification of Currency Systems (Selected Nations, Source: IMF Dec 2014) Exchange Rate System Exchange rate anchor (where relevant) US Dollar ($) Euro Composite or Other Currency Peg Fixed currency with no separate legal tender Ecuador Zimbabwe Kosovo, San Marino Currency Board System Hong Kong Bulgaria Conventional exchange rate peg (Fixed currency system) Bahrain Qatar Saudi Arabia Denmark Senegal Kuwait Nepal Crawling exchange rate peg (semi-fixed) Jamaica Croatia Botswana China Ethiopia Managed floating currency Kenya, Brazil, Ukraine, South Korea, India, Zambia, South Africa, Thailand, Turkey Free floating exchange rate Australia, Canada, Chile, Japan, Norway, UK, USA, Mexico, Euro Zone
  33. 33. Exchange Rates EdExcel Economics

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