4.3 EXCHANGE RATE
There are a variety of factors that affect the value of one currency against another. Money is constantly moving around the world in search of finding the best risk-adjusted rate of return. The rate of interest that is available in a country can increase or decrease the demand for that currency. A high interest rate will increase the demand for that currency, as ‘hot money’ is attracted in. As there is increased demand for this currency, the exchange rate for that currency increases.
Another factor that influences the exchange rate is inflation. If inflation of a country is relatively high in comparison to other countries around the world, the high inflation would make a country less competitive. This would cause individuals/ investors to sell their holding in this country’s currency and this causes the price to decline (this is similar to the interest point above. Economic agents will seek to maximise their real risk adjusted rate of return).
Confidence is a key factor in determining what the exchange rate of a country will be. If economic agents believe that one currency is not very safe in comparison to other currencies, they will sell their holding in this currency, which will destroy the value of the currency and therefore results in the currency’s values falling. This would have happened if Greece had their own currency, but as they were part of the Euro this was not the case.
Another factor that influences the exchange rate is inflation. If inflation of a country is relatively high in comparison to other countries around the world, the high inflation would make a country less competitive. This would cause individuals/ investors to sell their holding in this country’s currency and this causes the price to decline (this is similar to the interest point above. Economic agents will seek to maximise their real risk adjusted rate of return).
Confidence is a key factor in determining what the exchange rate of a country will be. If economic agents believe that one currency is not very safe in comparison to other currencies, they will sell their holding in this currency, which will destroy the value of the currency and therefore results in the currency’s values falling. This would have happened if Greece had their own currency, but as they were part of the Euro this was not the case.
Why is a currency value important?
The Bank of England/ other monetary authorities may choose to change the exchange rate of a country if they want to stimulate the export or import industries. A depreciation in the exchange rate makes imports relatively more expensive and exports relatively cheaper. This depreciation results in an increase in AD, which would be a good policy if the economy had a negative output gap with high unemployment. As AD increases, real output increases and as the demand for labour is derived for the demand of the final good, unemployment will fall. On the other hand, if an economy was starting to overheat, then the monetary authority may choose to adopt the policy that increases the exchange rate. This would have the opposite effect where imports are now cheaper so rise and exports are now relatively more expensive so fall. This appreciation in the exchange rate results in AD decreasing, which will be useful if the economy is over- heating and inflation is too high, as taking demand out of the economy will decrease the price level.
The Bank of England/ other monetary authorities may choose to change the exchange rate of a country if they want to stimulate the export or import industries. A depreciation in the exchange rate makes imports relatively more expensive and exports relatively cheaper. This depreciation results in an increase in AD, which would be a good policy if the economy had a negative output gap with high unemployment. As AD increases, real output increases and as the demand for labour is derived for the demand of the final good, unemployment will fall. On the other hand, if an economy was starting to overheat, then the monetary authority may choose to adopt the policy that increases the exchange rate. This would have the opposite effect where imports are now cheaper so rise and exports are now relatively more expensive so fall. This appreciation in the exchange rate results in AD decreasing, which will be useful if the economy is over- heating and inflation is too high, as taking demand out of the economy will decrease the price level.
Exchange Rate System
There are many systems in determining an exchange rate. Most countries choose to adopt a floating exchange rate where market forces determine what the exchange rate of a countries currency should be. With a floating exchange rate supply and demand shifts will determine what the exchange rate will be.
Another exchange rate system is having a fixed exchange rate. This is where the central bank of a country or the government sets a fixed exchange rate with various countries. For example, they would set an exchange rate of £1 equal to $1.5 or €1.3. At this price the central banks/ government will sell/ buy as much foreign exchange is supplied/ demanded. Fixed exchange rate can become very expensive for countries if markets move away from a country. Recently the Swiss central bank chose to scrap their minimum exchange rate. Business Insider UK reported that the central bank lost $51 billion by trying to maintain their exchange rate system and from the fall out of scrapping their system.
There is another exchange rate system called the semi fixed exchange rate system. This is where the central banks/ government allow the exchange to freely move within a band. When the exchange goes outside this band the government/ central banks will step in and try to push the exchange rate back into the designated band. An example of a band would be £1 being worth anything between $1.40 and $1.60 dollars. If £1 was worth less than $1.40 or more than $1.60, then the monetary authority would step in and interfere in the market.
There are many systems in determining an exchange rate. Most countries choose to adopt a floating exchange rate where market forces determine what the exchange rate of a countries currency should be. With a floating exchange rate supply and demand shifts will determine what the exchange rate will be.
Another exchange rate system is having a fixed exchange rate. This is where the central bank of a country or the government sets a fixed exchange rate with various countries. For example, they would set an exchange rate of £1 equal to $1.5 or €1.3. At this price the central banks/ government will sell/ buy as much foreign exchange is supplied/ demanded. Fixed exchange rate can become very expensive for countries if markets move away from a country. Recently the Swiss central bank chose to scrap their minimum exchange rate. Business Insider UK reported that the central bank lost $51 billion by trying to maintain their exchange rate system and from the fall out of scrapping their system.
There is another exchange rate system called the semi fixed exchange rate system. This is where the central banks/ government allow the exchange to freely move within a band. When the exchange goes outside this band the government/ central banks will step in and try to push the exchange rate back into the designated band. An example of a band would be £1 being worth anything between $1.40 and $1.60 dollars. If £1 was worth less than $1.40 or more than $1.60, then the monetary authority would step in and interfere in the market.