Exchange Rate Systems

The exchange rate is the price of one currency in terms of another.

• Floating Exchange Rate System: The value of the currency is determined purely by the market forces of supply and demand. The government or central bank undertakes minimal or no intervention.

• Fixed Exchange Rate System: The government or central bank pegs the currency's value against another major currency or a commodity (like gold). To maintain this chosen rate (or parity), the central bank must engage in continuous and significant intervention, buying or selling currency as needed.

• Managed Exchange Rate System (Dirty Float): This is a hybrid approach. The currency is allowed to float within a specific upper and lower band (a target zone). The central bank intervenes only when the rate threatens to move outside this band or to smooth out excessive short-term volatility.

Distinction between Revaluation and Appreciation of a Currency

• Appreciation: This refers to an increase in the value of a currency within a floating exchange rate system. It occurs naturally due to an increase in the market demand for the currency or a decrease in its supply.

• Revaluation: This refers to an increase in the value of a currency within a fixed exchange rate system that results from a deliberate decision by the government or central bank to officially raise the exchange rate.

Distinction between Devaluation and Depreciation of a Currency

• Depreciation: This refers to a decrease in the value of a currency within a floating exchange rate system. It occurs naturally due to a decrease in the market demand for the currency or an increase in its supply.

• Devaluation: This refers to a decrease in the value of a currency within a fixed exchange rate system that results from a deliberate decision by the government or central bank to officially lower the exchange rate.

Factors Influencing Floating Exchange Rates

The value of a floating currency is determined by shifts in the market supply and demand curves for the currency:

• Interest Rates (Relative): Higher domestic interest rates compared to other countries attract 'hot money' (short-term financial flows), increasing the demand for the currency and causing it to appreciate.

• Inflation Rate (Relative): A higher domestic inflation rate makes a country's exports less price competitive, which reduces foreign demand for the currency. This causes the currency to depreciate.

• Current Account Balance: A Current Account Surplus means a net inflow of foreign currency from exports, which is converted into domestic currency, increasing demand and causing appreciation. A deficit causes depreciation.

• Economic Growth: Stronger domestic economic growth relative to trading partners often leads to increased demand for imports, increasing the supply of the domestic currency and causing depreciation. However, it can also attract long-term investment (FDI), causing appreciation.

• Speculation: If speculators believe a currency will rise, they buy it, increasing demand and making the appreciation a self-fulfilling prophecy.

• Political and Economic Stability: Greater stability makes a country a more attractive place to invest, increasing capital inflows and demand, leading to appreciation.

Government Intervention in Currency Markets

Governments (through the Central Bank) use two primary tools to influence exchange rates:

1. Foreign Currency Transactions (Direct Intervention):

   • To prevent appreciation, the Central Bank will sell its own currency and buy foreign currency (increasing the domestic currency's supply).

   • To prevent depreciation, the Central Bank will buy its own currency, using its reserves of foreign currency (increasing the domestic currency's demand).

3. The Use of Interest Rates (Indirect Intervention):

   • To prevent depreciation, the Central Bank can raise interest rates. This attracts 'hot money' from overseas, increasing the demand for the currency.

   • To prevent appreciation, the Central Bank can lower interest rates. This encourages capital outflow, increasing the supply of the currency as investors sell it to move funds abroad.

Competitive Devaluation/Depreciation and its Consequences

Competitive devaluation/depreciation (sometimes called a 'currency war') is a deliberate attempt by a country to lower its currency's value to gain a trade advantage. The goal is to make exports cheaper and imports more expensive, boosting net exports and aiming for export-led growth.

Consequences:

• Trade War/Retaliation: Other countries may respond by depreciating their own currencies to restore competitiveness, leading to a downward spiral and reduced overall global trade.

• Global Instability: This process can breed international distrust and lead to increased protectionism.

• Domestic Inflation: Depreciation leads to higher import prices (cost-push inflation) and can cause the economy to overheat due to increased AD from higher net exports (demand-pull inflation).

Impact of Changes in Exchange Rates

Impact on the Current Account (CA) of the Balance of Payments

A depreciation (or devaluation) makes exports cheaper and imports more expensive.

• The J-Curve Effect: This effect shows the time lag between a depreciation and the resulting improvement in the trade balance .

  1. Short Run: The trade balance initially worsens. Export and import volumes have not yet adjusted, but the terms of trade have deteriorated (exports earn less foreign currency, imports cost more).

  2. Medium/Long Run: The trade balance eventually improves. Consumers and firms adjust their consumption/production patterns (buying fewer imports, selling more exports), and the volumes adjust sufficiently.

• The Marshall-Lerner Condition: For a depreciation/devaluation to be successful in improving the trade balance in the long run, the sum of the Price Elasticity of Demand (PED) for imports and the PED for exports must be greater than one (PEDexports​+PEDimports​>1). Demand must be sufficiently price elastic for the volume change to outweigh the initial adverse price change.

Impact on Economic Growth and Employment/Unemployment

• Depreciation/Devaluation: Increases net exports (X−M), increasing Aggregate Demand (AD). This boosts production, leading to higher economic growth and a fall in unemployment (derived demand for labour).

• Appreciation/Revaluation: Decreases net exports (X−M), reducing AD. This lowers economic growth and causes a rise in unemployment in export and import-competing sectors.

Impact on the Rate of Inflation

• Depreciation/Devaluation: Tends to be inflationary (inflation rises).

  • Cost-Push: Imported raw materials and components become more expensive, raising production costs.

  • Demand-Pull: Higher net exports increase AD, putting upward pressure on prices.

• Appreciation/Revaluation: Tends to be disinflationary (inflation falls).

  • Cost-Push Relief: Imported raw materials and components become cheaper.

  • Demand-Pull Relief: Lower net exports reduce AD, easing pressure on domestic capacity.

Impact on Foreign Direct Investment (FDI) Flows

• Depreciation/Devaluation: Tends to encourage FDI. Domestic assets (factories, land) and labour are cheaper for foreign investors. The country becomes a more attractive low-cost base for producing exports.

• Appreciation/Revaluation: Tends to discourage FDI. Domestic assets and labour are more expensive for foreign investors, making it a less attractive location for new investment.