We now turn to focus to the effects of exchange rates on the macroeconomy and in particular to the economics of fixed versus floating exchange rate systems as part of the operation of macroeconomic policy in a country.

Measuring the exchange rate

Exchange rate prices are expressed in various ways:

• Spot Exchange Rate - the spot rate is the actual exchange rate for a currency at current market prices. This is determined by the FOREX market on a minute-by-minute basis on the basis of the flow of supply and demand for any one particular currency.
• Forward Exchange Rate - a forward rate involves the delivery of currency at some time in the future at an agreed rate. Companies wanting to reduce the risk of exchange rate uncertainty by buying their currency ‘forward’ on the market often use this.
• Bi-lateral Exchange Rate - this is simply the rate at which one currency can be traded against another. Examples include:
• $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro
• Effective Exchange Rate Index (EER) - the EER is a weighted index of sterling's value against a basket of international currencies the weights used are determined by the proportion of trade between the UK and each country
• Real Exchange Rate - this measure is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of international competitiveness for a country.

 

Exchange rate systems

System	Main Characteristics	Recent UK History
Free Floating Exchange Rate	The value of the pound is determined purely by market demand and supply of the currency Both trade flows and capital flows affect the exchange rate under a floating system No target for the exchange rate is set by the Government There is no need for official intervention in the currency market by the central bank	Rare for pure free floating to exist Sterling has floated freely on the foreign exchange markets since the UK suspended membership of the ERM in September 1992 The Bank of England has not intervened officially in the markets to influence the pound’s value since it became independent
Managed Floating Exchange Rate	The value of the pound determined by market demand for and supply of the currency Central banks may to try to iron out big changes in exchange rates on a day-to-day basis Some currency market intervention might be considered as part of macro-economic demand management (e.g. a desire for a slightly lower currency to boost export demand or the desire for a strong currency to control inflationary pressures)	Governments normally engage in managed floating if not part of a fixed exchange rate system.   Managed floating was a policy pursued from 1973-1990
Semi-Fixed Exchange Rates	The exchange rate is given a specific target The currency can move between permitted bands of fluctuation on a day-to-day basis Exchange rate becomes an target of economic policy-making (interest rates are set to meet the exchange rate target) The Bank of England might have to intervene to maintain the value of the currency within the set targets if it moves outside the agreed range Re-valuations are seen as a last resort	The last time the UK operated a semi-fixed system was during October 1990 - September 1992 the period of the UK’s short-lived period of ERM membership Sterling was allowed to vary between 6% either side of DM2.95 Sterling eventually forced out of the ERM by a wave of speculative selling
Fully-Fixed Exchange Rates	The government makes a commitment to a fixed exchange rate The exchange rate is pegged There are no fluctuations from the central rate System achieves exchange rate stability but perhaps at the expense of domestic stability A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable	The Bretton Woods System which lasted from 1944-1972 was a fixed rate system where currencies were tied to the US dollar Gold Standard in the inter-war years – with currencies linked to gold Countries joining EMU fixed their exchange rates until 1st Jan 2002 when the Euro came into common circulation

 

Fixed versus floating exchange rates – which is best for an economy?

Each country must decide on the most appropriate currency regime or system. There is an ongoing debate in economics about the merits and de-merits of fixed versus floating exchange rates.

• 1973-1990: UK operated with a managed floating exchange rate. There was some intervention by the central bank to influence the exchange rate and government was in control of interest rates
• October 1990- September 1992: UK a member of the European exchange rate mechanism (ERM) – the exchange rate was a specific target of economic policy. Interest rates had to be set at a level consistent with keeping sterling within the agreed ERM bands (limits)

• September 1992 – present day: the UK has operated with a free-floating exchange rate – no intervention by the Bank of England. Exchange rate is purely market determined. Since 1999, the Euro has been in existence as twelve nations have established a single currency. Sterling floats freely against the Euro and also against the dollar, yen etc.

The case for floating exchange rates:

The main arguments for adopting a floating exchange rate system are as follows:

1. Reduced need for currency reserves: There is no exchange rate target so there is little requirement for the central bank (e.g. the Bank of England) to hold large scale reserves of gold and foreign currency to use in possible official intervention in the markets
2. Useful instrument of macroeconomic adjustment: A floating rate can act as a useful tool of macroeconomic adjustment – for example depreciation should provide a boost to net export demand and therefore stimulate growth. This assumes that the gains from a lower exchange rate are not dissolved in higher wage claims or export prices. The countries inside the Euro Zone for example might be hoping for a more competitive exchange rate as a means of creating an injection of demand into their slow-growing economies.
3. Partial automatic correction for a trade deficit: Floating exchange rates offer a degree of adjustment when the balance of payments is in fundamental disequilibrium – i.e. a large trade deficit puts downward pressure on the exchange rate which should help the export sector and control demand for imports because they become relatively expensive
4. Reduced risk of currency speculation: The absence of an explicit exchange rate target reduces the risk of currency speculation. Often, currency market speculators target an exchange rate target that they believe to be fundamentally over or undervalued.
5. Freedom (autonomy) for domestic monetary policy: The absence of an exchange rate target allows short term interest rates to be set to meet domestic macroeconomic objectives such as stabilising growth or controlling inflation. The Bank of England has enjoyed the autonomy that a floating exchange rate gives since it was made independent in May 1997.
6. Floating exchange rates are not always volatile exchange rates - although the sterling exchange rate has been floating, the volatility has not been that great. Businesses have learnt to cope with modest fluctuations – helped by having a flexible labour market.

The Case for Fixed Exchange Rates

The main arguments for adopting a fixed exchange rate system are as follows:

1. Trade and Investment: Currency stability can help to promote trade and investment because of lower currency risk – this is one of the reasons why currencies were locked within the Euro Zone in preparation for the launch of the Euro.
2. Some flexibility permitted: Some adjustment to the fixed currency parity is possible if the economic case becomes unstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement can be reached with other countries). That said, countries with fixed exchange rates are often reluctant to make parity adjustments – these decisions are often see as politically damaging.
3. Reductions in the costs of currency hedging: Because we can never predict what will happen to the market value of a currency, many businesses hedge against this volatility by buying the currency they need in the forward currency markets. With fixed exchange rates, businesses have to spend less on currency hedging if they know that the currency will hold its value in the foreign exchange markets (hedging involves risk)
4. Disciplines on domestic producers: A stable (fixed) currency acts as a discipline on producers to keep their costs and prices down and may lead to greater pressure for exporters to raise labour productivity and focus more resources on research and innovation. In the long run, with a fixed exchange rate, one country’s inflation must fall into line with another (and thus put substantial competitive pressures on prices and real wages)
5. Reinforcing gains in comparative advantage: If one country has a fixed exchange rate with another, then differences in relative unit labour costs will quite easily be reflected in changes in the rate of growth of exports and imports. Consider the example of China and the United States. China has a $100 billion trade surplus with the United States and it has also fixed its exchange rate against the US dollar. The pegged exchange rate between the Yuan and the dollar has been in place for several years. Most estimates indicate that the Chinese currency is undervalued against the dollar. This makes Chinese products cheaper than they would otherwise be and has led to a surge in import penetration from China into the US economy. This has led to numerous calls from US manufacturers for the Chinese to be persuaded to switch to a floating exchange rate or to adjust their currency by appreciating against the dollar. Finally in July 2005, the Chinese authorities did revalue their currency against the dollar and announced a new policy of allowing the Yuan to move against a basket of currencies, dominated by the dollar.

The relationship between interest rates and the exchange rate

In a floating exchange rate system relative interest rates do have an influence on the market value of one currency against another. To understand this, consider the risks and returns that face investors when deciding in which country to allocate their financial investments.

If UK interest rates are relatively higher than rates on offer in the Euro Zone, then ceteris paribus we expect to see a net inflow of currency into UK banks and other financial institutions. The higher the interest rate differential, the greater is the incentive for funds to flow across international boundaries and into the economy with the higher interest rates.

Speculative flows of currency will also flow into those economies where the expected returns on other types of investment are also higher. For example, money may flow into the UK as investors look to put their money into property or the stock and bond markets. Such a wall of speculative funds can have a powerful effect in the currency markets. You could show this by drawing an outward shift in the demand for sterling, leading to an appreciation in the value of the currency.

There are inevitable risks in shifting funds across international markets. What might happen to the currency if you leave $200,000 worth of cash in a UK bank account? What happens to the value of your investment if sterling depreciates against the US dollar? What are the risks in exchanging a similar value of US dollars and putting it into the UK stock market or into government bonds?

Investors often consider the risk-adjusted relative rate of return from different financial investments. Thus if UK interest rates are persistently above those in other countries, and the risks are pretty similar, then we would expect to see a rising demand for sterling and an appreciation of the currency. Interest rates are not the only factor that drives the external value of a currency in the foreign exchange markets – but they undoubtedly do have some effect.

How the exchange rate influences policy objectives, such as inflation, unemployment and the balance of payments.

For A2 economics, it is important to understand the transmission mechanism between a change in the exchange rate and its impact on the wider macro-economy. Recent trends in currencies and currency forecasts certainly figure prominently in the assessment of economic conditions made each month by the Monetary Policy Committee, although the Bank does not formally target the exchange rate since the UK operates with a floating exchange rate system.

The exchange rate and inflation:

The exchange rate affects the rate of inflation in a number of direct and indirect ways:

• Changes in the prices of imported goods and services – this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the sterling price of imported consumer goods and durables, raw materials and capital goods. The effect of a changing currency on the prices of imported products will vary by type of import and also the price elasticity of demand which is influenced by the extent of competition within individual markets.
• Commodity prices and the CAP: Many internationally traded commodities are priced in dollars – so a change in the sterling-dollar exchange rate has a direct impact on the £ price of commodities such as oil. The operation of the Common Agricultural Policy (CAP) can also help to absorb fluctuations in the prices of imported foodstuffs because of the variable import tariff. If world prices rise, the import tariff can fall to insulate the EU from the effects of higher import costs.
• Changes in the growth of UK exports – movements in the exchange rate affect the competitiveness of UK export industries in global markets. A higher exchange rate makes it harder to sell overseas because of a rise in relative UK prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels. A fall in export demand will reduce real national income relative to potential output – and thus might lead to a negative output gap. This puts downward pressure on inflation
• The exchange rate and wage bargaining – some economists believe that the exchange rate influences the power of employees to bargain for increases in real wages. When the exchange rate is high, there is pressure on businesses to control their costs of production in order to remain competitive – this may lead to downward pressure on wage inflation.

Bank of England research suggests that a10% depreciation in the exchange rate can add up to 3% to the level of consumer prices three years after the initial change in the exchange rate.

The exchange rate and unemployment

To the extent that movements in the exchange rate affect the growth of demand, output and investment in those sectors of the economy exposed to international trade, the rate of unemployment can also be influenced by currency fluctuations. In broad terms:

An exchange rate appreciation tends to cause a slower rate of growth of real GDP (e.g. because of a fall in net exports)
A reduction in demand and output may cause job losses as businesses seek to control costs. Some job losses are temporary – reflecting short term changes in export demand and import penetration. Others are permanent if domestic industries move out of some export markets or if imports take up a permanently higher share of the UK market
Some industries are more exposed than others to currency fluctuations – e.g. sectors where a high percentage of total output is exported and where demand is highly price sensitive (price elastic)

AD-AS analysis can be used to illustrate the effects. In the first diagram, we see an inward shift in the AD curve due to a rise in net imports and in the second diagram we draw the effects of a reduction in production costs arising from cheaper raw material and component prices.