Exchange Rates - Introduction & Overview

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

Currencies are traded in foreign exchange markets and the volume of money bought and sold is huge! Daily foreign exchange market turnover averaged $4 trillion in 2010, 20% higher than in 2007.

An exchange rate is the price of one currency in terms of another – in other words, the purchasing power of one currency against another.

Exchange rates are an important instrument of monetary policy

Measuring the exchange rate

Exchange rates are expressed in various ways:

Spot Exchange Rate - the spot rate is the rate for a currency at today’s market prices

Forward Exchange Rate - a forward rate involves the delivery of currency at a specified time in the future at an agreed rate. Companies wanting to reduce risks from exchange rate volatility can buy their currency ‘forward’ on the market

Bi-lateral Exchange Rate - 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) - a weighted index of sterling's value against a basket of currencies the weights are based on the importance of trade between the UK and each country.

Real Exchange Rate - this is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country.

Exchange rate systems

A country can decide the type of exchange rate system that they want to follow.

System	Main Characteristics	Recent UK History
Free Floating Exchange Rate	The value of a currency is determined purely by demand and supply of the currency Trade flows and capital flows affect the exchange rate under a floating system There is no target for the exchange rate and no intervention in the market by the central bank	Sterling has floated since the UK suspended membership of the ERM in September 1992 The Bank of England has not intervened to influence the pound’s value since it became independent
Managed Floating Exchange Rate	Value of the currency is determined by market demand for and supply of the currency Some currency market intervention might be considered as part of demand management (e.g. a desire for a lower currency to boost exports)	Governments normally engage in managed floating if not part of a fixed exchange rate system. Managed floating was a policy pursued in the UK from 1973-1990
Semi-Fixed Exchange Rates	Exchange rate is given a specific target. The currency can move between permitted bands of fluctuation on a day-to-day basis Interest rates are set at a level necessary to keep the exchange rate within target range – or direct intervention in the FOREX market Re-valuations are seen as a last resort	The UK operated a semi-fixed system from October 1990 - September 1992 when a member of the ERM. Sterling was eventually forced out of the ERM by a wave of speculative selling
Fully-Fixed Exchange Rates	The exchange rate is pegged and there are no fluctuations from the central rate A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable	Several countries operate with fixed exchange rates or currency pegs. The Ivory Coast Franc is pegged to the Euro, with the French Treasury guaranteeing convertibility. This facilitates exchange rate and price stability. The peg is not threatening international competitiveness given the low inflation rate in the Ivory Coast.

Countries with floating exchange rates

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 a central bank to hold foreign currency reserves to use during intervention
2. Useful instrument of economic adjustment: For example depreciation of the exchange rate can provide a boost to exports and stimulate growth during a recession and/or when there is a risk of deflation. A good example of this is Poland whose currency the Zloty depreciated against the Euro in 2009-10 which helped Poland to avoid recession during the global financial crisis. Indeed Poland was one of the few EU countries to avoid a slump during this difficult period.
3. Partial automatic correction for a trade deficit: Floating exchange rates can help when the balance of payments is in disequilibrium – i.e. a large current account deficit puts downward pressure on the exchange rate, which should help exports and make imports relatively more expensive. Much depends on the price elasticity of demand and supply of exports and the price elasticity of demand for imports – see the later section on the Marshall-Lerner condition and the J-curve effect
4. Less opportunity for currency speculation: The absence of an exchange rate target might reduce the risk of currency speculation. Speculators tend to attack weaker currencies where a government is trying to maintain a fixed exchange rate out of line with macro-economic fundamentals.
5. Freedom (autonomy) for domestic monetary policy: The absence of an exchange rate target allows policy interest rates to be set to meet domestic aims such as controlling inflation or stabilising the business cycle. Countries locked into a single currency system such as the Euro do not have the same freedom to manage interest rates to meet their key macroeconomic aims. This has become obvious as one of the limitations of being inside the Euro during the current crisis.

Floating exchange rates have their disadvantages – some of these are discussed next when we look at the advantages of fixed systems. One of the main disadvantages is that floating currencies can be volatile which makes doing businesses harder. An unexpected fall in the exchange rate can also be a cause of rising inflation.

Countries with managed floating exchange rates

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 promote trade and capital investment because of less currency risk. Overseas investors will be more certain and confident that the returns from their investments will not be destroyed by sudden fluctuations in the value of a currency.
2. Some flexibility permitted: Some adjustment to the fixed currency parity is possible if the case becomes unstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement can be reached with other countries). Some countries are tempted to engage in competitive devaluations and this threatens the outbreak of “currency wars”.
3. Reductions in the costs of currency hedging: Businesses have to spend less on currency hedging if they know that the currency will maintain a stable value in the foreign exchange markets.
4. Disciplines on domestic producers: A stable currency acts as a discipline on producers to keep costs and prices down and may encourage attempts to raise productivity and focus 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 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 be reflected in the growth of exports and imports. Consider the example of China and the United States. For several years China pegged the Yuan against the dollar. Until July 2005 the exchange rate was fully fixed; since then the Chinese have allowed only a gradual depreciation of the dollar against the Yuan. Most estimates indicate that the Chinese currency is persistently undervalued against the dollar. This makes Chinese products cheaper and 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.