4.1.8 Exchange Rates (Edexcel)

This Edexcel study note covers Exchange Rates

A) Exchange Rate Systems:

1. Floating Exchange Rate System:
   • In a floating exchange rate system, the exchange rate is determined by supply and demand in the foreign exchange market.
   • Governments and central banks do not actively intervene to fix the rate, allowing it to fluctuate freely.
2. Fixed Exchange Rate System:
   • In a fixed exchange rate system, the government or central bank sets a specific exchange rate and is committed to maintaining it.
   • To keep the rate stable, authorities may buy or sell their own currency as needed.
3. Managed Exchange Rate System:
   • A managed exchange rate system is a hybrid approach where authorities occasionally intervene to influence the exchange rate.
   • While there's some flexibility, there's also a commitment to maintain a certain degree of stability.

B) Distinction between Revaluation and Appreciation of a Currency:

• Revaluation: A revaluation is an increase in the official exchange rate of a currency set by the government or central bank. It is a deliberate policy move to strengthen the currency's value.
• Appreciation: Appreciation refers to a natural increase in the value of a currency due to market forces, such as increased demand for the currency in the foreign exchange market.

C) Distinction between Devaluation and Depreciation of a Currency:

• Devaluation: Devaluation is a deliberate policy action by a government or central bank to reduce the official exchange rate of its currency. This makes exports cheaper and imports more expensive.
• Depreciation: Depreciation occurs when a currency's value decreases in the foreign exchange market due to market forces, such as decreased demand for the currency.

D) Factors Influencing Floating Exchange Rates:

• Market forces drive floating exchange rates, influenced by:
  • Interest Rates: Higher interest rates attract foreign capital, increasing demand for the currency.
  • Economic Data: Economic indicators like GDP growth, inflation, and employment affect currency demand.
  • Speculation: Traders' perceptions of future exchange rate movements can drive short-term fluctuations.
  • Political Stability: Political events can impact investor confidence and currency values.
  • Trade Balance: Trade surpluses or deficits can affect a currency's value.

E) Government Intervention in Currency Markets:

• Governments can influence exchange rates through:
  • Foreign Currency Transactions: Buying or selling their own currency in the foreign exchange market.
  • Interest Rates: Adjusting domestic interest rates to attract or deter foreign capital inflows.

F) Competitive Devaluation/Depreciation and Its Consequences:

• Competitive devaluation/depreciation occurs when multiple countries intentionally lower their exchange rates to gain a competitive advantage in international trade.
• Consequences can include trade tensions, protectionism, and potential disruptions in the global economy.

G) Impact of Changes in Exchange Rates:

1. The Current Account of the Balance of Payments:
   • Marshall-Lerner Condition: A depreciation of the domestic currency will improve the trade balance if the sum of price elasticities of demand for exports and imports is greater than 1.
   • J Curve Effect: In the short term, a depreciation may initially worsen the trade balance before improving it, as it takes time for demand elasticities to adjust.
2. Economic Growth and Employment/Unemployment:
   • A weaker currency can boost exports, stimulating economic growth and potentially reducing unemployment.
3. Rate of Inflation:
   • A depreciating currency can lead to higher import prices, contributing to inflationary pressures.
4. Foreign Direct Investment (FDI) Flows:
   • Exchange rate fluctuations can affect the attractiveness of a country for FDI. A weaker currency may make a country's assets more appealing to foreign investors.

In summary, exchange rate systems, currency valuation actions, government interventions, and exchange rate impacts have profound effects on international trade, economic growth, inflation, and investment flows. Understanding these concepts is crucial for policymakers, businesses, and investors operating in the global economy.