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Understanding Exchange Rates: Flexibility, Balance of Payments, and Currency Dynamics

This overview explains the key concepts of exchange rates, including flexible and fixed systems. Flexible exchange rates adjust automatically based on supply and demand, influencing the balance of payments. A depreciation or appreciation of currency impacts domestic prices and trade dynamics. Adjustments are driven by factors such as consumer preferences, relative income, and interest rates. The text explores the consequences of these changes and the role of government intervention in maintaining exchange rate stability. Understanding these elements is crucial for navigating international finance.

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Understanding Exchange Rates: Flexibility, Balance of Payments, and Currency Dynamics

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  1. Exchange Rates

  2. Balance of payments deficit/surplus + adjustments depend on system of exchange • 1) flexible/floating: demand + supply • 2) fixed/pegged: gov’t determines rates + adjusts as necessary to maintain

  3. Currency demand down sloping: currency less expensive goods less expensive to foreigners higher demand for goods higher quantity demand for currency • Currency supply up sloping: as more expensive (dollar price of pounds rises/pound price of dollar falls) foreigners purchase more goods greater supply foreign currency (exchanging foreign currency for domestic)

  4. British Pounds S+D Dollar price of 1 pound S 2 D Q1 Q of pounds

  5. Depreciation • Dollar price of pounds increases dollar depreciation relative to the pound (more dollars to get single unit of pounds)

  6. Dollar price of 1 pound British Pounds S+D S Dollar depreciates (pounds appreciates) $3 $2 D2 D Q1 Q2 Q of pounds

  7. Appreciation • Dollar price of pounds decreases dollar appreciation relative to the pound (fewer dollars to get one unit of pounds)

  8. British Pounds S+D Dollar price of 1 pound S $2 Dollar appreciates (pounds depreciates) $1 D D2 Q1 Q of pounds Q2

  9. Generalizations • 1) Currency demand increases (ceteris paribus) appreciation • 2) Currency supply increases depreciation • 3) If US currency depreciates/appreciates some foreign currency appreciates/depreciates relative to it

  10. Determinants • 1) Tastes: changing demand products • 2) Relative income: relative fast income growth depreciation: income up more consumption domestic + imports greater relative demand foreign currency • 3) Relative price-level: purchasing power parity theory: exchange rates equate purchasing power of currencies (dollar gets same amount of stuff) • However: exchange rates differ from PPP even over long periods, BUT relative price levels a determinant (attempt to get relatively cheaper goods)

  11. 4) Relative interest rates greater demand financial investments greater demand currency • 5) Speculation: attempt to profit from rate changes (often self-fulfilling)

  12. Flexible Rates and Balance of Payments • Rates automatically adjust to eventually eliminate balance of payment deficits/surpluses • At equilibrium no need to draw down/build up official reserves to balance payments • Suppose D for pounds increases

  13. Dollar price of 1 pound British Pounds S+D c S $3 a b $2 D2 D Q1 Q2 Q of pounds

  14. If exchange rate stays at $2 = £1, balance of payments deficit of ab US demand b pounds, Brits only supply a quantity shortage pounds Competitive market new exchange rate (say $3 = £1) + dollar depreciates

  15. Dollar price of 1 pound S Dollar depreciates (pounds appreciates) c $3 a b $2 D2 D Q1 Q2 Q of pounds

  16. Exchange rates links all domestic and foreign prices • Dollar price foreign good= foreign price x exchange rate £ 9,000 car at $2 = £1 $18,000 • At $3 = £1 $27,000 car decline US imports B goods decrease quantity demanded pounds (movement point b to point c)

  17. Dollar price of 1 pound British Pounds S+D S Dollar depreciates (pounds appreciates) c $3 a b $2 D2 D Q1 Q2 Q of pounds

  18. US goods relatively cheaper B imports more (US exports more) increase quantity supply pounds movement a to c • Combination equilibrium S and D at new exchange rate

  19. Dollar price of 1 pound British Pounds S+D S Dollar depreciates (pounds appreciates) c $3 a b $2 D2 D Q1 Q2 Q of pounds

  20. Fixed Exchange Rates • G must intervene to maintain set exchange rate: • 1) Use of reserves: central bank buys/sells currency in open-market Reserves acquired: a) diff circumstances in past (surplus/deficit), b) gold as “international money” • If deficit persistent + sizable, may be unable to maintain peg bad news

  21. 2) Trade policies • Discourage imports: Tariffs or import quotas, special taxes • Encourage exports: subsidies •  loss of efficiency, retaliation

  22. 3) Exchange Controls + Rationing • EC: require all pounds acquired through trade sold to Fed ration only this amount • 1) Distorted trade: comparative advantage distorted • 2) Favoritism • 3) Restricted choice • 4) Black markets

  23. Domestic Macroeconomic Adjustments • Contractionary policy (tax hikes, reduce G, increase interest rates) lower income fewer imports + increased foreign investment (if higher relative rates) decrease D pounds + increase S pounds new exchange rate • Price of exchange-rate stability = recession

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