Edexcel A Level Economics: Exchange Rates

Exchange rates

Exchange rates are the value of one currency in relation to another currency.

Floating Exchange rates:

·       Currency set by the market interaction of demand and supply of currency in relation to other currencies.

·       No intervention by the central bank as central bank allows currency to find own level.

·       No target for macroeconomic policy

·       Reduces the need for foreign currency reserves.

·       Freedom for domestic monetary policy. Some fixed exchange rate requires manipulation of interest rates which can result to other unintended consequences, in floating monetary policy used for domestic policy.

·       Long term adjustments reflect relative economic strength. Can be a useful way of insulating from other countries e.g. if commodity prices go down may lead to worse BOP condition, but as a result currency depreciates which may mean exports increase and has wider effect on other industries.

·       Can be partial automatic correction for a trade deficit, e.g. trade deficit means that greater imports and so more supply of currency, greater supply. Shift in supply will result in lower currency price, which will lead to greater demand for currency as currency has depreciated, therefore reducing deficit.

·       Reduced risk of Currency depreciation

·       Marshall Lerner condition states that a currency deprivation will only correct if current account deficit if PED of exports and imports are greater than 1. This is because if overall net exports are inelastic…