EXCHANGE RATE SYSTEMS- TRADE AND INTERGRATION

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  • Created by: Simran
  • Created on: 26-02-14 19:33

EXCHANGE RATE SYSTEMS

  • There are 3 different types of exchange rates:

1) freely floating exchange rate: exchange rate system whereby the value of one currency against another is determined by the market forces of demand and supply 

2)Fixed exchange rate: an exchange rate system in which the the value of one curreny has a fixed value against another countries currency. This fixed rate is often set by the government.

3) Semi-fixed/ floating exchange rate: an exchange rate system that allows the currency's value to fluctuate within a permitted band of fluctuation 

FOREX: a term used to describe the coming together of buyers and sellers of currencies

FREELY FLOATING EXCHANGE RATE-- determined by market forces of demand and supply

  • In a freely floating exchange rate there is no governmen intervention in the FOREX market
  • so, there are other (3) ways in which the demand and the supply of the currency are influenced:

1) Trade = an increase in imports would increase the demand for the currency whereas an increase in exports would increase the demand for the currency

2) Short-term capital flows = flows of money in and out of a country in the form of bank deposits, these are highly volatile and take advantage of changes in the exchange rate 

3) Long-term capital transactions = flows of money related to the buying and selling of assets such as direct investment and potfolio investment 

There are 5 advantages of a freely floating exchange rate:

1) Governments free to set their domestic policy to achieve key objectives ,such as price stability,as they don't need to set interest rates to achieve an exchange rate target 

2) Monetary policy is now more effective  controlling AD and inflation. B/c of exchange rate effect which reinforces domestic monetary policy e.g.  government increases IR to reduce inflation so there is a reduction in AD, reinforced by increase in ER which reduce import prices, which would reduce the chances of cost-push inflation +  reduce domestic demand (now turned abroad)

3) Automatically corrects balance of payment problems. This is because a deficit means that more money is leaving than is entering, leading to a disequillibrium as supply exceeds demand, leading to a depreciation. A reduction in the price of exports would increase their demand eliminating the deficit

4) A FFEX provides mechanism for dealing with external economic shocks e.g. if global economy recession then demand for exports decrease, this decrease in demand for the pound in the FOREX market cause depreciation ER, cushioning the reduction in demand for exports by lowering price

5) Reduced speculation over the value of the £ b/c in FFEX the currency has tendency to reflect PPP, so unlikely be overvalued or undervalued. Speculators have nothing to gain as a result, so greater stability.

External economic shocks: unexpected events coming from outside the economy that cause unpredicted changes in AD or AS e.g. rapid increase in oil prices

Purchasing power parity: the exchange rate that equalises the price of a basket of identically traded gooded

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