Exchange Rates

Global Economic Issues

Assignment

Exchange Rates

Question 1

Explain why the exchange rate is such an important 'price' in terms of the impact it can have on a country's economic system.

The exchange rate is an important 'price' in terms of the impact it can have on a country's economic system. It can have an affect or be affected by many parties. Some for example, unemployment, inflation, growth and the trade balance between imports and exports. Since a currency's price depends on the aggregate demand and supply of it, the exchange rate affects exports and imports. Whereas a strong currency lowers the price of imports, the price of exporting goods and services rises. Conversely, lowers a weak currency the price of exports but increases the costs of imports.

For example, supposing a holiday to France costs 300 Euros, a British person would be more likely to go when the exchange rate was 2.00 Euros per Pound as if it was 1.50 Euros per Pound.

This shows that the stronger the currency the cheaper the imports and the higher the demand for the imported goods and services, in this case the holiday. The flow continues circle wise since the increase in demand for imports increases the demand for Euros, which lets the Euro appreciate against the Pound, which makes imports more expensive but exports cheaper and so on. The fact that many countries have different goods and services lets the trade balance between imports and exports be similar. This makes the exchange rate stay close to one figure since only big differences in the trading balance can cause a noticeable change in the exchange rate.

Question 2

Over the past 50 years, the world has moved away from fixed exchange rate systems towards a freely-floating exchange rate regime. Explain the factors that you believe have underpinned this move.

In deciding how the exchange rate is determined the government must choose among two major systems. Nowadays it is the freely floating exchange rate regime, which is mostly used instead of the fixed exchange rate regime, which started to be moved about 50 years ago.

Signing the International Monetary Fund (IMF) in 1944 also led to joining Bretton Woods where gold was the anchor to a fixed exchange rate. Big changes worldwide caused a collapse in 1971. The General Agreement on Tariffs and Trade (GATT) was found in 1947 and renamed in 1995 to World Trade Organisation (WTO), they moved away from fixed exchange rates after the Exchange Rate Mechanism (ERM) Crises but the main motive to restore world trade stayed the same.

The move away from fixed exchange rates can be explained by the many advantages of a freely floating exchange rate regime. Whereas in a fixed exchange rate system the government and country's central bank interfere as soon as demand and supply of a certain currency are not in equilibrium, in a freely floating system, the price of a currency is determined by market forces in absence of the central bank. The biggest advantage is the cost, which no longer becomes necessary. Otherwise when the quantity needs to be matched, they have to impose restrictions on demand, offer it for foreign currency assets or buy pounds by paying with foreign exchange reserves. Because of the increasing global trade the optimal outcome, a fair and appropriate value is best reached through a freely floating exchange rate regime. The reserves stay constant, the balance of payments is equal and it is more robust in case of a shock.

Question 3

Despite the general global move to a freely-floating exchange rate system, many countries have chosen to operate either a fixed or a 'dirty floating' exchange rate policy. Why do you think some countries have taken this approach and how successful have they been in sustaining this policy.

In addition to the advantages of a freely floating exchange rate system there are a few disadvantages, which should not be overlooked. Missing financial discipline, volatility and the fact that asset prices reflect beliefs about the future lead to an uncertain business climate and discourages global trade and foreign investment. These reasons and the disadvantages of a fixed exchange rate policy mentioned in number two made some countries choose a 'dirty floating' exchange rate regime. The USA for example are operating a 'dirty floating' system since 1973 where the government 'pretends' to have a freely floating policy but they intervene 'secretly' respecting informal guidelines that have been established by the International Monetary Fund (IMF). Those interventions are not only used to offset large and rapid fluctuations in demand and supply schedules in the short run but also to guide the exchange rate in the desired direction. On the other hand, the exchange rate is gradually allowed to find its own equilibrium level in the long run.

Considering the US Dollar, which was talked down before the actual happening, many speculators left the market earlier than necessary and disrupted the market. In these cases it is helpful that a nation can alter the degree to which it intervenes on the foreign exchange market. Although as we know from number one, it is not always bad to have a weak currency especially for abolishing a trade deficit.

Question 4

Twelve member countries of the European Union have formally replaced their national currencies with the European Single Currency (Euro). Outline the factors that motivated them to make this choice and what, if any, are the possible downsides of this policy decision.

To replace a national currency with a single currency, in this case the Euro, requires a lot of planning in advance. The European Monetary System (EMS) evolved from the 'snake' in the 1970s. Though assisted by the European Currency Unit (ECU) and the European Monetary Cooperation Fund (EMCF) the Exchange Rate Mechanism