This revision presentation is designed for students revising their A2 macroeconomics. It looks at the economics of currency markets and focuses in particular on different exchange rate systems and the debate over fixed versus floating currencies.

1. Exchange Rates
EdExcel Economics Unit 4 Macro

2. Exchange Rates
A2 Unit 4 - EdExcel Economics
A2 EdExcel Syllabus Specification:
Students need to cover the following aspects:
Influences on exchange rates
• Understand factors influencing exchange rates.
• Students should consider the significance of relative interest
rates; relative inflation rates; speculation.
Changes in exchange rates
• Consider the impact of changes in exchange rates.
• For example the implications for competitiveness.

3. Average Daily Turnover in Global FX Markets
1,527
1,239
1,934
3,324
3,981
5,345
0
1000
2000
3000
4000
5000
6000
1998 2001 2004 2007 2010 2013
AveragedailyturnoverinbillionU.S.dollars

4. Market share of leading foreign exchange currencies
87%
33%
23%
12%
9%
5%
5%
3%
2%
2%
2%
2%
1%
1%
1%
0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0%
U.S. dollar
Euro
Yen
British pound
Australian dollar
Swiss franc
Canadian dollar
Mexican peso
Chinese yuan
New Zealand dollar
Swedish krona
Russian rubel
Hong Kong dollar
Norwegian krone
Singapore dollar
Market share
The US dollar dominates currency trades in the
world economy.
1. It is the global reserve currency
2. USA is largest economy in the world
3. Majority of commodities are traded in $s
The Chinese Yuan will grow in significance as a
global currency – but not yet fully convertible
and traded in a floating currency system

5. Classification of Currency Systems
(Selected Nations, Source: IMF Dec 2014)
Exchange Rate System Exchange rate anchor (where relevant)
US Dollar ($) Euro
Composite or Other
Currency Peg
Fixed currency with no
separate legal tender
Ecuador
Zimbabwe
Kosovo, San Marino
Currency Board System Hong Kong Bulgaria
Conventional exchange
rate peg (Fixed currency
system)
Bahrain
Qatar
Saudi Arabia
Denmark
Senegal
Kuwait
Nepal
Crawling exchange rate peg
(semi-fixed)
Jamaica Croatia
Botswana
China
Ethiopia
Managed floating currency
Kenya, Brazil, Ukraine, South Korea, India, Zambia, South Africa,
Thailand, Turkey
Free floating exchange rate Australia, Canada, Chile, Japan, Norway, UK, USA, Mexico, Euro Zone

6. Fixed and Floating Exchange Rates
Floating Exchange
Rates
• The market determines
the value of the currency
without government /
central bank intervention
Fixed exchange Rates
• Exchange rate is pegged
• Occasional realignments
e.g. usually a devaluation
• Day to day, the external
value of the currency is
usually stable

7. Floating Exchange Rates
• The strength of currency supply and demand drives
the external value of a currency in the markets
Currency value set by market forces
• Central bank allows currency to find it’s own level
No intervention by the central bank
• External value of currency is not an intermediate
target of macroeconomic policy
No target for the exchange rate

8. Sterling against the US Dollar
Sterling depreciation of
more than 20% in
2008-09
Floating currencies don’t
necessarily have to be
volatile currencies!
US dollar now
appreciating

9. Sterling against the Euro
Sterling falls against
the Euro as the global
financial crisis hits
Sustained appreciation
during the “Euro Crisis”

10. Euro: A Currency Union & a Floating Exchange Rate
The nineteen countries in the euro area have a
hard peg (a currency union) with other members
of the bloc, but the euro itself floats against third
currencies such as sterling & the $.

11. Floating Currencies – the Australian Dollar
Depreciation of
Australian dollar as
global financial
crisis took hold
Rapid appreciation of
Australian dollar – due
to booming economy,
surge in exports, rising
current account surplus
and higher interest rates
AUS $ now
depreciating again
– growth slowing
as exports hit by
Chinese weakness

12. What factors determine a currency’s value?
• In a floating exchange
rate system, the
external value of a
currency is determined
by market demand for
and supply
• Much currency dealing
is speculative but trade
and investment flows
have a key role to play
• Factors mentioned in
the graphic will usually
lead to a currency
appreciation (i.e. rising
external value)
Current account
surplus on the
balance of
payments
Strong inward
investment
inflows +
portfolio flows
Relatively high
policy interest
rates
Speculative
currency
demand
A Rising
Currency

13. Currency Market Analysis: Higher Interest Rates
Value of
currency
Quantity of currency traded
D1
Supply
Rise in policy interest
rates by central bank
Currency more attractive
for investors
Attracts inflows of short-
term hot money
Causes outward shift in
currency demand
Currency appreciates in
value in a floating system
P2
P1
D2

14. Currency Market Analysis: A Slump in Exports
Value of
currency
Quantity of currency traded
Demand
Supply
Recession in a
trading partner
Causes a fall in
export sales
Worsening of
trade balance
Inward shift of
currency demand
Currency will
depreciate
D2
P1
P2

15. Economic Effects of a Currency Depreciation
This will have an effect on a number of economic indicators
Domestic production  Trade deficit  Domestic jobs 
Changes in import and export prices will affect demand
Import sales will CONTRACT Export sales will EXPAND
When the pound depreciates against the US dollar
It makes UK import prices RISE It makes UK export prices FALL

16. Will an Exchange Rate Depreciation improve the BoP?
Time period after
depreciation
Trade
surplus
Trade
deficit
Currency
depreciation
here
Trade deficit may
grow in initial
period after
depreciation
Net improvement
in trade provided
certain conditions
are met
The diagram below shows the “J Curve effect” – it shows the time
lags between a falling currency and an improved trade balance

17. The Marshall Lerner Condition
The Marshall Lerner condition states that a depreciation /
devaluation of the exchange rate will lead to a net improvement in
the trade balance provided that the sum of the price elasticity of
demand for exports and imports > 1
Ped for exports Ped for imports
Sum of price
elasticity
Will fall in
currency
improve the
trade balance?
Country A 0.4 0.3 0.7 No
Country B 1.2 0.7 1.9 Yes
Country C 0.8 0.2 1.0
Will leave it
unchanged

18. Evaluating the Effects of a Currency Depreciation
In theory a depreciation of the exchange rate provides stimulates
aggregate demand and economic growth ....but this depends on..
1. The length of time lags as consumers and businesses respond
2. The scale of any change in the exchange rate i.e. a 5%, 10%, 20%
3. Whether the change in the currency is short-term or long-term –
i.e. is a change in the exchange rate temporary or likely to persist
4. Price elasticity of demand for imports and exports
5. The size of any second-round multiplier and accelerator effects
6. When the currency movement takes place – i.e. Which stage of
an economic cycle (recession, recovery etc.)
7. The type of economy (e.g. small developing v large advanced)
8. The degree of openness of the economy to international trade

19. Managed Floating Exchange Rates
• Central bank gives a degree of freedom for market
exchange rates on a day-to-day basis
Currency usually set by market forces
• Buying to support a currency (selling their FX reserves)
• Selling to weaken a currency (adding to their FX reserves)
• Changes in policy interest rates to affect “hot money flows”
Central bank may intervene
• Higher exchange rate to control inflationary pressures
• “Competitive devaluation” to improve competitiveness
Currency becomes a target of policy

20. Instruments for Managing the Exchange Rate
• Changes in interest rates e.g. lower interest rates to depreciate the exchange rate
• Causes movements of “hot money” banking flows
Changes in monetary policy interest rates
• Increase liquidity in the banking system, usually causes outflow of money –
depreciation of the exchange rate
Quantitative easing
• Direct intervention in the market
• Buying and selling of domestic / foreign currencies
Direct buying / selling in the currency market (intervention)
• Taxation of foreign deposits in banks cut the profit from hot money inflows
• Controls on the free flow of capital into and out of a country
Taxation of overseas currency deposits and capital controls

21. Stock of Currency Reserves (December 2015)
3,406.11
1,233.21
602.49
368.4
367.96
358.82
356.46
350.38
247.75
177.6
173.68
156.51
155.88
118.46
105.93
79.75
49.27
38.64
25.56
6.03
2.2
0. 500. 1,000. 1,500. 2,000. 2,500. 3,000. 3,500. 4,000.
China: Mainland
Japan
Switzerland
Russian Federation
Korea, Republic of
China: Hong Kong
Brazil
India
Singapore
Mexico
Germany
Thailand
United Kingdom
United States
Indonesia
Canada
Australia
Chile
Argentina
Greece
Ireland
International reserves and foreign currency liquidity in selected countries
worldwide as of December 2015 (in billion U.S. dollars)

22. Countries with Managed Exchange Rate Systems
Brazilian Real
Swiss Franc
Japanese Yen
Norwegian Krone
Ghana - Cedi

23. The Swiss France against the Euro
Swiss maintained a currency
fix against the Euro from
late 2011 to January 2015
Peg lifted – the Swiss Franc
appreciates dramatically
against the Euro!

24. Fixed Exchange Rates
• External value is pegged to one or more currencies (known as
the anchor currency)
Government / central bank fixes currency value
• Trade takes place at this official rate
• There might be unofficial trades in shadow markets
Pegged exchange rate becomes official rate
• Occasional realignments may be needed
• E.g. a devaluation or revaluation depending on economic
circumstances – the currency may have drifted from the
fundamental value
Adjustable peg

25. Danish Kroner is fixed against the Euro

26. Danish Kroner is fixed against the Euro
0.6%
movement
over the
last 5 years

27. China and the US Dollar – From Fixed to Crawling Peg
Fixed exchange rate for over
ten years – ended in 2005
China has “managed” the
appreciation of the Yuan
over the last eleven years

28. China and the US Dollar – Yuan is now Depreciating
Yuan has been depreciating against the
US dollar over the last two years.
China's central bank has cut rates six
times since November 2014
Shock
devaluation
here!
“The expectation of higher
US interest rates has
contributed to a massive
outflow of capital from
China, as investors take
their money in search of
higher and safer returns
elsewhere” - Source:
Deloitte, March 2016

29. Floating versus Fixed Exchange Rates
Floating Currency
• Reduces the need for foreign
currency reserves
• Freedom to set policy interest
rates to meet domestic
objectives
• May help to prevent imported
inflation
• Insulation for an economy
after an external shock
especially for export-
dependent countries
• Partial automatic correction
for a current account deficit
• Less risk of speculative attack
Fixed Currency
• Certainty of currency value
gives confidence for inward
investment
• Reduced costs of currency
hedging for businesses
• Stability helps to control
inflation – it is a discipline on
businesses to keep unit labour
costs low
• Can lead to lower borrowing
costs (lower yields on bonds)
• Imposes responsibility on
government policies
• Less speculation if the fixed
exchange rate is credible

30. Floating versus Fixed Exchange Rates
Floating Currency
• Reduces the need for foreign
currency reserves
• Freedom to set policy interest
rates to meet domestic
objectives
• May help to prevent imported
inflation
• Insulation for an economy
after an external shock
especially for export-
dependent countries
• Partial automatic correction
for a current account deficit
• Less risk of speculative attack
Fixed Currency
• Certainty of currency value
gives confidence for inward
investment
• Reduced costs of currency
hedging for businesses
• Stability helps to control
inflation – it is a discipline on
businesses to keep unit labour
costs low and drive efficiency
• Can lead to lower borrowing
costs (lower yields on bonds)
• Imposes responsibility on
government policies
• Less speculation if the fixed
exchange rate is credible

31. Key Arguments: Floating versus Fixed Exchange Rates
Fixed rates may be optimal for developing countries wanting to control inflation
Export-dependent economies may favour a managed floating rate
Struggling "southern" countries inside Euro have experienced deflationary
pressures – falling wages and very high unemployment
General drift towards managed floating - game theory in action!
Not every country has the reserves to influence currency - China does!
"Competitive depreciations" when conventional monetary policy fails
Choice of currency regime is hugely important for developing countries

32. Classification of Currency Systems
(Selected Nations, Source: IMF Dec 2014)
Exchange Rate System Exchange rate anchor (where relevant)
US Dollar ($) Euro
Composite or Other
Currency Peg
Fixed currency with no
separate legal tender
Ecuador
Zimbabwe
Kosovo, San Marino
Currency Board System Hong Kong Bulgaria
Conventional exchange
rate peg (Fixed currency
system)
Bahrain
Qatar
Saudi Arabia
Denmark
Senegal
Kuwait
Nepal
Crawling exchange rate peg
(semi-fixed)
Jamaica Croatia
Botswana
China
Ethiopia
Managed floating currency
Kenya, Brazil, Ukraine, South Korea, India, Zambia, South Africa,
Thailand, Turkey
Free floating exchange rate Australia, Canada, Chile, Japan, Norway, UK, USA, Mexico, Euro Zone

33. Exchange Rates
EdExcel Economics