IB Economics - introduction to exchange rate mechanisms

1. International Trade 4.6 Exchange Rates IB Economics | ISS Singapore | Andrew McCarthy

2. Key understandings Flexible Exchange Rates Depreciation and appreciation What causes exchange rates to change? Flexible rates and effects on the balance of payments Disadvantages of flexible exchange rates Fixed Exchange Rates Use of reserves to maintain a fixed exchange rate Trade policies related to fixed exchange rates Domestic macroeconomic adjustments

3. Concepts of Trade Money Flow CHINA SINGAPORE Real Flow

4. Concepts of Trade Money Flow Demand for apples increasing Demand for SGD increasing Real Flow

5. Concepts of Trade Demand for Singapore Dollar (SGD) comes from buyers from overseas who want to buy our exports. (products, tourism) Supply for Singapore Dollar (SGD) comes from people wishing to sell their holdings of Singapore currency when they get other currencies. (Singaporean’s heading to Thailand)

6. Foreign exchange market Price of SGD in overseas currency S of SG$ Appreciation Depreciation D of SG$ Q1 Q of SGD

7. Changes to a floating exchange rate Section 4 : Trade

8. Section 4 : Trade Increased selling / supply of one currency Leads to increased buying / demand for another currency S2 D2 Increased number of Singaporean’s going on holiday in Malaysia = SGD depreciates Increased number of tourists from Singapore arriving in Malaysia = MYR Ringgit appreciates

9. ExportersAppreciation = BadDepreciation = Good US$2.40 APPRECIATION SGD$3.00 SGD$1 = US$0.80 US$2.10 Sell Buy SGD$3.00 SGD$1 = US$0.70 US$1.80 DEPRECIATION SGD$3.00 SDG$1 = US$0.60

10. ImportersAppreciation = GoodDepreciation = Bad SGD $25.00 US$20.00 APPRECIATION SGD $1 = US$0.80 US$20.00 SGD $28.50 Buy Sell SGD $1 = US$0.70 SGD $33.30 US$20.00 DEPRECIATION SGD $1 = US$0.60

11. Impacts of changes to Foreign Exchange Market When the exchange rate is high, people overseas have to find more of their own currency to buy SGD $ This disadvantages exporters, as the price of their goods on the overseas market is relatively expensive. Importers are advantages as they need to find less SGD$ to buy their imported goods. If the exchange rate is low….. Exporters are advantaged as price of their goods has fallen on overseas markets to QD increases. Importers are disadvantaged as they need to find more money to pay to get their imports. APPRECIATION DEPRECIATION

12. Evaluation of exchange rate changes Section 4 : Trade Welker wikinomics

13. Section 4 : Trade Evaluation of exchange rate changes Welker wikinomics

14. What causes the exchange rate to change in a floating system? Generalizations….. Changes in Tastes ( T ) Relative Income changes ( I ) Relative Price Level changes ( P ) Speculation ( S ) Relative Interest rates changes ( I ) The way to remember determinants of exchange rates: TIPSI

16. Example: If technological advances in U.S. wireless phones make them more attractive to British consumers and businesses, then the British will supply more pounds in the exchange market in order to purchase more U.S. wireless phones.

18. A country's imports vary directly with its income level.

20. The purchasing-power-parity theory holds that exchange rates equate the purchasing power of various currencies. When a good becomes more expensive, after going through an exchange rate translation, the good will appear on the international market as relatively more expensive

23. What causes the exchange rate to change in a floating system? Relative Interest Rates Changes in relative interest rates between two countries may alter their exchange rate When country ABC has higher interest rates, investors are more reluctant to invest; therefore, forgoing their currency and demand more of ABC's currency Higher interest rate = appreciation (lower interest rate = depreciation) People put their money in foreign banks where interest rate is higher, appreciating their currency

24. Disadvantages of Flexible Exchange Rates create uncertainty on international markets, reducing levels of FDI as investors find it hard to assess the level of return and risk May fluctuate too much floating rates do not always self-adjust to eliminate current account deficits due to political and social factors worsen existing levels of inflation: high inflation in US --> reduce demand for US products abroad --> reduce demand for $ --> $ weakens --> imports more expensive for Americans --> inflation!

25. Flexible Exchange Rate and the Balance of Payments Appreciation Imports become cheaper Import Payments rise Exports less price competitive Export receipts fall M > X Balance of Trade deteriorates Balance of Payments deficit

26. How do you maintain a fixed exchange rate? Use of reserves: Trade Policies: Domestic macroeconomic adjustments:

27. Singapore Managed Exchanges Rates Section 4 : Trade

28. Singapore Dollar is ‘pegged’ to a basket of other exchange rates Section 4 : Trade SGD appreciates against basket United States Dollar $ Japanese Yen ¥ British Pound £ Euro Dollar € The basket is weighted according to the level of trade and investment that occurs between the two nations. SGD depreciates against basket

29. A managed floating exchange rate  Section 4 : Trade S2 D2 D2 Increased demand for Singapore exports from USA = pressure for SGD to appreciate MSA will sell Singapore dollars and buy USD on foreign exchange market = shift of Supply to right, currency remains unchanged

30. How do you maintain a fixed exchange rate? Use of reserves: Currency interventions: Using official reserves to manipulate the market. Foreign currency and gold can be sold. For example: The dollar has depreciated relative to the pound. The US can sell its reserves of pounds to shift supply of pounds to the right and restore the exchange rate. The US could also sell gold to Britain to obtain pounds, and then sell the pounds for dollars. By selling the foreign reserve, the country can increase the supply of the currency and shift out the supply curve Important: If persistent deficits occur, the reserves may be exhausted and/or the fixed exchange rate will fail – eg. Argentina in 2001 Also, with a fixed exchange rate, the amount of government intervention is large. Every fluctuation needs government attention and correction.

31. How do you maintain a fixed exchange rate? Trade Policies To maintain fixed exchange rates, a nation can try to control the flow of trade and finance directly by discouraging/encouraging imports/exports through new tariffs and import quotas or special taxes and subsidies. Fundamental problem: this reduces the volume of world trade and creates inefficiency

32. How do you maintain a fixed exchange rate? Domestic macroeconomic adjustments: Use of monetary and fiscal policy to eliminate the shortage of foreign currency High interest rate from contractionary policy reduce total spending in the US--> reduce imports--> reduce demand for foreign currency Higher interest rate also encourages foreign investment--> increased demand of US Dollar; foreign currency depreciates--> reduce demand for foreign currency

33. How do you maintain a fixed exchange rate? Exchange Controls and Rationing: U.S. government could handle the problem of a pound shortage by requiring that all pounds obtained by U.S. exporters be sold to the Federal government. --> then, the government would allocate/ration this short supply of pounds among various U.S. importers, thus restricting the value of U.S. imports to the amount of foreign exchange earned by U.S. exports.

34. Criticisms of Fixed Exchange Rates Distorted Trade: Like tariffs, quotas, and trade controls, exchange controls would distort the pattern of international trade away from the pattern suggested by comparative advantage. Favoritism: The process of rationing scarce foreign exchange might lead to government favoritism toward selected importers or lobbyists. Restricted Choice: Controls would limit freedom of consumer choice Example: Even though some U.S. consumers may prefer Volkswagens, they may have to buy Chevrolets if the government limited imports. As a result, a limit placed on imports would impair business opportunities for some U.S. importers Black markets: Shortage of certain needed imported goods encourage black market operation Example: Black markets in China such as Hua Ting and Xiang Yang mainly supply western goods. The short supply of real western goods in China has encouraged widespread as well as popular black markets, showing the need in a society for more western goods.

35. Practice Question – Nov 96 Explain how changes in interest rates can be expected to affect exchange rates. Section 4 : Trade

36. Long Response Question – May 2007 Explain the various factors which may affect an exchange rate in a floating exchange rate system (10 marks) Evaluate a government decision to adopt a floating exchange rate system as opposed to a fixed exchange rate system (15 marks) Section 4 : Trade

37. Graph Revision Section 4 : Trade Draw a graph to illustrate the impacts of protectionism on domestic producers. Draw a graph to show the impact of lower demand for French wine exports on the foreign exchange market of the Euro. Draw a fully labeled graph to illustrate the costs of trade diversion to the members of a customs union (HL only) Draw a graph to illustrate the impact on the Argentinean foreign exchange market if more citizens are heading to Brazil for holidays and tourism.

38. Quick Quiz Define interest rates State one factor that leads to an increase in supply of a currency Explain how increased demand for imports will affect a domestic exchange rate Describe the impact of an appreciation in the domestic currency vs US Dollar on exporters and importers. Section 4 : Trade

39. Quick Quiz - Answers Define interest rates Price of borrowing money from financial institutions and factor reward for saving money in financial institutions. State one factor, that leads to an decrease in supply of a currency Decrease in demand for imports, decrease in foreign interest rates, less people travelling overseas on holidays. Explain how increased demand for imports, will affect a domestic exchange rate Imports payments increase, selling of currency increases, shift of S of Currency to the right = depreciation of currency. Describe the impact of an appreciation in the domestic currency vs US Dollar on exporters and importers. Appreciation – importers find it cheaper to import products, thus QD increases as price falls (M increase) Exports are relatively more expensive, foreign demand falls, exports fall (X falls) assuming that all products are unit elastic (neither price elastic or inelastic)