Exchange Rate Systems

1. Aquinas College Economics Department
Exchange Rate Systems
Floating or Fixed
ECON4

2. Aquinas College Economics Department
Floating Exchange Rates
Currency value in terms of another is
determined through the demand and supply of
that currency

3. Aquinas College Economics Department
Price of €s in £s
£1
£2
S
A B
Demand and Supply of Euros
D
D1
At A the price of €1 is
£1
However if demand
increases for the Euro,
to D1 then the price of
the €1 will increase to
£2
This is Euro is now
worth more so it has
appreciated whilst
the Pound is now
worth less so it has
depreciated

4. Aquinas College Economics Department
Floating Exchange Rates
A change in the value of a currency will mean
a change in the prices of imports and exports

5. Aquinas College Economics Department
Complementary Movements
Influences demand and supply of a currency
•Interest Rates
–will attract supplies of hot money should the rate be
high enough
•A rise in UK imports
–can be shown through an increased demand for the
Euro
•Speculation
–If think Sterling will fall and Euros increase they will
‘dump’ sterling and purchase Euros

6. Aquinas College Economics Department
Adv & Dadv of Floating Exchange
Rates
Advantages Disadvantages
Continuous and automatic adjustment
through Forex
No guarantee that a rate will clear a
Balance of Payments deficit
Destabilising effect of speculation is
removed
Effects on domestic inflation
Reduces the need for central banks to
hold large amounts of foreign
currency
Uncertainty
Foreign currency reserves are kept
anyway by Central Banks

7. Aquinas College Economics Department
Factors affecting a currency value
 Relative interest rates
 Higher rates mean large hot money inflows
 Inflation
 Domestic inflation goes up, people suck in
imports
 Foreign Direct Investment
 Continued flows will encourage an appreciation
 Trade and Current Account Deficits
 Can cause panic among Forex traders

8. Aquinas College Economics Department
Fixed Exchange Rates
Where exchange rates are set by government
at a certain level with others
£1 = $2
Not used
widely
anymore
UK Rates fixed between
1944-1972
ERM: 1990-1992

9. Aquinas College Economics Department
Why are the uncommon?
• Different inflation rates in countries
– If the UK rate of inflation grew more people
would import – makes it difficult to
maintain a rate
• Different levels of growth
– Pressures through trade are applied to
maintaining the rate
• Vulnerable to speculation

10. Aquinas College Economics Department
A run
When currency speculators ‘dump’ or sell
large amounts of currency that they think
is overvalued
Government may try to pop the currency
up
–Increasing interest rates
–Purchase their currency to decrease supply

11. Aquinas College Economics Department
A Run on a Currency
0
F10
S
A B
Demand and Supply of Pound Sterling [GBP]
D
Graph shows the Price
of £s in terms of
French Francs
A pound is valued at
F10
However it may be
overvalued
When speculators sell
at B they still receive
F10 per pound
Government struggle
to maintain value as
supply increases
S1
S2

12. Aquinas College Economics Department
Black Wednesday
16th September as Britain was pegged to other European Currencies, many
thought the Pound was over valued so dumped the currency
Government increased interest rates twice in once day and bought pounds on
the market
Yet the value couldn’t be sustained and Britain fell out of the Exchange Rate
Mechanism

13. Aquinas College Economics Department
Adv & Dadv of Fixed Exchange Rates
Advantages Disadvantages
Certainty Require continual revision of the rate
Measure of controlling inflation Impacts on Fiscal policy at home as
government may need to change
economic plans to maintain rate
International price stability Speculation can cause the
devaluation

14. Aquinas College Economics Department
AS Level Revision Site (ECON1, ECON2)
• http://www.aquinaseconomicsas.co.uk
A2 Level Revision Site (ECON3, ECON4)
• http://www.aquinaseconomicsa2.co.uk
Aquinas Economics on Twitter
• http://www.twitter.com/aquinaseconomic
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