3 2 EXCHANGE RATES IB Economics HL EXCHANGE

3. 2 EXCHANGE RATES IB Economics HL

EXCHANGE RATE: The price of the currency of one country stated in terms of the currency of another country, that is, the rate of exchange of one currency for another. Exchange rates, also termed foreign exchange rates, are prices determined in foreign exchange markets that are set up to trade the currencies of different nations (foreign exchange). In general, exchange rates reflect the overall health, vitality, and productivity of a nation's economy. However, because exchange rates also affect international trade (exports and imports) among nations they are often subject to governmental policy control.

The Nominal Exchange Rate Nominal exchange rate: the rate at which one country’s currency trades for another We express all exchange rates as foreign currency per unit of domestic currency. Some exchange rates as of December 3, 2014, all per US$: 1. 00 USD = 0. 812189 EUR Euro 1. 00 USD = 0. 637339 GBP British Pound 1. 00 USD = 119. 867 JPY Japanese Yen 1. 00 USD = 61. 8942 INR Indian Rupee

The Real Exchange Rate Real exchange rate: the rate at which the goods & service of one country trade for the goods & services of another. ex. P Real exchange rate = P* where P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate, i. e. , foreign currency per unit of domestic currency

Example With One Good A Big Mac costs $2. 50 in U. S. , 400 yen in Japan e = 120 yen per $ e x P = price in yen of a U. S. Big Mac = (120 yen per $) x ($2. 50 per Big Mac) = 300 yen per U. S. Big Mac Compute the real exchange rate: 300 yen per U. S. Big Mac ex. P = P* 400 yen per Japanese Big Mac = 0. 75 Japanese Big Macs per US Big Mac

Interpreting the Real Exchange Rate “The real exchange rate = 0. 75 Japanese Big Macs per U. S. Big Mac” This does not mean a Japanese citizen literally exchanges Japanese burgers for American ones. Correct interpretation: To buy a Big Mac in the U. S. , a Japanese citizen must sacrifice an amount that could purchase 0. 75 Big Macs in Japan.

2: Compute a real exchange rate ACTIVE LEARNING e = 10 pesos per $ price of Tall Starbucks Latte P = $3 in U. S. , P* = 24 pesos in Mexico A. What is the price of a US latte measured in pesos? B. Calculate the real exchange rate, measured as Mexican lattes per US latte. 7

ACTIVE LEARNING 2: Answers e = 10 pesos per $ price of Tall Starbucks Latte P = $3 in U. S. , P* = 24 pesos in Mexico A. What is the price of a US latte in pesos? e x P = (10 pesos per $) x (3 $ per US latte) = 30 pesos per US latte B. Calculate the real exchange rate. ex. P 30 pesos per U. S. latte = P* 24 pesos per Mexican latte = 1. 25 Mexican lattes per US latte 8

The Real Exchange Rate With Many Goods P = U. S. price level, e. g. , Consumer Price Index, which measures the price of a basket of goods P* = foreign price level Real exchange rate = (e x P)/P* = price of a domestic basket of goods relative to price of a foreign basket of goods An appreciation of the U. S. real exchange rate means U. S. goods are becoming more expensive relative to foreign goods.

The Law of One Price Law of one price: the notion that a good should sell for the same price in all markets � Suppose coffee sells for $4/pound in Seattle and $5/pound in Boston, and can be costlessly transported. � There is an opportunity for arbitrage, making a quick profit by buying coffee in Seattle and selling it in Boston. Such arbitrage drives up the price in Seattle and drives down the price in Boston, until the two prices are equal. Arbitrage: The simultaneous purchase and sale of the same securities, commodities, or foreign exchange in different markets to profit from unequal prices.

Purchasing-Power Parity (PPP) Purchasing-power parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries based on the law of one price implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries

Purchasing-Power Parity (PPP) Example: The “basket” contains a Big Mac. P = price of US Big Mac (in dollars) P* = price of Japanese Big Mac (in yen) e = exchange rate, yen per dollar e x P = P* According to PPP, price of US Big Mac, in yen § Solve for e: P* e = P price of Japanese Big Mac, in yen

PPP and Its Implications P* e = P PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels. If the two countries have different inflation rates, then e will change over time: � If inflation is higher in Mexico than in the U. S. , then P* rises faster than P, so e rises – the dollar appreciates against the peso. � If inflation is higher in the U. S. than in Japan, then P rises faster than P*, so e falls – the dollar depreciates against the yen.

Limitations of PPP Theory Two reasons why exchange rates do not always adjust to equalize prices across countries: Many goods cannot easily be traded � Examples: haircuts, going to the movies � Price differences on such goods cannot be arbitraged away Foreign, domestic goods not perfect substitutes � E. g. , some U. S. consumers prefer Toyotas over Chevys, or vice versa � Price differences reflect taste differences

Limitations of PPP Theory Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends. For example, PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US). The data support this prediction…

List of countries by GDP (PPP) per capita by 2014 International Monetary Fund GDP per Capita Ranking 2015 | Data and

The Big Mac index Burgernomics is based on theory of purchasingpower parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a Mc. Donald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued. http: //www. economist. com/markets/bigmac/

1. Explain that the value of an exchange rate in a floating system is determined by the demand for, and supply of, a currency. Floating exchange rate system means that the exchange rate is allowed to fluctuate according to the market forces without the intervention of the Central bank or the government. Usually the exchange rates are determined by the demand supply of that currency in the international market. Demand for any country’s currency on the foreign exchange market is determined by demand for that country’s exports of goods and services and by changes in foreign investment in that country. This is because when foreigners buy another country’s exports of goods or services they must pay for these in the currency of the exporting country. In the same way Supply of any country’s currency on the foreign exchange market is determined by that country’s imports of goods and services and by its investment in other countries. Thus when the demand for a currency rises its price goes up and it becomes costlier.

2. Draw a diagram to show determination of exchange rates in a floating exchange rate system.

3. Calculate the value of one currency in terms of another currency. Let's look at an example of how to calculate exchange rates: Suppose that the EUR/USD exchange rate is 1. 20 and you'd like to convert $100 U. S. dollars into euros. To accomplish this, simply divide the $100 by 1. 20 and the result is the number of euros that will be received - 83. 33 in that case. Converting euros to U. S. dollars involves reversing that process by multiplying the number of euros by 1. 20 to get the number of U. S. dollars. An easy way to remember this is to multiple across left-to-right and divide across right-to-left, with the ending currency being the desired output of the calculation. In the example above, we divided across right-to-left to determine how many euros we could purchase with U. S. dollars and then multiplied across left-to-right to see how many U. S. dollars we'd receive from

3. Calculate the value of one currency in terms of another currency. HOW TO: If you know the price of one currency in terms of another, you can quickly find the price of the other. For example. If 1 euro = 1. 2 CHF, then 1 CHF = 1/1. 2 euro, or 0. 83 Euro. The price of one currency is the inverse of the price of the other.

4. Calculate the exchange rate for linear demand supply functions. HOW TO: If you can calculate equilibrium price and quantity for a good using linear equations, then finding the equilibrium exchange rate is easy. Given the equations for two currencies, simply set them equal to each other and find the equilibrium. Example: Assume the demand for Euros in Switzerland is represented by the equation Qd = 10 -2 P, where P is the exchange rate of the Euro in CHF. Supply of Euros in Switzerland is represented by the equation Qs = -3 + 4 P where P is the exchange rate of the Euro in CHF. Calculate the equilibrium exchange rate of the Euro in Switzerland. Set the demand supply equal to one another: 10 – 2 P = -3 + 4 P, and solve for P: 13 = 6 P P = 13/6 = 2. 1 CHF / Euro

5. Plot demand supply curves for a currency from linear functions and identify the equilibrium exchange rate. HOW TO: This is the same as plotting linear demand supply equations for any good. � Find the q-intercept of demand (this is the ‘a’ variable) � Find the p-intercept of both demand supply (set Q = 0 and solve for P in both equations) � Draw the demand curve by connecting the q-intercept and the p-intercept � Find the equilibrium price (or exchange rate in this case). � Plot the supply curve by connecting the p-intercept of supply and the equilibrium exchange rate. � Draw dotted lines over to the equilibrium exchange rate and down to the equilibrium quantity.

6. Using exchange rates, calculate the price of a good in different currencies. HOW TO: If you know the price of a good in one currency and you know the exchange rate between that currency and another, you can always find the price of the good in the other currency. For example: A hotel room in London costs 250 British Pounds per night. The British Pound exchange rate in Switzerland is 1. 5 CHF / pound. How much does the London hotel room cost in CHF? Convert the room’s price to CHF. So, 250 x 1. 5 = 375 CHF per night.

7. Explain the factors that lead to changes in currency demand supply, including foreign demand for a country’s exports, domestic demand for imports, relative interest rates, relative inflation rates, investment from overseas in a country’s firms (foreign direct investment and portfolio investment) and speculation. What causes the fluctuation in currency value? Changes in the imports and exports of the country: An increase in exports of a country will lead to an increase in demand for the currency and thus the value rises. Changes in Interest rate: Higher interest rate will attract more foreign investors to invest in the country and thus the demand for currency will rise, resulting in appreciation in value of the currency. Changes in Inflation rate: Higher inflation rate will make the country uncompetitive in the international market. The exports will fall resulting in decreased demand for the currency and hence lower value. Rise in domestic income relative to incomes abroad: currency depreciates.

7. Explain the factors that lead to changes in currency demand supply, including foreign demand for a country’s exports, domestic demand for imports, relative interest rates, relative inflation rates, investment from overseas in a country’s firms (foreign direct investment and portfolio investment) and speculation. What causes the fluctuation in currency value? Investment opportunities: if bright lead to appreciation. Speculative sentiments: Individuals and institutions invest in currency markets with the sole intention to get short term gains. This is quiet like investing in stock exchange. Whenever a currency is going strong, people will invest more in an expectation to gain from it. This fuels the demand for that particular currency and it appreciates further. Global trading patterns: if strong global presence in trade then the currency appreciates. Changes in relative inflation rates: high inflation rate leads to exports becoming less competitive in international market

7. Explain the factors that lead to changes in currency demand supply, including foreign demand for a country’s exports, domestic demand for imports, relative interest rates, relative inflation rates, investment from overseas in a country’s firms (foreign direct investment and portfolio investment) and speculation. Direct foreign investment: Is a cross-border investment by a resident entity in one economy with the objective of obtaining a lasting interest in an enterprise resident in another economy. Most concretely, it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility, in the form of property, plants or equipment. Direct portfolio investment: Is a category of investment instruments that are more easily traded, may be less permanent, and do not represent a controlling stake in an enterprise. These include investments via equity instruments (stocks) or debt (bonds) of a foreign enterprise that does not necessarily represent a long-term interest.

8. Distinguish between a depreciation of the currency and an appreciation of the currency. Appreciation (or “strengthening”): an increase in the value of a currency as measured by the amount of foreign currency it can buy Depreciation (or “weakening”): a decrease in the value of a currency as measured by the amount of foreign currency it can buy Examples: During 2005, the U. S. dollar… � appreciated 15% against the euro � depreciated 5% against the Mexican peso

8. Distinguish between a depreciation of the currency and an appreciation of the currency. Appreciation: A currency is said to appreciate in value if its exchange rate increases, such as an increase in the exchange rate of pounds from 2 dollars per pound to 3 dollars per pound. Currency appreciation makes exports from the country relatively more expensive resulting in fewer exports and usually more imports. The factors that might cause an increase in the demand for a currency include an increase in the interest rate, lower inflation compared to main trading partners, or an increase in the rate of economic growth in the main trading partners.

8. Distinguish between a depreciation of the currency and an appreciation of the currency. Depreciation: Alternatively, a currency is said to depreciate in value if its exchange rate decreases, such as a decrease in the exchange rate of dollars from 0. 5 pounds per dollar to 0. 33 pounds per dollar. Currency depreciation makes exports from the country relatively less expensive resulting in more exports and usually fewer imports. This could be caused by a decrease in the demand for the currency and/or an increase in the level of supply.

9. Draw diagrams to show changes in the demand for, and supply of, a currency. An ‘equilibrium’ exchange rate is the specific rate where export revenue and import spending are equal. At currency ‘£’, import spending equals export revenue, at ‘Q’. At a higher rate, say at £ 1 imports now appear cheap in the UK, and spending increases to Qm, and exports appear expensive abroad, and fall to Qx. This opens up a trade gap (Qx to Qm).

9. Draw diagrams to show changes in the demand for, and supply of, a currency. An increase in the exchange rate For example, an increase in UK exports to the USA will shift the demand curve for Sterling to the right and push up the exchange rate of the pound against the US dollar.

9. Draw diagrams to show changes in the demand for, and supply of, a currency. An increase in the supply of a currency will depress its price. This could result from and increase in imports relative to exports, or speculative selling of the currency.

10. Calculate the changes in the value of a currency from a set of data. HOW TO: Consider the following. A London hotel room that costs 250 pounds per night used to cost 375 CHF. Following a change in the exchange rate, the same room now costs 400 CHF. Calculate the new exchange rate of British Pounds in Switzerland. The old exchange rate was: 375 / 250 = 1. 5 CHF / GBP. The new exchange rate, therefore, is 400 / 250 = 1. 6 CHF / GBP

11. Evaluate the possible economic consequences of a change in the value of a currency, including the effects on a country’s inflation rate, employment, economic growth and current account balance. Exchange rate fluctuation effects country’s inflation rate, employment, economic growth and current account balance. Scenario 1 - Currency depreciates A depreciation in exchange rate should lead to a rise in demand for exports and a fall in demand for imports – the balance of payments should ‘improve’, Exports will improve, this will lead to more output, more employment will be created thus economic growth will be achieved. However, exports is a component of AD, an increase in exports will lead to the shift of AD to the right and might also lead to inflation. The economy might also suffer from ‘imported inflation’ as imports are now expensive due to depreciation of your currency.

11. Evaluate the possible economic consequences of a change in the value of a currency, including the effects on a country’s inflation rate, employment, economic growth and current account balance. Scenario 2 – Currency appreciates An appreciation of the exchange rate should lead to a fall in demand for exports and a rise in demand for imports – the balance of payments should get ‘worse’. When exports fall, real output will fall which leads to unemployment. Economic growth is compromised and the economy may suffer from ‘deflationary gap’. However, The volumes and the actual amount of income and expenditure will depend on the relative price elasticity of demand for imports and exports. Refer to Marshall. Lener curve.

11. Evaluate the possible economic consequences of a change in the value of a currency, including the effects on a country’s inflation rate, employment, economic growth and current account balance. Evaluation points on the effects of exchange rate changes Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume ceteris paribus – all other factors held constant – which of course is highly unlikely to be the case Counter-balancing use of fiscal and monetary policy: For example the government can alter fiscal policy to manage AD Time lags – it takes time for demand for exports and imports to change following a movement in the currency. Businesses need to have the capacity and access to credit to expand their production. Low elasticity's of demand: In the short term, the effects of exchange rates on export and import demand tends to be low because of low price elasticity of demand

11. Evaluate the possible economic consequences of a change in the value of a currency, including the effects on a country’s inflation rate, employment, economic growth and current account balance. Business response to the challenge of a high exchange rate: Businesses can and do adapt to a high exchange rate. There are several ways in which industries can adjust to the competitive pressures that a strong pound imposes. Some of the options include: � Cutting their export prices when selling in overseas markets and therefore accepting lower profit margins to maintain competitiveness and market share � Out-sourcing components from overseas to keep production costs down � Seeking productivity / efficiency gains to keep unit labor costs under control or perhaps trying to negotiate a reduction in pay levels � Investing extra resources in new product lines where demand is price inelastic and less sensitive to exchange rate fluctuations. This involves producing products with a higher income elasticity of demand, where non-price factors such as product quality, design and effective marketing are as important in securing orders as the actual price

11. Evaluate the possible economic consequences of a change in the value of a currency, including the effects on a country’s inflation rate, employment, economic growth and current account balance. Possible economic consequences Depreciation of a Free Floating Currency Appreciation of a Free Floating Currency Exports Increase Decrease Imports Decrease Increase (NX) (AD) (GDP) Increase Demand Pull Inflation Increase Decrease Cost Push Inflation (Import Inflation) Increase Decrease Domestic Jobs tied to Exports Increase Decease Balance of Payments Improved Worsen

11. Evaluate the possible economic consequences of a change in the value of a currency, including the effects on a country’s inflation rate, employment, economic growth and current account balance. Cost-push Inflation: Depreciation makes imports more expensive so domestic producers that are dependent on imported inputs has their production cost rise resulting in cost-push inflation (Import Inflation). Appreciation makes imported inputs cheaper thus lowering costpush inflation. Demand-Pull Inflation: Depreciation Increases exports and reduces imports so XM increases which increase AD which can increase economic growth thus GDP. Whether this causes demand-pull inflation depends on where you are in the business cycle and the short run equilibrium. Past full-employment depreciation would lead to demand-pull inflation. Appreciation by making imports cheaper would result in less demand -pull inflation.

11. Evaluate the possible economic consequences of a change in the value of a currency, including the effects on a country’s inflation rate, employment, economic growth and current account balance. Employment: Depreciation which increases XM and therefor increases AD would lead to a fall in cyclical unemployment. Appreciation which decreases XM and therefor decreases AD would lead to a rise in cyclical unemployment. Economic Growth: Depreciation Increases exports and reduces imports so XM increases which increase AD which can increase economic growth thus GDP. Appreciation reduces exports and increases imports so XM decreases which decreases AD which can decrease economic growth and thus

11. Evaluate the possible economic consequences of a change in the value of a currency, including the effects on a country’s inflation rate, employment, economic growth and current account balance. Current Account Balance: Depreciation causes exports to increase and imports to decrease thus XM should improve and so the trade balance should improve. Appreciation causes exports to decrease and imports to increase thus XM should worsen and so the trade balance should worsen. Foreign Debt: Depreciation causes the value of foreign debt to increase. Appreciation causes the value of foreign debt to

12. Describe a fixed exchange rate system involving commitment to a single fixed rate. A fixed exchange rate is established at a specific level and maintained through government actions (usually through monetary policy actions of a central bank). To fix an exchange rate, a government must be willing to buy and sell currency in the foreign exchange market in whatever amounts are necessary to keep the exchange rate fixed. A fixed exchange rate typically disrupts the balance of trade and balance of payments for a country. But in many cases, this is exactly what a country is seeking to do.

13. Distinguish between a devaluation of a currency and a revaluation of a currency. Devaluation is when the price of the currency is officially decreased in a fixed exchange rate system. Revaluation is the official increase in the price of the currency within a fixed exchange rate system.

14. Explain, using a diagram, how a fixed exchange rate is maintained. Under this system, the central bank first announces a fixed exchange-rate for the currency and then agrees to buy and sell the domestic currency at this value. The market equilibrium exchange rate is the rate at which supply and demand will be equal, i. e. , markets will clear. In a fixed exchange-rate system, the pre-announced rate may not coincide with the market equilibrium exchange rate. The foreign central banks maintain reserves of foreign currencies and gold which they can sell in order to intervene in the foreign exchange market to make up

14. Explain, using a diagram, how a fixed exchange rate is maintained. If there is excess supply of the fixed currency, the central bank will have to intervene and buy the excess currency by selling some of its foreign currency reserves. This will shift out the demand curve to the fixed rate.

14. Explain, using a diagram, how a fixed exchange rate is maintained. If there is excess demand for the fixed currency then the central bank will have to intervene by selling the peg currency by buying the other currency and placing it in its reserves. This will shift out the supply of the pegged currency and return it to the fixed rate.

14. Explain, using a diagram, how a fixed exchange rate is maintained. Other tools that a country can use to maintain a fixed exchange rate beside reserve currency account include: Increasing interest rates This will attract investment spending from other countries which will lead to an increase in demand for the fixed currency. However, this could slow down the home county at the expense of a fixed currency. Borrowing from abroad If a country borrows from abroad, it loans will come in the form of foreign exchange, which when converted into the fixed currency. This will cause the demand for the fixed currency to rise. However, borrowing from abroad will have to be repaid and might lead to numerous other problems if they can’t repay the loans.

14. Explain, using a diagram, how a fixed exchange rate is maintained. Efforts to limit imports The government could use policies to limit imports, because this reduces the supply of the domestic currency, since it reduces the demand foreign exchange needed to buy the imports. Contractionary fiscal and or monetary policies Trade protection trade policies However, both of these policies options come with their own set of issues and future problems. Imposing exchange controls Exchange controls are restrictions imposed by the government on the quantity of foreign exchange that can be bought by domestic residents of a country. This restricts the outflows of funds from the country. However, this leads to a serious resource misallocation.

15. Explain how a managed exchange rate operates, with reference to the fact that there is a periodic government intervention to influence the value of an exchange rate. A managed currency is an exchange rate that is basically floating in the foreign exchange markets but is subject to intervention from time to time by the monetary authorities, in order to resist fluctuations that they consider to be undesirable. Normally the currency floats freely in the market - the value is determined by the forces of supply and demand for a given currency. But the government and/or central bank of a country may decide to use intervention in the currency market as a way of manipulating its value to achieve given macroeconomic objectives

15. Explain how a managed exchange rate operates, with reference to the fact that there is a periodic government intervention to influence the value of an exchange rate.

15. Explain how a managed exchange rate operates, with reference to the fact that there is a periodic government intervention to influence the value of an exchange rate.

15. Explain how a managed exchange rate operates, with reference to the fact that there is a periodic government intervention to influence the value of an exchange rate. For example an attempt to bring about a depreciation to � � (i) Improve the balance of trade in goods and services / improve the current account position (ii) Reduce the risk of a deflationary recession - a lower currency increases export demand increases the domestic price level by making imports more expensive (iii) To rebalance the economy away from domestic consumption towards exports and investment (iv) Selling foreign currencies to overseas investors as a way of reducing the size of government debt Or to bring about an appreciation of the currency � � (i) To curb demand-pull inflationary pressures (ii) To reduce the price of imported capital and technology

16. Examine the possible consequences of overvalued and undervalued currencies. Overvalued Currency Advantages Downward pressure on inflation i. e. imported goods will be cheaper More imports can be bought High value of currency forces domestic producers to improve their efficiency to be more competitive in the international market. Disadvantages Overvalued currency will make exports uncompetitive in the international market which will hurt the export industries. Imports are relatively cheaper to buy due to overvalued currency. Consumers will go in for more imports which will damage to

16. Examine the possible consequences of overvalued and undervalued currencies. Undervalued currency Advantages If currency is undervalued, the exports will be cheaper and they will grow leading to greater employment in export industries Undervalued currency will make imports expensive for consumers, they will divert to domestic goods and thus employment in domestic industries will increase. Disadvantages As discussed earlier undervalued currency makes imports expensive which also leads to Imported inflation i. e. all the products using imported components/raw material will become expensive thus effecting the general price level.

Advantages of a strong exchange rate Downward pressure on inflation. Imported inputs are cheaper. More imports are bought. Money goes farther. Forces domestic producers to improve their efficiency. To remain competitive.

Disadvantages of a strong exchange rate Damage to export industries Damage to domestic industries

Advantages of a weak exchange rate Greater employment in export industries Greater employment in domestic industries Investment growth stimulated by growing demand of goods Increase tax receipts for government through higher profits and income tax receipts Decrease government spending on unemployment benefits and welfare

Disadvantages of a weak exchange rate Inflation. Import inputs are more expensive. The effects of foreign indebtedness Disincentive for improved efficiency and productivity A deterioration in the terms of trade

17. Compare and contrast a fixed exchange rate system with a floating exchange rate system, with reference to factors including the degree of certainty for stakeholders, ease of adjustment, the role of international reserves in the form of foreign currencies and flexibility offered to policy makers. Advantages of a Fixed Exchange Rate Reduce uncertainty, business can plan ahead. The Government is forced to take measures to ensure that inflation is low, in order to keep businesses competitive on foreign markets. Should reduce speculation in the foreign exchange markets

17. Compare and contrast a fixed exchange rate system with a floating exchange rate system, with reference to factors including the degree of certainty for stakeholders, ease of adjustment, the role of international reserves in the form of foreign currencies and flexibility offered to policy makers. Disadvantages of a Fixed Exchange Rate The government is compelled to keep the exchange rate fixed, so domestic macro goals may have to be sacrificed. The government must maintain high levels of foreign reserves in order to defend its currency by buying and selling of foreign currencies. Finding the correct value to fix the currency is difficult. There are many variables. If everyone else views your fixed rate too low there may be retaliation and disputes.

17. Compare and contrast a fixed exchange rate system with a floating exchange rate system, with reference to factors including the degree of certainty for stakeholders, ease of adjustment, the role of international reserves in the form of foreign currencies and flexibility offered to policy makers. Advantages of a Floating Exchange Rate Interest rates are free to be employed as a domestic monetary tool. Should adjust itself, in order to keep the current account balanced. High levels of foreign reserve are not needed.

17. Compare and contrast a fixed exchange rate system with a floating exchange rate system, with reference to factors including the degree of certainty for stakeholders, ease of adjustment, the role of international reserves in the form of foreign currencies and flexibility offered to policy makers. Disadvantages of a Floating Exchange Rate Creates uncertainty on international markets. Harder to plan for the future. Many factors effect the currency than just supply and demand. So currency markets may not self adjust. May worsen the existing levels of inflation. Higher input prices form imports may lead to cost-push inflation.

Pegging exchange rate A number of developing countries peg their currencies to the a major currency, and float together with it. The main reason for pegging currencies is that this stabilizes the exchange rate of the pegged currency in relation to the currency to which it is pegged. This prevents abrupt or strong fluctuations and this helps facilitates trade flows.