AS Monetary Policy

There should be an understanding that changes in the exchange rate can affect the prices of exports and imports, the level of domestic economic activity, as well as the balance of payments on current account.

Note: candidates do not need to know about how interest rates and exchange rates are determined. These topics are included in Unit 4.

the rate of one currency expressed in terms of another.

E.g. £1 = 1.3 Euros

The value of the currency is determined in the foreign currency markets without government interference

Country A trades only with two countries.

60% of its trade is with country X and 40% with country Y.

Country A trades only with two countries.

60% of its trade is with country X and 40% with country Y.

Freely floating exchange rates Fully-fixed exchange rates

Adjustable peg systems Crawling peg systems Semi-fixed exchange rates Managed floating exchange rates

The Euro

The spot price or spot rate of a currency is the price that is quoted for immediate settlement, payment and delivery.

Trade weighted exchange rate is the value of a currency expressed using an index of a basket of currencies weighted to take account of the amount of trade transacted in those currencies

Exchange rate of the £

A single fixed exchange rate with no permitted fluctuations. The value of a currency is maintained at the agreed rate because the central bank promises to buy and sell currencies at the specified rate.

The Gold Standard

C18th, C19th up to 1931

Most of the world’s major currency were on the Gold standard at some point.

UK acted as the guarantor

Before 1914 and between 1925 and 1931 the Bank of England would give you 0.315 ounces of gold for a pound. But not now

Each central bank agreed to buy back their own currency with a fixed amount of gold. This meant that any currency in the scheme would remain worth the same in terms of other countries’ currencies.

If there was any fluctuation in value, it was a simple matter for a firm to sell pounds, buy gold and then use the gold to buy the foreign currency. In this way currencies could only fluctuate in value by as much as it cost to transport gold from one country to another.

Similar to fully fixed but currencies are allowed to devalue or revalue by agreement.

E.g. Bretton Woods Agreement 1944 - 1971

Similar to adjustable peg but small adjustments made regularly (monthly for example).

E.g.The European Exchange Rate Mechanism (ERM), which was the precursor to the

Here the Exchange rate is given a specific target but the currency can move within a percentage from the target currency

From 1987 until joining the ERM in 1990, The UK shadowed the Deutschmark.

A managed floating rate system is a hybrid of a fixed exchange rate and a flexible exchange rate system.

In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market.

Launched 1999 Notes and coins

2002 23 countries have

currencies pegged to the Euro – 150 million Africans.

Benefits Lower import prices –

boosts real living standards of consumers

Increase in real purchasing power of UK residents travelling overseas

Cheaper to import raw materials, components and capital inputs

Improvement in the terms of trade

Helps to control domestic inflation

Costs Cheaper imports leads to

rising import penetration and larger trade deficit

Exporters lose price competitiveness and market share

Damages profits and employment in some sectors (e.g. manufacturing)

Negative impact on economic growth

Some regions affected more than others

Value (purchasing power) of a currency in terms of what it can buy of other currencies

Measures the external value of a currency Price determined in the foreign exchange

markets Global currency markets are open 24 hours per

day Markets are operated by the major banks Daily turnover in the currency markets is

enormous London is the main centre of global currency

dealing Large share of trading is purely speculative

Bi-lateral exchange rate £/ $ or $ / ¥ or £ / €

Effective Exchange (EER) Sterling's average value against a basket of

currencies Weighted against the proportion of trade

that the UK does with each country Heavily weighted currencies are the Euro

and the dollar Spot Exchange Rate Forward Exchange Rate

Currency traders / speculators make huge sums dealing in very small currency fluctuations

Example: Current exchange rate is £1 = $1.50 You expect the value of sterling to rise You spend $600,000 today and buy £400,000 Two months later the pound has appreciated so that £1 =

$1.60 You sell the £400,000. You get $640,000 Speculation has led to a significant capital gain The greater the expected profit – the higher the

speculative demand for sterling at a given rate of interest (This example ignores transactions costs)

Money is worth what it can earn Example:

Money in a UK deposit account earns 6% a year Money in a Euro-based account earns 4% a year Assume that exchange rate expectations between

sterling and the Euro are constant “Footloose” Money will flow out of Euros and into

Sterling A positive interest rate differential will lead to an

increased demand for sterling in currency markets Sterling appreciates against the Euro. Changes in interest rates will affect the differential and

cause changes in “hot money” flows between currencies

Variety of strategies for UK businesses in response to strong sterling Cut export prices (lower profit margins) to

maintain price competitiveness and hold onto market share

Out-source components and raw materials from overseas

Seek productivity / efficiency gains to keep unit labour costs under control

Move into product lines where demand is more inelastic and less sensitive to exchange rate fluctuations

Move production overseas

Government policies to switch production which is being sold domestically to being sold abroad.

i.e. a devaluation of the pound makes imports dearer and exports more expensive. (fixed or pegged rate systems)

Currency controls (before 1979) stop people taking money abroad.

Gert FröbeHarold Sakate

A policy of reducing the level of aggregate demand so that imports are reduced and exports increased. For example:

Increasing interest rates

Incomes policy

Rationing.

If the exchange rate depreciates – imports are dearer (p1 to p2)

price

Qs&d

p1p2

D

q1q2

Expenditure on imports falls from (p1 x q1) to (p2 x q2)

Ceteris paribus, the BoP current account improves

If the exchange rate depreciates – imports are dearer (p1 to p2)

price

Qs&d

p1p2

D

q1q2

Expenditure on imports RISES from

(p1 x q1) to (p2 x q2)

Ceteris paribus, the BoP current account deteriorates

Surplus

Deficit

Time

the combined price elasticity of demand for imports and exports must be greater than one for improvements to be effected in the balance of payments by a devaluation of the currency.