International Monetary Systems. Exchange Rate Regimes and Forex Markets

International Monetary Systems Exchange Rate Regimes and Forex Markets Functions of the forex market The forex market is used for three main purposes:    Currency conversion Foreign exchange risk hedging Currency speculation Exchange rates and Systems It may be expressed in two ways: 1. Indirect quote: Foreign currency units per unit of the domestic currency $1.13 = £1 2. Direct quote: Domestic currency units per unit of the foreign currency £0.88 = $1 Floating exchange rate system • A system in which the exchange rate or price of a currency is left to be determined by market forces with no or minimal government/ central bank intervention. • The exchange rate fluctuates in response to changes in the supply or demand for the currency. Fixed exchange rate system • A system in which the exchange rate of a currency is fixed by the central bank against another currency or basket of currencies. • The central bank commits itself to buy or sell the currency as appropriate to maintain the fixed exchange rate. Taxonomy of Exchange Rate Regimes The case for floating exchange rates  Monetary policy autonomy Under a fixed rate system, a country needs to follow the monetary policy of the key currency(-ies) its own currency is pegged to in order to experience the same inflation and keep the exchange rate fixed. Furthermore, under such a system a country’s ability to expand or contract its money supply is limited by the need to maintain the fixed exchange rate. In contrast, under a floating rate system, a country can use monetary policy to stimulate or cool down the economy.  Automatic foreign trade balance adjustments Advocates of floating rate systems argue that floating rates can help a country reduce its trade deficit, through a depreciation of its exchange rate. By making its imports more expensive, and its exports cheaper, exchange rate depreciation should correct the trade deficit.  Economic recovery from severe economic crises Advocates of floating rate systems also argue that floating rates can help a country recover from a severe economic crisis, through the country’s currency depreciation and the subsequent increase in exports. The case for Fixed exchange rates  No uncertainty or unpredictability about foreign exchange rates Uncertainty surrounding future currency movements that characterise floating rate systems is avoided.  Less currency speculation Advocates of fixed rate systems argue that they can limit the destabilising effects of currency speculation.  Monetary discipline The need to maintain the fixed exchange rate ensures that governments do not expand their money supply at inflationary rates. Plus... × Floating rates cannot help a country reduce trade imbalances × Floating rates cannot help a country get out of a severe crisis A country’s trade deficit or economic crisis will contribute to a depreciation of its currency. But, critics of floating rate systems argue that the currency’s depreciation might not lead to higher exports, but rather to higher inflation, as it makes a country’s imports more expensive. Higher inflation will wipe out any gains in cost competitiveness arising from currency depreciation. It will also make it more difficult to recover from an economic crisis. What explains changes in exchange rates? At the most basic level, exchange rates are determined by the supply and demand for one currency relative to demand and supply for another. Factors that influence exchange rates      Change in the relative inflation rate Change in the relative interest rate Change in the relative income level Change in government controls Change in expectations of future exchange rates and economic conditions more generally Relative Inflation Rates Relative Interest Rates A relatively high interest rate may reflect expectations of relatively high inflation, which may discourage foreign investment. It is thus useful to consider the real interest rate, which adjusts the nominal interest rate for inflation. Real interest rate = Nominal interest Rate – Inflation Rate Where the difference in inflation rates explains the difference in interest rates, higher interest rates are not attractive, as the increased attraction of higher £ interest rates is offset by the fall in £ value due to higher inflation. Relative Income Levels Government Controls • Governments may influence the equilibrium exchange rate by: • Intervening in the foreign exchange market; • Imposing foreign trade, investment or foreign exchange barriers; • Affecting macroeconomic variables such as inflation, interest rates, and income levels. Expectations • Foreign exchange markets react to any news that may have a future effect on the economy and exchange rates.