For Grade 12SL Economics
The Exchange Rate
It represents the rate at which one currency buys other currency and shows the power with which it can purchase goods and services around the world. Important to note that their are two most popular exchange rate systems one is freely floating exchange rate (capitalist economies) and the second is fixed exchange rate system (command economies). Its not an hidden fact that counties around the world try to influence the exchange rate in order to stimulate the exports and to depress the imports. They usually follow various ways to rein in uncontrolled exchange rates. In modern day countries have adopted a middle path known a managed floating exchange rate system. Its important to the student of economics to learn these system of exchange rate adopted around the world to improve their knowledge of international trade.
Below is given the links of two articles about the exchange rate.
Here is a question to practice.
Analyse and Evaluate the importance of freely floating exchange rate in the all round development of a country.
Post your essay here by clicking on the comment.
[you can select any other country for your reference, give link to any specific article if you are using, careful I will use turnitin for honesty]
Word count 500 words, Due date for submission Sunday, January 11th,2015.
Ref Article 1. Exchange rates, headaches [The Economist]
Ref. Article 2: Will Venezuela's New Floating Exchange Rate Curb Inflation?
Reference 3: Exchange Rate
3 comments:
Meet Sarvaiya:
Exchange rate is the rate at which one currency can be exchanged for another, or the number of units of foreign currency that correspond to the domestic currency. A freely floating exchange rate is one where this rate is determined by the free forces of demand and supply in the foreign exchange market instead of the government or central bank.
This freely floating exchange rate is very important to countries because during times of globalisation and free trade, countries need to import and export goods for trade. When this happens, there is an increase the demand of a particular currency and or decrease in it; for example importing goods from a particular country increases the demand of that country’s currency and its value.
“Venezuela exports petroleum and petroleum byproducts and imports most of what it needs, the exchange rate is crucial for economic stability”, thus it depends a lot on global trade. Such an exchange rate is beneficial for a country like Venezuela as if the government is in debt the exchange rate undergoes an automatic balance of payments adjustment. If it has a balance of payments deficit (imports more than exports) then the value of its currency will fall, its exchange rate will depreciate- the supply of its currency will increase and the demand for other currencies increases. Due to a fall in its value, it can buy less abroad and its goods appear cheaper to buy. Venezuela’s exports will become cheaper and imports more expensive thus increasing demand for its goods abroad, increasing exports and thus dealing with the balance of payments deficit. Also if it is freely floating, there will be no need for internal management of the rates or involvement of the central bank, which can focus on other issues. The floating exchange rate can also affect inflation, employment and economic growth. Currency depreciation can lead to increased exports and domestic production, which can slowly lead to inflation as well as increased GDP and therefore employment in a country. A currency appreciation will have the opposite effect and if this rate is floating, either can happen depending on the demand and supply of foreign currencies thus it may become difficult for the government to set macroeconomic objectives for a Venezuela. Besides causing inflation, the floating rate also creates uncertainty in the market, sellers will be unconfident when they sell abroad and unsure of what prices they may receive. Importers will thus be unsure of the costs of importing raw material and so there can be a lack of investment as well.
Thus overall a freely floating exchange rate has effects on factors such as economic growth, inflation and employment, depending on whether the rate increases in value or decreases in value in terms of other rates. The biggest drawback of floating exchange rates is the uncertainty it causes and thus a managed exchange rate would be most appropriate which is determined by the market but stabilized by the central bank over periods of time.
Exchange rate is the rate of once currency with respect to another currency. Freely floating exchange rate is when the exchange rate is determined completely by external market forces. In such a system, the market forces causes the exchange rate to reach a point of equilibrium where the quantity of currency demanded is at equilibrium to the quantity of a specific currency supplied. There is no government intervention in a free-floating exchange rate system. For example: dollars. There are various causes that lead to changes in the exchange rate such as
1) Foreign demand for a country’s exports
2) Domestic demand for imports
3) Relative interest rate changes
4) Relative rates of inflation
5) Investment from abroad
6) Changes in income
7) Speculation
8) Use of foreign currency reserves
To analyze the importance of exchange rates, the state of the exchange rate of a particular currency needs to be figured. The states include currency appreciation and currency depreciation. Currency appreciation is when the value of a currency of one country rises compared to the value of another currency of another currency whereas a fall in the value of currency of one country with respect to another is called depreciation. If the currency depreciates it is beneficial to the economy in terms of unemployment. Unemployment will fall as the net exports increases and so does the aggregate demand but a currency appreciation will have the opposite effect. Although appreciation is beneficial to the economy, it does not provide the benefits of decreasing unemployment but rather increases it. The question requires analyzing the effects for the development of a country, and for development a higher unemployment is negative. Appreciation and depreciation has varied effects on the economic growth. For the effects on economic growth, a change in the exchange rate not only affects the net exports and aggregate demand but also in some cases the aggregate supply. Appreciation makes imports cheaper, so firms relying on importing raw materials are benefited; this low price on imports can lead to a fall in price of the products thus benefiting consumers.
‘When an economy is hit by a negative shock, its current and future prospects start to look gloomy. Domestic assets—company shares and government bonds, say—look less attractive, and demand for them falls.’
Companies or countries wishing to invest in this particular country may think twice, so the relative price of the currency falls and thus the currency depreciates.
“Venezuela exports petroleum and petroleum byproducts and imports most of what it needs, the exchange rate is crucial for economic stability”
This shows that the balance of payments is favored to the imports, and due to the few exports there is a trade deficit. So to counter this the freely floating exchange rate automatically adjusts to the economy. The currency depreciates naturally as exports are less than imports. This relates to the effect of demand-pull inflation where the exports will become cheaper and imports more expensive as the economy works to increase aggregate demand
A country's exchange rate system is when the foreign exchange market sets its currency relative to other currencies. A floating exchange rate system is an exchange rate whereby market forces determine the rate based on how a country is viewed. Due to its open nature, floating exchange rate systems may result in huge changes in currency values, which are detrimental to the countries trade performance.
Governments can use exchange rates to change economic performance. A rising exchange rate may lead to exports becoming more expensive but imports cheaper. A fall in the exchange rate would lead to the reverse and might help domestic businesses to increase their export.
A floating exchange rate is a riskier form of exchange. But despite the possibility of loss, there is a great potential for growth. A fixed exchange rate, on the other hand, leaves no room for growth. Having a floating exchange rate is beneficial, especially to developing countries, in many ways. Firstly, balance of payments disequilibrium tends to be rectified by a change in the exchange rate. For example, if a country has a balance of payments deficit then the currency should depreciate. The depreciation would make exports cheaper and imports more expensive, thus increasing demand for domestic goods abroad and reducing demand for foreign goods in the country. With a fixed rate, rectifying a deficit would involve policies resulting in external consequences such as unemployment. The floating rate allows governments to use internal policy objectives without external effects.
One example of the benefit of a floating rate the OPEC oil shock (1973), after which there were great changes in the pattern of world trade. A fixed exchange rate at that time would have caused major problems. Having a floating rate permit countries to re-adjust to external shocks more flexibly.
However, the disadvantage of a floating rate is that at any moment the exchange rate of a country could collapse. The fact that a currency changes in value from day to day establishes an instability and uncertainty into the market. For instance, sellers may be unsure of how much money they will receive when they sell abroad. This can lead to a lack of foreign investment to a country. Systems that are more rigid help countries anchor inflation expectations and sustain output growth, but they also restrict the use of macroeconomic policies and increase vulnerability to crises. The alternative is greater flexibility in exchange rates. That is the direction in which many developing countries have been moving. The classical argument in favour of flexibility states that if prices move slowly, it is both faster and cheaper to move the nominal exchange rate in response to a shock that requires an adjustment in the real exchange rate. Exchange rate flexibility is especially effective if a country is frequently struck by shocks from abroad. A flexible exchange rate is preferable for exporters of primary products and countries highly indebted abroad, characteristics common to developing countries.
A developing country’s exchange rate system can heavily influence both its domestic stability and its trade performance. The fixed exchange rate may be more stable, however, I do not believe it is the best system to follow if a country is in need of development. For the overall development of a country, which demands room for change, a floating exchange rate is more apt.
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