3.3 Exchange Rates
By the end of this unit you should be able to:
Determination of freely floating exchange rates:
Determination of freely floating exchange rates:
- Explain that the value of an exchange rate in a floating system is determined by the demand for, and supply of, a currency
- Draw a diagram to show determination of exchange rates in a floating exchange rate system
- Describe the factors that lead to changes in currency demand and 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
- Distinguish between a depreciation of the currency and an appreciation of the currency
- Draw diagrams to show changes in the demand for, and supply of, a currency
- The effects of exchange rate changes:
- 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
- Describe a fixed exchange rate system involving commitment to a single fixed rate
- Distinguish between a devaluation of a currency and a revaluation of a currency
- Explain, using a diagram, how a fixed exchange rate is maintained
- 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
- Examine the possible consequences of overvalued and undervalued currencies
- 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
Dismantling Trump’s obsession with Chinese trade by understanding how exchange rates work
Over the last 18 months you have heard a lot about America’s trade imbalance with China. Many Americans are worried about Chinese economic growth and see it as a threat to American businesses and consumers. In the 1980’s there was a similar ‘issue’ with Japanese and U.S trade relations. Let’s go through some points and compare the current
Is America worse off if China is more productive? The answer is categorically no. If they are more productive (the Chinese LRAS curve shifts to the right) they have goods and services that Americans can buy at better prices. Also, they will have more money so they can buy goods and services from Americans.
The U.S accuses China of purposely keeping the Yuan low against the dollar to encourage Chinese exports to the U.S. This accusation was certainly true in the mid-2000’s, but today China is not seen as a currency manipulator. Anyway, how could China keep its currency undervalued against the dollar if it wanted to? The answer is simple, they could buy up American dollars on the FOREX pushing the demand up and therefore the value of the American dollar up. The Japanese did the same thing during the 1980’s. But even if this is the case what can the Chinese do do with these American dollars? There are two options.
Also this argument does not really take into account how a floating exchange rate works. Imagine that everything in China was cheaper than it is in America, so Americans want to buy from China. Chinese companies want to make money so they will sell, but they receive dollars. What are they going to do with these dollars if everything is cheaper in China than in America? It makes no sense to buy American products so they’ll buy (exchange the dollars for) Yuan, thus increasing the price of Yuan against the dollar so Chinese goods get more expensive and American goods get less expensive.
Here are some points that the Trump Administration have seemingly failed to grasp:
Is America worse off if China is more productive? The answer is categorically no. If they are more productive (the Chinese LRAS curve shifts to the right) they have goods and services that Americans can buy at better prices. Also, they will have more money so they can buy goods and services from Americans.
The U.S accuses China of purposely keeping the Yuan low against the dollar to encourage Chinese exports to the U.S. This accusation was certainly true in the mid-2000’s, but today China is not seen as a currency manipulator. Anyway, how could China keep its currency undervalued against the dollar if it wanted to? The answer is simple, they could buy up American dollars on the FOREX pushing the demand up and therefore the value of the American dollar up. The Japanese did the same thing during the 1980’s. But even if this is the case what can the Chinese do do with these American dollars? There are two options.
- Invest them in America by possibly opening factories or other commercial enterprises or buy U.S goods and services which benefits the US economy
- Or, use the dollars to buy Chinese Yuan which will increase the value of the Yuan against the Dollar
Also this argument does not really take into account how a floating exchange rate works. Imagine that everything in China was cheaper than it is in America, so Americans want to buy from China. Chinese companies want to make money so they will sell, but they receive dollars. What are they going to do with these dollars if everything is cheaper in China than in America? It makes no sense to buy American products so they’ll buy (exchange the dollars for) Yuan, thus increasing the price of Yuan against the dollar so Chinese goods get more expensive and American goods get less expensive.
Here are some points that the Trump Administration have seemingly failed to grasp:
- China’s economic growth has been slowing since 2014 leading to a decrease in the value of the Yuan. In order to stabilize the currency and prevent foreign capital leaving China the Chinese government actually stepped in to prop the currency up. If it had not done so the actual value of the Yuan would be lower than it is now.
- Trump has overseen fiscal expansion through tax cuts and government spending which increase aggregate demand and thus lead to inflation and a higher U.S dollar against the Yuan.
- Also his tariffs on Chinese goods is actually hurting his own manufacturers because he does not understand that if foreign exporters are cut off from the U.S. market, they will not have money to buy U.S. goods.
Exchange Rates and FOREX |
Fixed vs Floating Exchange Rates |
|
|
|
