Exchange Rates and Fiscal Requirements for Price Stability - Case Study Example

Name : xxxxxxxxxxx Institution : xxxxxxxxxxx Course : xxxxxxxxxxx Title : Exchange Rates Tutor : xxxxxxxxxxx @2010 Exchange Rates Part A Introduction From a fiscal point of view, it is critical to understand how exchange-rate shifts influence economic decisions and operations. The essay first describes the exchange rates, factors affecting the exchange rate and their link to goods and services produced (Woodford, 2001). Exchange rate The exchange rate is defined as the price of one currency in terms of another currency, for instance, a United.States company is purchasing 150,000 pounds worth of compact discs from Britain. The exchange rate being at $2 = £1, so the American purchaser must exchange its $400,000 for £200,000 at an American financial institution. The American financial institution will give up its £200,000 in the London bank to the importer, who will pay the British compact discs exporter, who will deposit the money in the exporter's bank. Depreciation means the value of a currency has fallen; thus it takes more units of that country's currency to buy another country's currency (Woodford, 2001). Appreciation means the value of a currency or its purchasing power has risen; since it takes less of that currency to buy another country's currency. Types of Exchange rates International Exchange Rate Systems - provided for fixed exchange rates in terms of a certain amount of currency for an ounce of gold. Flexible Exchange Rates - rates are determined by the forces of demand and supply. Fixed Exchange Rates - are those that are pegged to some set value, such as gold. Floating Exchange Rate - these are rates that are determined by foreign - market demand and supply of the currency in relation to other currencies (Sanger, 2005). Exchange rates and their modes of determination. Changes in preferences for a country's products would shift the demand for the currency. The relative income changes cause changes in the demand and supply of currencies. Rising incomes increase the demand for imports, which increases the supply of that country's currency and the demand for other country's currencies. The relative price changes will cause changes in the demand and supply of currencies. The theory of purchasing power parity asserts that exchange rates will change to maintain a uniform price in one currency (Chipello, 2004). The changes in relative real interest rates will affect the demand and supply of currencies. Speculation; If one is convinced that the value of a currency is about to fall, it will increase the supply of that currency and reduce its demand; if is convinced believes the value of a currency is about to rise, it will increase its demand and reduce its supply as people want to hold that currency. Lastly the balance of payment; which is the total of all transactions that take place between its residents and the residents of all foreign nations. These include : exports and imports, tourist expenditures, and interest plus dividends from the sale and purchases of financial assets that are overseas. As depreciation occurs, imports become more costly as it takes more currency to buy foreign goods and services and exports create a demand for the currency and a supply of foreign money Demand and Supply curve in relation to exchange rates and currency value The demand curve currency is down sloping because as the currency becomes less expensive, people will be willing to buy more of that nation's goods and, therefore, want larger quantities of the currency. The supply curve for a currency is upsloping because as its price rises, holders of that currency can purchase other currencies more cheaply and will want to buy more imported goods and, therefore, will give up more of their currency to buy other currencies. Like other commodities, the intersection of the supply and demand curves for a currency determine the price or exchange rate (Articlesbase, 2008). Part B United States United States Exchange Rates against the Euro 1999-2010. Note; the numbers represents the years; 1999-2010. Source; European Central Bank (Eurosystem). Hey, the order 364141, Part A is good. But for Part B, the paper was main on the general explanation of different indicators, defenations. Could you plz explain more specificlly and apply those indicators into the fact of US exchange rate. Since the requirement said that" show how the exchange rate has changed and what factors caused these changes?" Thus it is more important to show the analysis and evidences on reasons of the ER changes. A floating exchange rate which also referred to as a fluctuating exchange rate is a form of exchange rate regime in which a country’s currency is permitted to fluctuate in accordance to the foreign exchange market. The currency that makes use of the floating exchange rate is known as the floating currency. This mode of operation does not suit the running of developing countries in that they are not able to maintain the stability in the exchange market. Floating exchange rates can automatically regulate themselves and therefore provide a country with the necessary power to reduce the potential damages that are as a result of shocks and unfamiliar business cycles and finally to preempt the likelyhood of having a crisis that pertains to balance of payment. Floating exchange rate can additionally be divided into the following forms: dirty floating and clean floating (Ernets & Bulent, 1996). Clean floating is the rate in which the governing central bank is not allowed to intervene so as to affect the value of the exchange rate. Dirty floating, is the form of exchange rate that is mostly practiced and it entails intervention from the governing central bank so as to manipulate the value of the exchange rate. Floating exchange rate has a number of advantages the most significant being there is not any likelihood of the occurrence of any form of foreign exchange crisis. However, there are instances in which fixed exchange rates are prefered due to their certainity and stability.Incases of intense appreciation or depriciation central banks are forced to intervene to rectify the situation and hence stabilize the currency (Yeyati & Sturzenegger, 2004). An exchange rate system is a mode of operation in which a country’s national currency is determined by the supply and demand forces. There are a number of factors that affect the demand and supply of various currencies. The factors include; the strength of a country’s economy, the existing rate of inflation, the current account balance of a country and interest rates in comparison to other countries. The factors that cause the exchange rate of a currency to change are as follows; interest rates, political stability, purchasing power parity, trade imbalances, government intervention and speculators. The exchange rate of the United States dollar showed a decline between the years 2008-2010. This was due to the impending global financial crisis which resulted into servere inflation. The global financial crisis is thought to have begun on 9th August 2007. The crisis is thought to have originated from the Sub-prime mortgage business where US banks gave out high risk loans to people with poor credit history. It was further propelled by a fall in house prices in the USA. This then led to a fall in the value of securities backed by subprime mortgages. The full force of the global credit crunch hit hard after a couple of years thus the unprecedented inflation rates (Woodford, 2001). Inflation is a situation in which there is a general increase in the level of prices attached to goods and services provided to consumers. It is valued as a yearly percentage increase. A rise in inflation level dictates that each dollar owned by an individual purchases a smaller amount of a good or service. It therefore follows that the value of a dollar is not constant in the event of inflation. A dollar’s value is viewed in terms of its purchasing power which is seen as the real tangible merchandise that money can buy. It is noted that when inflation increases there is consequently a drop in the purchasing power of the money at hand. For instance, when the inflation rate is 2% yearly, then in theory a $1 pack of sweets will go for $1.02 yearly. It therefore follows that a dollar cannot purchase an equal number of goods that it could purchase beforehand. Inflation relys on supply and demand. It may emanate from the fear that supplies might run out at some instance in the future. Causes of inflation; It all depends on supply and demand. It can emanate from increased demand for a certain product. It can be as a result of increased prices of materials. It can stem from inadequate supplies. It can also be from the fear that supplies might run out at some point in the future (Calvo & Reinhart, 2002). Output Gap; is the balance between supply and demand in the economy is called output gap. The output gap is a measure of the difference that exists between the economy’s potential (a situation where all capital and labor resources are being used) and the economy’s authentic output level. To obtain the actual output level; is done via the measurement of the GDP, on the other hand getting the but potential output is not simple and is therefore only estimated. Measure of Inflation; Inflation being one of the macroeconomic indicators can be measured by the use of many methods; for instance by the use of consumer price index (CPI). CPI being a measure of inflation is made use of by numerous investors. Consumer Price Index is a measurement of an increase in the price value of a type of "basket" of goods and services bought by the common consumer. It is therefore given that the percentage increase in the cost of these goods in a period of 12 months (one year) is dubbed the inflation rate. If the event that the percentage increase becomes negative, then it’s referred to as the rate of deflation. Policy recommendation; demand for the US dollar overseas is high. Unlike the economies of other countries, the US is the only country that can just print more dollars without any negative consequence related to exchange rate just because there is a high demand for US dollars overseas (Calvo & Reinhart, 2002). Another cause of the changes in the United States’ exchange rate is the size of its interest rates. Relative interest rates is the magnitude of the differential that occurs between the real interest rates that is available to prospective investors in any given country. It is therefore just the nominal interest rate that is there for an investor to make use of in a short-term investment and is subtracted from the country’s inflation rate. In United States’ dollar suffered during the global financial crisis and as a result was very volatile. The volatility of the U.S exchange rate was caused by the fall in real-estate prices and high interest rates which resulted in a big number of mortgage payment defaulters. The interest rates on mortgages rose from 1% to 5.35% in the period 2004-2006. This caused a ripple effect that negatively affected investors in that they became reluctant in taking up more Collaterallized Debt Obligations (CDOs). This had an effect of freezing of credit markets. Due to the aforementioned effect, Banks were reluctant to lend each other as they were not aware of the number of bad loans in their rivals’ books. This led to investors having a reduction in the incentive to invest in the United States thus a reduction in the demand for dollars and hence its decline. The political stability of a country also affects its exchange rate. This is because the dealing in a country’s currency is pegged on investors’ or citizens’ confidence level. In that it is noted that people are inticed to trade with a particular country when they are sure that they will be able to exchange it with the next person. Political instability or any speculation of an erupting distability will therefore result in lack of confidence and thus a fall in a country’s currency value. From the graph above there was a drop in the exchange rate value from 2000 -2002. This was due to the occurrence of a bubble in the stock valuations . This was such that at the start of March 2000, the market was expected to give back around 50% to 75% of the entire growth that took place in the1990s. The economy took a downward plunge in 2001 with their output showing an all time rise of 0.3% with unemployment and business failures showing a rise of a tentative amount which led to recession which is more often than not blamed on Terrorist Attack which took place in September of 2001 (Evans, 2009). Trade imbalances is also another of the causes of changes of a country’s exchange rate. The changes occur due to trade deficits that may occur between any particular two countries. This happens due to an imbalance of the currency reserves that may occur between the trading partners. In the 1980s and 90s Japan and the United States trading heavily with each other. Japan ran fairly considerable trade surpluses with their then major trading partner; the United States. AS a result of their trade; Japanese companies obtained a very big amount of the United States currency while U.S companies obtained a lower amount of the yen. In the long run the Japanies companies were required to change the United States dollars that they had obtained into yen and the United States companies were to change the yen into dollars. Due to the mismatch in the quantity of the currencies that were to be exchanged in the countries that were mentioned, the supply and demand law resulted in a distortion of the then exchange rate. Due to the mismatch of the currencies; the American companies were in a robust position to demand a large amount of dollars in return for their small amount of the yen. As a result the United States trade deficit that resultes from their trade with Japan resulted in the strengthening of the yen against the United States dollar (Woodford, 2001). Lastly, government intervention also affects the value of their country’s currency. This is because the value of their currency will ultimately affect their citizen’s wealth, the competitiveness of their locally created goods, the price tag on a country’s labor and lastly the capacity of a country to compete. Due to the aforementioned factors the governments influence the value of their currencies by; the alteration of their monetary policies, fiscal policies and also by taking part in the currency markets. The United States government took part in rectifying the global financial crisis by creating an economic stimulus by injecting money in the car industry. The US Federal Bank tried to bolster the money markets by availing funds for banks at more favorable terms. The interest rates were also reduced to encourage lending (BBC News, 2009). Conclusion The floating exchange is the most widely adopted mode of operation since it ensures that there is some form of fairness in operations between countries. Its biggest set back is that it has to be backed by the reigning central banks. This was very evident in the recent global financial crisis in which central banks took center stage in aiding world economies. The UK government also launched its own bail-out that would see it injecting £400bn to eight of the largest UK banks and building societies in return for preference shares in them (BBC News, 2009). All in all it is the preferred mode of operation. References European Central Bank (2010) Euro Exchange Rates in USD. Retrieved 3 May 2010. Available at: http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-usd Woodford, M. (2001) “Fiscal requirements for price stability”, Journal of Money Credit and Banking, Vol. 33, No. 3 pp.669-727 Calvo, G., and Reinhart, C. (2002). "Fear of Floating." Quarterly Journal of Economics, 117: 379-408. Levy-Yeyati, E. and F. Sturzenegger (2004). "Classifying Exchange Rate Regimes: Deeds vs. Words." European Economic Review. Ernest, R. & Bulent, U. (1996). International Journal of Social Economics. [Online]. 23(7) pp. 49-56 [Accessed 7th April 2010]. Available at: British Broadcasting Corporation (BBC) News (2009) Timeline: Credit Crunch to Downturn: [online]. UK: BBC News. [Accessed 15th February 2010]. Available at: http://news.bbc.co.uk/2/hi/7521250.stm#table. Articlesbase (2008) The Strength of the US Economy. Retrieved 3 May 2010. Available at: http://www.articlesbase.com/finance-articles/the-us-economy-strength-671005.html Evans, E.A (2009). Understanding Exchange Rates: A Weakening U.S Dollar. Retrieved 3 May 2010. Available at: http://edis.ifas.ufl.edu/fe546 Chipello, C. 2004. Dollars Slide Leaves Global Impact. The Wall Street Journal. Wednesday, December 29. Sanger, D. 2005. U.S. Faces More Tension Abroad as Dollar Slides. The New York Times, January 25. Read More