A Level Economics 94: Exchange Rate Policy

Influencing Exchange Rates in a Managed Float System:

In a managed float system, monetary authorities have some control over the exchange rate, but they do not fix it at a specific value as in a fixed exchange rate system. Instead, they intervene in the foreign exchange market to influence the exchange rate and stabilize it within a certain range. The key methods used by central banks and monetary authorities to influence the exchange rate are as follows:

1. Foreign Exchange Market Intervention: Central banks can actively buy or sell their domestic currency in the foreign exchange market. When they want to weaken their currency, they sell their currency and buy foreign currencies, increasing the supply of their currency in the market. This increased supply drives down the exchange rate. On the other hand, when they want to strengthen their currency, they buy their currency and sell foreign currencies, reducing the supply of their currency in the market and leading to an appreciation of the currency.

2. Interest Rate Policy: Central banks can use interest rates as a tool to influence capital flows and demand for their currency. Higher interest rates can attract foreign investors seeking better returns, increasing the demand for the domestic currency and leading to its appreciation. Conversely, lower interest rates can reduce demand for the currency, leading to its depreciation.

3. Foreign Exchange Reserves Management: Central banks maintain foreign exchange reserves, which they can use to stabilize the exchange rate during times of excessive volatility. By buying or selling foreign currencies from their reserves, central banks can influence the exchange rate.

4. Forward Guidance: Central banks can also influence the exchange rate through forward guidance, which involves signaling their future monetary policy actions. Market participants may adjust their expectations based on central bank communication, impacting the exchange rate.

Impact of Exchange Rate Changes on Terms of Trade: Exchange rate changes can have significant effects on a country's terms of trade, which is the ratio of export prices to import prices. The impact depends on the direction of the exchange rate change:

1. Currency Depreciation: When a country's currency depreciates, its export prices become relatively cheaper in foreign markets. This can lead to an increase in export revenues as foreign buyers find the country's goods and services more attractive due to their lower prices. However, import prices become more expensive, potentially leading to higher costs for imported goods and potentially fueling inflation.

2. Currency Appreciation: On the other hand, when a country's currency appreciates, its export prices become relatively more expensive for foreign buyers. This can result in a decline in export revenues as foreign demand may decrease. However, import prices become cheaper, benefiting domestic consumers and businesses reliant on imported inputs, which can potentially help keep inflation in check.

Advantages and Disadvantages of Holding Exchange Rates Artificially:

1. Advantages:

   a. Export Competitiveness: By keeping the exchange rate undervalued, a country's goods and services can become more competitive in international markets, which can boost export volumes and support domestic industries.

   b. Current Account Balance: An undervalued exchange rate can improve the country's current account balance by promoting exports and reducing imports, potentially leading to a reduction in trade deficits.

2. Disadvantages:

   a. Inflationary Pressures: Artificially keeping the exchange rate low can lead to inflationary pressures as the cost of imports rises, impacting domestic consumers' purchasing power.

   b. Imports and Input Costs: An undervalued exchange rate can increase the cost of imported goods and raw materials for domestic businesses, potentially affecting their profitability.

   c. Speculative Pressure: Artificially managing exchange rates can attract speculative activities in the foreign exchange market, leading to financial market instability and creating risks for the economy.

The Marshall Lerner Condition and J Curve:

The Marshall Lerner condition states that a depreciation (or appreciation) of a country's currency will improve the trade balance if the sum of the price elasticities of demand for exports and imports is greater than one. In other words, if demand for exports and imports is responsive to changes in their prices, a change in the exchange rate can lead to a significant impact on trade balances.

The J curve effect refers to the short-term worsening of a country's trade balance immediately after a currency depreciation. It occurs because the demand for exports and imports may be relatively inelastic in the short term, meaning that changes in prices do not have an immediate effect on demand. As a result, in the short term, a currency depreciation may lead to a worsening trade balance. However, over time, as demand becomes more elastic and adjusts to price changes, the trade balance may improve.

Conclusion: In a managed float exchange rate system, monetary authorities have some control over the exchange rate through interventions and other policy measures. Exchange rate changes can have significant effects on the economy, including impacts on trade balances, inflation, and competitiveness. While managing exchange rates can offer advantages such as export competitiveness, there are also risks and disadvantages associated with artificially influencing currency values. Policymakers must carefully consider the trade-offs and potential side effects when implementing exchange rate policies.