Title Chapter 9 (Unit 4).pdf ✅

THE EXCHANGE RATE EXCHANGE RATE AND ITS ECONOMIC EFFECTS Exchange rate or Foreign Exchange rate is the rate at which the currency of one country is exchanged for the currency of another country. ▪ A foreign currency transaction is a transaction that is denominated in or requires settlement in a foreign currency, including transactions arising when an enterprise either: (a) buys or sells goods or services whose price is denominated in a foreign currency. (b) borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency. (c) becomes a party to an unperformed forward exchange contract; or (d) otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency. THE EXCHANGE RATE REGIMES ▪ An exchange rate regime is the system by which a country manages its currency with respect to foreign currencies. It refers to the method by which the value of the domestic currency in terms of foreign currencies is determined. There are two major types of exchange rate regimes at the extreme ends; namely: 2) Floating exchange rate regime (also called a flexible exchange rate) 1) Fixed exchange rate regime (also called a pegged exchanged rate IDPetQu Quotation] : Depict the - Indirect Quote - /E= $0. - 012 C American Currency Quot] Pi ↑ * S P OSP - > & Free ed Manay
Free-floating exchange rate system ▪ Governments and central banks do not participate in the market for foreign exchange. The relationship between governments and central banks on the one hand and currency markets on the other is much the same as the typical relationship between these institutions and stock markets. Governments may regulate stock markets to prevent fraud, but stock values themselves are left to float in the market. Advantages ▪ A free-floating system has the advantage of being self-regulating. There is no need for government intervention if the exchange rate is left to the market. Market forces also restrain large swings in demand or supply. � Suppose, for example, that a dramatic shift in world preferences led to a sharply increased demand for goods and services produced in Canada. This would increase the demand for Canadian dollars, raise Canada’s exchange rate, and make Canadian goods and services more expensive for foreigners to buy. Some of the impact of the swing in foreign demand would thus be absorbed in a rising exchange rate. ▪ In effect, a free- floating exchange rate acts as a buffer to insulate an economy from the impact of international events. A floating exchange rate has the greatest advantage of allowing a Central bank and/or government to pursue its own independent monetary policy. Floating exchange rate regime allows exchange rate to be used as a policy tool: for example, policy-makers can adjust the nominal exchange rate to influence the competitiveness of the tradable goods sector. ▪ As there is no obligation or necessity to intervene in the currency markets, the central bank is not required to maintain a huge foreign exchange reserves. � Basically, the free floating or flexible exchange rate regime is argued to be efficient and highly transparent as the exchange rate is free to fluctuate in response to the supply of and demand for foreign exchange in the market and clears the imbalances in the foreign exchange market without any control of the central bank or the monetary authority ↓Depreciate - E80/$-58000 corts'↑ Imports 1 (Payment -$100 E x 85/$-58500 Demand for Ex
Disadvantages ▪ The primary difficulty with free-floating exchange rates lies in their unpredictability. Contracts between buyers and sellers in different countries must not only reckon with possible changes in prices and other factors during the lives of those contracts, they must also consider the possibility of exchange rate changes. ▪ An agreement by an Indian distributor to purchase a certain quantity of US goods each year, for example, will be affected by the possibility that the exchange rate between the Indian rupee and the U.S. dollar will change while the contract is in effect. Fluctuating exchange rates make international transactions riskier and thus increase the cost of doing business with other countries. The greatest disadvantage of a flexible exchange rate regime is that volatile exchange rates generate a lot of uncertainties in relation to international transactions and add a risk premium to the costs of goods and assets traded across borders. US India - 1$E83 2 $ + Riskpemin
Managed Float Systems Governments and central banks often seek to increase or decrease their exchange rates by buying or selling their own currencies. Exchange rates are still free to float, but governments try to influence their values. Government or central bank participation in a floating exchange rate system is called a managed float. ▪ Countries that have a floating exchange rate system intervene from time to time in the currency market in an effort to raise or lower the price of their own currency. Typically, the purpose of such intervention is to prevent sudden large swings in the value of a nation’s currency. Such intervention is likely to have only a small impact, if any, on exchange rates. Still, governments or central banks can sometimes influence their exchange rates. How Government Intervenes? Suppose the price of a country’s currency is rising very rapidly. The country’s government or central bank might seek to hold off further increases in order to prevent a major reduction in net exports. An announcement that a further increase in its exchange rate is unacceptable, followed by sales of that country’s currency by the central bank in order to bring its exchange rate down, can sometimes convince other participants in the currency market that the exchange rate will not rise further. That change in expectations could reduce demand for and increase the supply of the currency, thus achieving the goal of holding the exchange rate down. Buy-Esupply - Pricet - currency Appreciate Sell-Esupply * - Priced - Current Depreciate Currericy - PA ->Demon ↑ Expo, ~ Fixed &