4.5 Exchange Rates

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1) Fixed Exchange Rate System
In a fixed exchange rate system, a country's currency is tied to another major currency (like the USD) or a basket of currencies. The government or central bank intervenes in the forex market to maintain the currency’s value within a specific band.
Example: The Hong Kong dollar (HKD) is pegged to the US dollar, maintaining a fixed exchange rate of around 7.8 HKD per USD.

Advantages:
Certainty for international traders and investors.
Prevents large fluctuations in exchange rates.
Disadvantages
Requires large reserves of foreign currency to defend the peg.
Can lead to speculative attacks if the market perceives the fixed rate as unsustainable.

In a floating exchange rate system, the value of a currency is determined by the forces of supply and demand without direct intervention from the government or central bank.
Example: The United States dollar (USD) and the Euro (EUR) are part of floating exchange rate systems.
Advantages:
Automatic adjustment of balance of payments imbalances.
Monetary policy independence.
Disadvantages:
Volatile exchange rates, making international trade and investment riskier.
Uncertainty for businesses involved in foreign trade.

A managed float system is a hybrid where the currency is allowed to fluctuate but the central bank intervenes occasionally to stabilize or direct the exchange rate.
Example: The Indian Rupee (INR) operates under a managed float system. The Reserve Bank of India (RBI) intervenes occasionally to curb excessive volatility.
Advantages:
Combines benefits of both fixed and floating systems.
Allows some degree of market determination, but also provides stability through interventions.
Disadvantages:
Unpredictability in intervention policies can create market confusion.
Requires consistent monitoring of exchange rate movements.

1) Demand and Supply Factors
Exchange rates fluctuate based on the supply and demand for currencies. Higher demand for a currency increases its value, while an oversupply can decrease its value.
Example: Increased demand for US goods will increase demand for the USD, causing it to appreciate.
2) Interest Rates
Higher interest rates attract foreign capital, increasing demand for the country's currency. Conversely, lower interest rates lead to capital outflows, depreciating the currency.
Example: When the US Federal Reserve raised interest rates in 2022, the USD appreciated as foreign investors sought higher returns in US markets.
3)Inflation Rates
Countries with high inflation will see their currency depreciate as the purchasing power erodes, making exports less competitive.
Example: Persistent high inflation in Turkey has led to a depreciation of the Turkish lira (TRY).
4)Political Stability and Economic Performance
Political stability and strong economic performance increase investor confidence, leading to currency appreciation.
Example: During the Brexit referendum in 2016, the uncertainty led to a depreciation of the British Pound (GBP).
5)Speculation
Traders often buy or sell currencies based on expectations of future movements. If investors believe a currency will depreciate, they will sell it, causing a self-fulfilling prophecy.
Example: Speculation about the Eurozone’s economic stability has led to fluctuations in the value of the euro.

1)Impact on Exports and Imports
A currency depreciation makes a country's exports cheaper and more competitive in international markets, while imports become more expensive.
Example: After the depreciation of the British Pound post-Brexit, UK exports became cheaper, boosting export revenues.
2) Inflationary Pressures
A depreciated currency increases the cost of imported goods, leading to imported inflation.
Example: The depreciation of the Argentine peso has led to significant inflation as the cost of imported goods skyrocketed.
3) Investment Flows
Currency appreciation attracts foreign investment, while depreciation discourages it. Foreign investors prefer to invest in economies with stable or appreciating currencies.
Example: Japan’s strong yen during the 1980s led to massive foreign investments in Japanese real estate and stock markets.
4) Debt Repayment
Countries with significant foreign-denominated debt will find it more difficult to repay when their currency depreciates. The cost of servicing the debt increases as the value of their local currency falls.
Example: Many developing countries, such as Venezuela, have struggled with repaying dollar-denominated debt after their local currencies depreciated sharply.

Fixed, As previously discussed, in a fixed exchange rate system, the value of a currency is maintained at a fixed rate against another currency or a basket of currencies. This requires active government intervention through foreign exchange reserves.
Example: The Chinese yuan was historically pegged to the US dollar, but in recent years, China has adopted a more managed float system.
Floating, In a floating system, the value of the currency is determined by market forces with little to no intervention from the central bank.
Example: The USD and EUR operate under a floating exchange rate system.

No one system is perfect, and the choice of system depends on the specific needs and economic circumstances of the country.
Fixed exchange rate systems provide stability but can be costly to maintain, while floating systems offer flexibility but come with the risk of volatility.
Many countries adopt a managed float approach to combine the advantages of both systems.
Example: The Eurozone combines elements of both systems, with the euro being used as a common currency among member states, while the European Central Bank intervenes periodically to manage inflation and exchange rate stability.