P. 39. Exchange Rates.

In free market (floating or freely fluctuating w/o Gov. intervention):

The ER is the result of the interaction of export demand & import supply.

Demand for sterling is the supply of dollars etc.

Appreciation - if the price of foreign currency rises.

Depreciation - if the price falls

1. Inflation

2. Changes in demands for export import

3. Invisible trade

4. Interest rates

5. Capital movements

6. Speculation

7. Government activities

8. Confidence to future

The exchange rate debate

Floating ER only from 1970s.

Advantages

Disadvantages

1. Automatic stabilisation

1. Uncertainty

2. Freeing internal(unempl) policy constr.

2. Lack of investment

3. Absence of crisis (occur when fixed rate)

3. Speculation

4. Management can still exist

4. Lack of discipline

5. Flexibility(after oil price changes)

6. Avoiding the "import" of inflation.

7. Lower reserves needed

Fixed exchange rates:

Gold standard (abandoned)

Pegged exchange rates (fixed to another currency by Gov.)

Exchange control (restrictions to change currencies)

The adjustable peg (allowed to vary a bit)

Equilibrium exchange rate.

1. The purchasing power parity =

The baskets of goods must cost the same.

The basket determining domestic price has nothing to do with IT

Exchange rates are influenced by other things (govn. interest rates)

Confidence is also significant

If demand for import good is inelastic, the supply of pounds is reversible, that suggest instability in foreign exchange markets.

2. The portfolio balance theory - assumes that large investors will now in which country they can gain and switch their investment. Ignores future expetations.

3. The interest rate parity theory - deals with forwards

Recent developments:

1. Monetary funds - next chapter - attempt to stabilise (organisat. in essay)

2. Dirty floating - buying up excess in market (managed flexibility)

Done by the Exchange Equalisation Account.