Floating Exchange Rates

The exchange rate refers to how much of a foreign currency one unit of domestic currency will buy you. £1=$1.40 means that £1 of sterling will buy $1.40 of US dollars.

Floating exchange rate

With floating exchange rates, the government or central bank let the foreign exchange markets set exchange rates.
The value of a floating exchange rate is affected by the supply and demand of the currency in public markets.

Effect of interest rates

Expansionary monetary policy usually lowers interest rates to increase demand in the economy. This affects foreign exchange markets because:
- The lower interest rates will reduce demand for the currency because returns in that country are lower, leading to a depreciation in the domestic currency.
A central bank can also influence FX markets directly. It can increase the supply of its own currency (£) and buy other foreign currencies, again depreciating the domestic currency.

Volatility of floating rates

Supporters of floating exchange rates argue that if government policies were more predictable and stable, then inflation rates and interest rates would be more predictable and stable.
But floating exchange rates have been more volatile than economists expected them to be in the 1970s.

SPICEE!

There is an easy way to remember the impact of an exchange rate movement: SPICEE!
Strong.
Pound.
Imports.
Cheaper.
Exports.
Expensive(r).

Advantages of Floating Exchange Rates

Floating exchange rates are when the external value of a currency can change continuously because of market forces (due to supply and demand for that currency). There are several advantages to this system.

Stabilise balance of trade

A free floating currency allows for an automatic adjustment mechanism.
- E.g. if there is a current account deficit, this will lead to outflow of currency, causing a depreciation of the currency.
- This depreciation will lead to a greater competitiveness of exports. This will help to improve the current account and partially correct the problem.
When demand for exports rise, the value of the currency will rise making exports more expensive and when demand for exports falls, the value of the currency will fall making exports cheaper.

Freedom to use monetary policy for other aims

It is not possible for a country to have fixed exchange rates, perfect capital mobility and independent monetary policy. This is called the monetary trilemma.
Sacrificing control over exchange rates allows capital (funds) to flow freely into a country, which encourages investment, and also for the central bank to have control over the interest rate, allowing them to better manage inflation.

Less need to hold reserves

With floating rates, there is no obvious need for a central bank to hold foreign exchange reserves. This is because a key reason to hold them is to intervene in the currency market.
With a fixed exchange rate, the Central Bank needs to hold reserves and is vulnerable to speculation.

Disadvantages of Floating Exchange Rates

Floating exchange rates are when the external value of a currency can fluctuate because of market forces (that is, due to supply and demand for that currency). There are also disadvantages to this system.

Increased uncertainty

Increased uncertainty over the exchange rate could mean that long term international investment is discouraged because potential investors will be of unsure of future prices.
This hampers business confidence, which in turn deters investment and could give rise to a negative multiplier.

Cost-push inflation from depreciation

If a currency depreciates, the price of imports rises. This could lead to imported raw material costs rising, leading to cost-push inflation.
Less macroeconomic discipline is needed by a government - if the domestic inflation is higher than foreign inflation rates, the currency will depreciate. This will reduce the difference the impact the inflation is having.

Potential speculation

A freely traded currency can still be vulnerable to speculation as investors try to make investment returns by trading FX.
Higher levels of speculation could in turn increase volatility.

1Microeconomics

1.1Competitive Markets: Demand & Suply

1.1.1Markets & Demand

1.1.2Diminishing Marginal Returns

1.1.3Supply

1.1.4Market Equilibrium

1.1.5Price Mechanism

1.1.6Consumer & Producer Surplus

1.1.7IB Multiple Choice - Demand

1.1.8IB Multiple Choice - Supply

1.2Elasticity

1.2.1Elasticities of Demand

1.2.2Factors Affecting Price Elasticity of Demand

1.2.3Elasticity of Supply

1.2.4Price Elasticity of Supply

1.2.5IB Multiple Choice - Price Elasticity of Demand

1.2.6IB Multiple Choice - Price Elasticity of Supply

1.2.7IB Multiple Choice - Other Elasticities

1.3Government Intervention

1.3.1Indirect Taxes & Subsidies

1.3.2Application Question - Taxing Prices or Quantities

1.3.3Subsidies & Price Controls

1.3.4Deadweight Loss & Government Intervention

1.3.5Elasticity & Tax Incidence

1.3.6IB Multiple Choice - Government Intervention

1.4Market Failure

1.4.1Types of Market Failure

1.4.2Introduction to Externalities

1.4.3Negative Externalities

1.4.4Policy for Negative Externalities

1.4.5Positive Externalities

1.4.6The Deadweight Welfare Loss of Externalities

1.4.7Case Study - The Externalities of Education

1.4.8Public Goods & the Free-Rider Problem

1.4.9Asymmetric Information

1.4.10End of Topic Test - Market Failure

1.4.11Application Questions - Market Failure

1.5HL: Theory of the Firm & Market Structures

1.5.1Theory of the Firm & Market Structures

2Macroeconomics

2.1The Level of Overall Economic Activity

2.1.1The Circular Flow of Income

2.1.2Defining GDP

2.1.3Limitations of GDP

2.1.4IB Multiple Choice - Economic Indicators

2.1.5Business Cycles

2.1.6Output Gaps

2.2Aggregate Demand & Aggregate Supply

2.2.1The Aggregate Demand Curve

2.2.2Components of Aggregate Demand

2.2.3Shape of the Aggregate Demand Curve

2.2.4Shifts in Aggregate Demand

2.2.5IB Multiple Choice - Aggregate Demand

2.2.6Short & Long-Run Aggregate Supply

2.2.7Alternative Models of LRAS

2.2.8Equilibrium in the AD-AS Model

2.2.9Output Gaps & the AD-AS Model

2.3Macroeconomic Objectives

2.3.1Introduction to Unemployment

2.3.2Limitations of Unemployment

2.3.3Types of Unemployment

2.3.4Causes & Impact of Unemployment

2.3.5Defining Inflation

2.3.6Measuring Inflation

2.3.7Use of Index Numbers

2.3.8The Consumer Price Index

2.3.9Consequences of Inflation

2.3.10Causes of Inflation

2.3.11Inflation & Unemployment Tradeoff

2.3.12The Short-Run Phillips Curve

2.3.13The Long-Run Phillips Curve

2.4Economic Growth, Poverty & Inequality

2.4.1Measuring Economic Growth

2.4.2Determinants of Productivity

2.4.3Economic Growth & Productivity

2.4.4Absolute & Relative Poverty

2.4.5Inequality

2.4.6Inequality 2

2.4.7Lorenz Curve

2.4.8Government Policy on Poverty

2.4.9End of Topic Test - Poverty & Inequality

2.4.10Application - Inequality & Poverty

2.5Fiscal Policy

2.5.1Introduction to Fiscal Policy

2.5.2Fiscal Policy and AD-AS Model

2.5.3Fiscal Policy Lags

2.5.4Automatic Stabilizers

2.5.5IB Multiple Choice - Fiscal Policy

2.6Monetary Policy

2.6.1Objectives of Monetary Policy

2.6.2Monetary Policy Implementation

2.6.3Monetary Policy & AD-AS Model

2.6.4Monetary Policy Lags & Pitfalls

2.7Supply-Side Policies

2.7.1Supply-Side Policies

2.7.2Supply-Side Policies 2

3The Global Economy

3.1International Trade

3.1.1Globalisation

3.1.2Globalisation for LEDCs

3.1.3Globalisation for MEDCs

3.1.4Comparative Advantage & Trade

3.1.5Protectionism

3.1.6Arguments for Protectionism

3.1.7Arguments Against Protectionism

3.1.8End of Topic Test - Globalisation & Trade

3.1.9Case Study - Globalisation & Trade

3.2Exchange Rates

3.2.1Floating Exchange Rates

3.2.2Fixed Exchange Rate

3.2.3Effect of a Stronger & Weaker Dollar

3.3The Balance of Payments

3.3.1Balance of Payments

3.3.2Balance of Payments 2

3.3.3FDI & Reducing a BoP Deficit

3.4Economic Integration

3.4.1Customs Unions & WTO

3.4.2Merged Currency

3.5Terms of Trade

3.5.1Absolute & Comparative Advantage

3.5.2Gains from Trade

3.5.3Terms of Trade

3.5.4IB Multiple Choice - Comparative Advantage & Trade

3.6Economic Development

3.6.1Factors Influencing Growth & Development

3.6.2International Institutions

3.6.3Measures of Development

3.6.4Barriers to Development

3.6.5Case Study - The Bottom Billion

3.6.6End of Topic Test - Emerging & Developing

3.7The Role of Domestic & International Factors

3.7.1Interventionist Strategies

3.7.2Development Strategies

3.7.3Development Promotion Policies

3.7.4End of Topic Test - Growth & Global Development

3.7.5Application Questions -Growth & Global Development

3.8The Role of International Trade

3.8.1International Institutions

3.8.2End of Topic Test - Globalisation & Trade

3.9The Role of Foreign Aid

3.9.1Aid

3.9.2Limitations of Aid

3.9.3Support for Aid

3.9.4Application Questions - Developing Countries

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