If you asked the 'Average Joe' what the exchange rate is, he would probably tell you "it's the amount of dollars

(or euros, for example) you get to the pound". Whilst not the perfect definition, he is technically correct. Of

course, most people only need to understand exchanges rates when they go on holiday. As an economist, you

need to understand how they affect thebalance of payments, the inflation rate and many other

important macroeconomicobjectives.

Unfortunately, our layman's definition of the exchange rate is not the only one. In this Learn It, we shall look

at the different definitions of the exchange rate before we go on to investigate more important issues like how

this exchange rate is determined.

The layman's exchange rate

This is the definition that most people understand when discussing the exchange rate. It is often referred to as

the nominal exchange rate. This is defined as the rate at which one currency can be converted, or 'exchanged',

into another currency.

The pound is currently worth about one and a half US dollars. One pound can be converted into one and a half

dollars. This, therefore, is the exchange rate between the pound and the dollar. The table below gives you

some of the exchange rates against the pound over the last 20 years:

Year German mark French franc The euro

1980 4.23 9.83

1981 4.56 10.94

1982 4.24 11.48

1983 3.87 11.55

1984 3.79 11.63

1985 3.78 11.55

1986 3.18 10.16

1987 2.94 9.84

1988 3.12 10.60

1989 3.08 10.45

1990 2.88 9.69

1991 2.93 9.95

1992 2.76 9.33

1993 2.48 8.50

1994 2.48 8.48

1995 2.26 7.87 1.19

1996 2.35 7.98 1.21

1997 2.84 9.56 1.45

1998 2.91 9.77 1.49

1999 2.97 9.97 1.52

2000* 3.24 10.86 1.66

* The exchange rate of the euro is based on the market rate on the 23rd August 2000. The rates for the German

mark and French franc are based on their respective rates against the euro as of 1st January 1999 (which haven't

changed) multiplied by the pound/euro exchange rate on the 23rd August 2000.

The figures for the euro only began in 1995. Pre-1999, these figures represent an average of the 11 countries

that eventually joined the single currency.

As you can see, the pound was particularly strong in the early 80s, due to the effects of being a net exporter of

oil for the first time. It was weak in the few years after the UK fell out of theExchange Rate Mechanism

(ERM), and then rose again from the summer of 1996 to its current high levels. There will be much discussion

of the reasons for these changes in later Learn-Its.

The trade weighted index

The formal name for this measure of the exchange rate is the effective exchange rate. Most newspapers prefer

to use the name 'trade weighted index', probably because it is a better description of the exchange rate itself.

This measure is an index series. The 'numbers' published have no units and the series is based on a base year,

which is currently 1990 (although it could be any year). Changes in this 'number' can be used to measure

percentage changes in the statistic on which the index series is based (in this case, the value of the pound).

Like the Retail Price Index (RPI), which tries to reflect the average price level in the UK across thousands of

goods and services, the trade weighted index is trying to give an idea of the average exchange rate across all

the important currencies. The weights in the average reflect the fact that the UK does more trade with some

countries than others (just like the weights in the RPI reflect the fact that some goods and services are more

important than others).

The example below should help to explain. Assume that the UK only trade with three countries - the USA,

France and Ireland. The table below shows how the nominal exchange rates have changed, but that the value

of the weighted average depends on the importance of the countries in trading terms with the UK.

Country Weight Exchange rate (1998) Exchange rate (1999) % change over the year

USA 50% £1 = %1.50 £1 = %1.65 + 10%

France 40% £1 = 10 francs £1 = 11.5 francs + 15%

Ireland 10% £1 = 2 punts £1 = 1 punt -50%

TOTAL 100%

It should be noted that these exchange rates are not totally accurate. They were picked to make the arithmetic

easy, as you will see.

In the example above, we can see that the pound rose fairly robustly against the dollar and franc over the year,

but the pound fell drastically against the Irish punt. If we took a non-weighted, normal average, we would find

that the pound fell overall against these three currencies:

In other words, each country has a weight of 33%. So, another way of working this out is the following:

What has happened here is that the large fall in the pound's exchange rate against the punt (the least important

currency in terms of trade - hence the 10% weight) has outweighed the significant rise in the pound against the

more important currencies (in terms of trade). This is why weights are used to reflect this importance. Look at

the weighted average below:

In the example that has been constructed, if we assume that the base year is 1998, which is then given the

'number' 100, the 'number' given to the year 1999 is 106, because the weighted average has risen by 6%.

The overall rise in this 'trade weighted index' reflects the fact that the pound rose against the currencies that

made up 90% of the 'importance' of this measure.

The diagram below shows what has happened to the real trade weighted index over the last 20 years:

This graph is only a sketch and uses the figures for yearly averages, but you still get a feel for the trends in the

effective exchange rate over the last 20 years. It should be noted that, just like the RPI, the weights for this

exchange rate do change over time. In the 70s, the weight for the USA was about a third, and the combined

weight for the 15 EU countries was slightly more. The UK now trades much more with the EU than the USA.

The weight for the USA is now nearer one-sixth and the weight for the 15 EU countries is about three-quarters!

It is of no surprise, therefore, that the trade weighted index measure of the pound tends to follow the pound's

course with the euro rather than the dollar. The pound has lost around 8% of its value against the dollar over

the last year. The pound has risen about 9% against the euro in the same time. The trade-weighted index has

risen by about 4% over the year, showing that the influence of the euro is stronger than that of the dollar.

If you put 100 pounds in a bank, and earn 8% interest over the year (eight pounds interest), this is only

the nominal rate of interest. What you really get - the real rate of interest - depends on the rate of inflation as

well. If inflation was running at 5% over the year, then the real rate of interest was only 3% (8% − 5%). Your

100 pounds became 108 pounds, but goods and services costing 100 pounds a year ago now cost 105 pounds.

In real terms you have only really made 3 pounds.

The nominal exchange rate between, say, the pound and the dollar is simply the amount of dollars you can buy

for each pound as dictated by the price in the foreign exchange markets. To find the real exchange rate, we

have to allow for relative inflation rates in the two countries, just as you do with interest rates, of growth, or

spending, or incomes or anything where the price rises distort the picture.

In this case, the picture that is being distorted is the UK's competitiveness, in terms if trade, with other

countries. If the trade weighted index for sterling fell by, say, 5% over a given year, this would make UK

manufacturers' exports 5% cheaper in foreign countries. If sterling falls, UK manufacturers are happy! But if,

over the same period of time, prices in the UK rose by 5%, the benefit in terms of the reduced value of the

pound for UK manufacturers would be cancelled out by the higher domestic prices.

The real exchange rate tries to take relative changes in countries' inflation rates into account. Look at the

formula below:

In this formula, the 'world' price level is an average of the price levels of the sixteen countries that are included

in the trade weighted effective exchange rate. Assume that the UK's effective exchange rate stays constant over

a given year. If UK inflation is 10% over that year, and world inflation is only 7%, then the real exchange rate

will rise by roughly 3% (10% − 7%). The exact rise would be 2.8%. See if you can work out why it is not

exactly 3%. Read through the following example, trying to understand the principles,click to reveal answer

when you have finished.

Assume that the RPI in the UK is 100 and the RPI for the rest of the world also happens to be 100. Hence:

In the example above, we said that UK inflation was 10% over the given year. This gives a new RPI of 110. In

the same way, the new RPI for the rest of the world will be 107. So the new ratio of price levels will be:

So the ratio has risen by 0.028. As a percentage (multiplying by 100) this is 2.8%.

The problem for the UK during the 70s and 80s was that, regardless of how low the effective exchange rate

was, its inflation rate tended to be higher than the world average. This caused the real exchange rate to rise (for

a given effective exchange rate), making UK exports relatively more expensive abroad and so less competitive

pricewise. For a detailed discussion on the competitiveness of UK industry, see the topic called 'Why trade?'

Purchasing Power Parity (PPP)

This is not an official measure of the exchange rate, but is often used to assess at what level the exchange rate

ought to be. PPP gives a 'parity', or exchange rate, based on the prices of a given basket of goods and services

in two different countries.

For example, let us assume that this basket of goods and services contained the price of a bottle of lager, a

pound of cheddar cheese, a litre of petrol and a visit to the cinema. Look at the table below.

Items Britain USA France

One bottle of lager £2.20 $2.90 25 francs

One pound of cheese £2.50 $3.60 20 francs

One litre of petrol £0.80 $0.70 7 francs

A visit to the cinema £4.50 $6.80 53 francs

Totals £10.00 $14.00 105 francs

The four items in question cost £10 in the UK. The same items cost $14 in the USA and 105 francs in France.

So if the exchange rate between the UK and the USA was based on the price of these four goods and services,

it would be £1 = $1.40. The PPP between the UK and France would be £1 = 10.50 francs.

It is often felt that the actual market exchange rates should match these PPPs as closely as possible. The pound

is felt to be overvalued at the moment by around 10% against the euro. Paris always used to be the most

expensive European city in which to spend a weekend. This dubious honour now belongs to London.

ing supply and demand curves

As you have probably worked out by now, virtually any market can be analysed using supply and demand

curves, and the markets for currency are no different. Luckily, in terms of remembering the diagram, the

supply curve has the normal upward sloping look about it, and the demand curve is a normal downward

sloping curve.

Why is the demand curve downward sloping?

Have a look at the diagram below:

This is the standard price/quantity situation, except the 'price' is the price of the pound in terms of the dollar

(i.e. the exchange rate of the pound against the dollar) and the 'quantity' is the quantity of pounds being

demanded.

If the price of the pound in terms of dollars drops in value from $2 to $1, British exports in the USA will

become much cheaper relative to the home-produced goods on offer. The demand for these British exports will

rise in America, and the demand for pounds to buy these exports will also rise as a result. So at lower prices (or

exchange rates) more pounds will be demanded, and vice versa.

Why is the supply curve upward sloping?

In the diagram above, the price of the pound in terms of dollars has risen from $1.50 to $2. This will make the

price of imports from the USA fall and, assuming the price elasticity of demand for these American imports

is greater than one, the amount of pounds that UK consumers will need to supply in order to buy the dollars to

buy the goods will rise. So at higher prices (or exchange rates) more pounds will be supplied, and vice versa.

Putting demand and supply together

In the example, below, we shall be looking at what happens to the exchange rate when an American decides to

buy a British made Rover car. There are two diagrams. One shows what happens to the price of the pound in

terms of dollars, and the other shows what happens to the dollar in terms of the pound:

If an American buys a British Rover, there will be an increase in the demand curve for pounds. The demand

curve will shift from D1 to D2. In order to buy these pounds the supply of dollars will have to rise. The supply

curve in the second diagram shifts to the right from S1 to S2. In the first diagram, the 'price' of the pound rises

from £1 = $1.50 to £1 = $1.60. In the second diagram, the 'price' of the dollar falls from $1 = £0.67 to $1 =

£0.63.

Obviously, if the price of the pound in terms of dollars rises, the price of the dollar in terms of pounds must

fall. Note that the prices used above were made up. It is very unlikely that the changes in demand and supply

of pounds and dollars will cause the exchange rate to change by so much!

From this analysis, it follows that if the value of exports into the USA (from the UK) exceed the value of

imports into the UK (from the USA) then the value of the pound in terms of dollars will rise and the value of

the dollar in terms of pounds will fall. If the UK imports more than it exports (which is more usual) then the

value of the pound will fall.

What affects the 'price' of the pound?

The supply and demand analysis above worked quite well in the days before the war and, to a certain extent, in

the three decades afterwards. This was because there were tight capital controls, so most of the demand for

foreign currencies was for the purposes of importing goods and services. Trade deficits would lead,

eventually, to a fall in the exchange rate, andtrade surpluses would cause the exchange rate to rise.

In the last twenty years, capital markets have been opened up; there are now very few controls on the flow of

capital worldwide. In the UK, the controls on currencies were abolished in 1979; one of the first acts of the

new Conservative government. This has created many more reasons to demand and supply currencies.

Foreign direct investment

The UK is the recipient of the second largest amount of capital from abroad for the purpose ofdirect

investment. Foreign direct investment includes any investment in a business overseas to gain profit. It could

also include the transfer of ownership of businesses across national boundaries. Examples include when Nissan

built a factory in Sunderland, or when Marks & Spencer invested in new shops around the world.

The UK always used to invest more money abroad than foreigners invested in the UK. This has changed

recently, with the net flow of money being into the UK. This means that the demand for pounds for this

investment in the UK is higher than the demand for foreign currencies by UK businessmen investing abroad.

This will cause the pound to rise in value. The diagrams above can be used to show this effect. The principle is

exactly the same as when the demand for pounds to buy British goods out-strips the demand for foreign

currencies to buy foreign imports of goods.

Portfolio investment

Portfolio investment refers to investment in things like shares and bonds. Again, much of this investment

occurs across national boundaries nowadays. If a British resident decides to buy shares in an American

company, this will cause a rise in the demand for dollars in the same way that the purchase of an American

computer does. The standard supply and demand analysis can be used again.

Official reserves

Governments often attempt to influence the value of their currency. If the country in question is part of a fixed

exchange rate system then it is imperative that they use some of their official reserves to buy the currency

when it threatens to drop below the allowed bands, or sell the currency and buy the appropriate foreign

currencies to stop it from rising too high.

But even nowadays, when the pound floats freely on the foreign exchange markets, the government may

intervene if they feel that the market has taken the value of the pound too high (which crucifies exporters with

very high export prices) or too low (which can be very inflationary through higher import prices).

It should be noted, though, that governments are powerless against the power of the foreign exchange markets

if investors and speculators feel that a currency is fundamentally at the wrong level. The total foreign exchange

reserves of all major countries added together are still dwarfed by the daily turnover of foreign exchange in

the world's currency markets.

The UK government spent £7 billion in one day buying various European currencies (especially German

marks) in an attempt to stop the pound from falling out of the Exchange Rate Mechanism (ERM) on the

16th September 1992. They even raised interest rates by 5% on the same day to try and persuade speculators to

buy the pound. The traders just laughed and kept selling the pound. It was a sign of desperation and simply

confirmed that they had been right all along, and that the pound was certain to fall out of the ERM.

Speculation

This is easily the biggest cause of changes in exchange rates in today's world of global capitalism. Numerous

people work in the foreign exchange markets around the world whose sole job is to make money by trying to

predict the movements of currencies. The daily turnover of foreign exchange in the UK foreign exchange

market (the biggest in the world) is now over $600 billion! Whilst not all of this trade is for speculation, the

majority of it certainly is.

So why might a speculator believe that a currency would rise or fall in the future? Here are some of the issues

involved.

Interest rate differentials

Differences in the interest rate of different countries help to explain the differences in exchange rates in the

short and long term. Investors will move spare cash into the currency whose country has the

highest real interest rate. Of course, it is easy to see which country has the highest interest rate, in real and

nominal terms, so the short-term decisions are easy. To see how the currency might move in the long term, the

speculator has to consider the likely future path of interest rates and inflation rates in the relevant countries.

This leads us onto...

Inflation rates

As you can see above, inflation rates affect real interest rates. Over the long term, countries with higher

inflation rates will see their currency drop in value, because their exports will become uncompetitive, reducing

future demands for their currency.

But as we have already seen, currency transactions for trade form a tiny proportion of total currency

transactions. Speculators are nervous of investing in currencies whose inflation rate is starting to rise. This may

be suggesting that the economy is over-heating. As night follows day, recessions tend to follow booms in the

economy. This leads us onto the third point.

The state of the economy

The exchange rate of an economy is, in a sense, its barometer. Generally, economies that are 'doing well' have

relatively strong currencies. Economies that are failing will have relatively weak currencies.

The recent economic history of the UK is a classic example. Economic theory suggested that the value of the

pound should have started to fall in the summer of 2000 as the trade deficitrose to record levels. The demand

for the pound for UK exports was low relative to the demand for the currencies of the foreign imported goods

that UK consumers were buying. In the 60s, this would have led to a 'sterling crisis' and the value of the pound

would have dropped like a stone.

Today, speculators dominate the market for currencies. They don't care about a large trade deficit as long as

they think it can be financed. The pound stayed strong because the speculators were confident that the trade

deficit could be financed; the fundamental strength of the economy gave the UK a 'safe haven' status in the

currency markets. Whilst the strength of the UK economy was attractive, its stability was paramount. This

appeals to investors and speculators alike.

The theoretical link

For those of you who have not read the previous Learn-It, here is a quick recap. Theoretically, acurrent

account deficit should cause the value of the pound to fall. In this case, the value of imports into the UK is

higher than the value of exports sold to foreigners. Hence, the demand for foreign currencies to buy these

imports is higher than the demand for the pound to by our exports. Simple supply and demand analysis,

therefore, suggests that the value of the pound should fall. For a current account surplus, simply reverse the

above explanation.

In the case of a deficit, the subsequent lower value of the pound will make exports relatively cheaper and

imports relatively more expensive. The value of exports sold should rise and the value of imports bought

should fall. The deficit should be eliminated automatically (again, reverse the explanation for a surplus).

This story worked well until the controls on the world capital markets were lifted. Once capital could go

wherever it wanted, currency transactions for investment and speculative purposes took over. A country's trade

position is no longer relevant. If an economy is doing well, which usually means that consumer spending is

high (spending on imports in particular), a current account deficit is expected. Perversely, instead of the

currency falling for the reasons outlined above, the currency is as likely to rise, because investors and

speculators like to place their money on 'winners' (for example, economies that are doing well). In fact, a

currency may even rise following a cut in interest rates (which would normally cause the currency to fall

following the outflow of money trying to find better rates elsewhere) because the markets may take it as a sign

that the economy will improve in the future! See the previous Learn-It for more discussion on the

determination of the exchange rate.

In the rest of this Learn-It, we shall be looking at the theoretical relationship between a change in the exchange

rate and current account disequilibria.

The Marshall Lerner condition

Assume that the UK has a current account deficit (which is not hard to do!). If the pound were to devalue (a

large drop in its value) then one would expect the deficit to reduce. Why? Because exports will become

relatively cheaper, and so their demand should rise in foreign markets, and imports will become relatively

more expensive, so their demand should fall in the UK.

But will this always be the case? The success of a devaluation of the pound in terms of reducing a current

account deficit will depend on foreigners' elasticity of demand for British exports and UK consumer's

elasticity of demand for foreign imports.

The Marshall Lerner condition states that for a devaluation to be successful in terms of a reduced current

account deficit, the sum of the two elasticities, must be greater than one.

To illustrate that this should be true, let's look at exports and imports separately.

Export elasticity

If you think about it, UK exporters can't go wrong if the pound falls in value. How ever small

thedepreciation in the pound is, and however low the elasticity for their exports is, the revenue they will

receive will have to rise.

For example, let's take a car company that is exporting cars to the USA whose price is £10,000 in the UK. Let

us also assume that the exchange rate between these two countries is £1 = $2. These cars will have a price of

$20,000 in the USA. Now assume that the pound devalues by 10% so that the new exchange rate is £1 = $1.80.

The price in the USA is now $18,000. Unless the elasticity of demand for these cars in the USA is zero (highly

unlikely) then the demand for these cars in the USA will increase. Although American consumers now only

have to pay $18,000, the British car company still receives £10,000 for each sale. However large or small the

fall in the value of the pound is, the sterling price of the car stays the same. Even if this company only sells one

extra car, they will still receive an extra £10,000.

In summary, for export revenue to rise following a devaluation of the pound, the elasticity of demand for these

exports simply has to be greater than zero (which is perfectly inelastic demand). Obviously, the higher the

elasticity the bigger the increase in export revenue, but anything over zero will help reduce the current account

deficit.

Import elasticity

In the case of imports the situation is a little less favourable. A devaluation of the pound will cause the price of

imports into the UK to rise. The demand for these imports will fall, but the revenue that the foreign producers

receive will not necessarily fall.

For example, assume that an American car company exports their cars into the UK. The price for these cars in

the USA is $30,000. Again, assume that the initial exchange rate is £1 = $2. This means that the price of these

cars in the UK will be £15,000. Now assume that the pound devalues by 25% giving an exchange rate of £1 =

$1.50. Swapping this exchange rate around to give the price of dollars in terms of pounds, we have $1 = £0.67.

So now the American cars are priced at £20,000 in the UK. The change in the revenue received by the

American car company will depend on the elasticity of demand for their cars in the UK.

Assume that the elasticity is 1.5, which is relatively elastic. As you will know from the topic called

'Elasticities', if demand is relatively elastic and the price rises, the decrease in demand will be relatively larger.

This means that the loss in revenue from the decrease in demand is higher than the gain in revenue on each unit

due to the higher price. The diagram below helps to explain:

Note that the elastic demand curve is relatively flat, so that when the price rises, the fall in demand is relatively

larger, and the 'gain' box is much smaller than the 'loss' box. The moreelastic the demand for UK imports is,

the more successful a devaluation will be in terms of reducing import revenues (which go out of the country)

and the bigger the reduction in the current account deficit.

Now assume that the elasticity is 0.5, which is relatively inelastic. Again, you should know that, in this case,

when the price rises, the decrease in demand in relatively smaller. This means that the loss in revenue from the

decrease in demand is lower than the gain in revenue on each unit due to the higher price:

This demand curve is relatively inelastic, and so is fairly steep. You can see that the price rise is

proportionately much larger than the fall in demand, so the 'gain' box is much larger than the 'loss' box. If the

demand for UK imports is relatively inelastic then devaluation will result in increasing import revenues

(which go out of the country), which contribute to a larger current account deficit.

Putting exports and imports together

So, the condition for exports and imports separately can be summarised as follows:

Eex > 0 for a devaluation to increase export revenues

Eim > 1 for a devaluation to reduce foreigners import revenue

By adding the zero and the one, we get the following overall condition:

Eex + Eim > 1 For a devaluation to be successful in terms of reducing a current account deficit.

Note that, overall, as long as the two elasticities add up to more than one the devaluation will reduce the

deficit, even if the two individual conditions above are not satisfied. For example, if Eex = 0.6 and Eim = 0.6,

import revenue will rise following a devaluation, but this will be more than compensated for by a larger rise in

export revenue. The elasticities add up to 1.2, which is more than one, so overall the situation improves.

Obviously, the higher both elasticities are, the more successful devaluation will be in terms of reducing the

current account deficit.

The J-curve

As the title suggests, this is a curve that is shaped like a 'J'. Look at the diagram below:

Let us assume that the economy is at point A, experiencing a current account deficit. The government decides

to devalue the pound to help eliminate this deficit. The J-curve shows that, in the short term, the deficit may

get bigger before, eventually, it starts to reduce. In other words, the Marshall Lerner condition is not satisfied

in the short run, even though it will be in the medium to long term.

Why might this be the case? The main reason is time lags. It takes time for producers and consumers to adjust

their purchases to the changed prices brought about by the devalued exchange rate. Certainly, firms will have

orders planned in advance, and will not react to the price changes for a number of months.

Exports revenues may not rise immediately, but they will not fall either, but foreign import revenues may well

rise, as increased import prices are combined with static, or at least very inelastic, demand. The current account

deficit will probably get worse. After a period of time, foreigners will react to the lower export prices and UK

firms and consumers will react to the higher import prices. The Marshall Lerner condition should be satisfied

as demand for both exports and imports become more elastic and the deficit should start to fall.

Remember that higher import prices will feed through to higher inflation eventually. This will reduce the

competitiveness of British industry causing long-term problems for the current account. This is why many

politicians see devaluation as failure. Once the economy is past the trough of the J-curve and the deficit is

falling, the devaluation may seem like a good idea. But the subsequent rise in inflation (the government's

number one macroeconomic objective nowadays) and its implications for competitiveness mean that

devaluation is never a good long-term solution. British exporters complain of the high pound, but devaluation

will not necessarily do them any favours.

It should be noted that in today's world of free flowing capital, it is very hard (some would say impossible) for

a government to actually implement a policy of devaluation. The markets decide the country's exchange rate.

When the UK was part of the Bretton Woods fixed exchange rate system, occasional 'realignments' would

occur (i.e. devaluations). Now that the pound floats on the foreign exchange markets, the currency

might appreciate (rise gently in value) or depreciate (fall gently in value) but big, one off drops in the value

of the currency do not really happen. The last big devaluation was when the pound fell out of the ERM and the

pound fell by around 15% in one day.

The 'upside down' J-curve

The analysis above can work for countries with persistent current account surpluses that they want to

eliminate. Look at the diagram below:

Assume that the economy is at point B, experiencing a current account surplus. Rather than devaluation, the

government will want to revalue their currency to make exports relatively more expensive (reducing their

demand) and imports relatively cheaper (increasing their demand). Again, there will be time lags. Consumers

and producers will not react to these changes immediately. The demand for both exports and imports will be

relatively inelastic in the short run. Export revenues will not change (a fixed UK price, remember) but the

revenue paid for foreign imports will fall. This will make the current account surplus get even bigger in

the short run.

In the medium term, firms and consumers will adjust their purchases in line with the changed prices. The

demand for both exports and imports will become more elastic and the surplus will eventually start to fall. The

result is an upside down J-curve!

Broadly, exchange rate systems fall into two categories, fixed systems and floating systems. As the name

suggests, in a fixed system, the currencies involved are not allowed to appreciate or depreciate against each

other. If a currency is floating, then it 'floats' around taking any level it wants; its value is determined in the

foreign exchange markets.

Few exchange rate systems are totally fixed. The eleven countries that are currently involved in the single

currency are, in a sense, part of a totally fixed exchange rate system. Their currencies were totally fixed as of

1st January 1999. But one could argue that they are not part of a fixed exchange rate system any more; they

have become one and share a single currency.

Fixed exchange rate systems of the past have tended to be 'fixed but adjustable'. This meant that the

participants fixed their currency at some central rate, but were allowed to move it up and down within quite

tight bands, say, +1%. These systems tended to allow for 'realignments' as well. If one of the countries kept

recording current account deficits, meaning that their exchange rate within the fixed system was obviously

wrong (too high), the currency would be allowed to devalue to a new fixed parity. Obviously these

'realignments' were not regular occurrences. If currencies were realigning every five minutes it wouldn't really

be a fixed exchange rate system anymore.

The next few sections will look at some past examples of these systems. After that, we shall look at the

advantages and disadvantages of fixed and floating exchange rate systems.

The Bretton woods system

This was the system set up after the Second World War to promote stability and help the countries in the world

that had persistent trade imbalances. The International Monetary Fund (IMF) was set up to oversee the

system. Every country chose its own initial exchange rate. This was done by choosing the number of units of

their currency that they were prepared to exchange for an ounce of gold, valued at $35. This is why the dollar

was the currency in which all other currencies were expressed.

In any one year, a country's currency could move by +1% against the chosen rate. Countries with severe and

persistent current account deficits were allowed to devalue their currency and countries with persistent

surpluses could revalue their currency, as long as the IMF agreed that the balance of payments were in

'fundamental disequilibria'. Hence, exchange rates were fixed, but not totally fixed. The system became known

as the 'adjustable peg' system.

The IMF also had a lot of funds at its disposal (provided by the rich members of the system) to help poorer

countries who had low reserves and whose poor international credit rating meant that it was difficult to borrow

reserves from foreign countries. The money provided was only a loan, and only granted under certain

conditions, but it did stop failing countries from going under.

The system worked well, but some argued that it was a little inflexible. In over twenty years, there were only

six 'adjustments' in terms of revaluations and devaluations. Most famously, the UK devalued twice, in 1949

and 1967. The second devaluation is remembered by most for the 'pound in your pocket' speech by the Prime

Minister, Harold Wilson. He was trying to explain to the general public that a devalued currency did not mean

that 'the pound in your pocket' had been devalued (i.e. a pound was still a pound as far as UK shopkeepers

were concerned). Of course, he did not explain that the inflation that tends to be a by-product of a devaluation

will, in real terms, reduce the amount that any given pound can buy in the shops.

To be fair, it was a difficult balance for the IMF. Too many 'adjustments' and the system would lose its

stability, credibility and discipline. But if there were too few (as many critics argued) then too many countries

go through years of disequilibria and hardship. If a deficit country could not devalue, then the only way to cut

imports was to deflate the economy. Import controls could be used, but the likely retaliation meant that this

policy was self-defeating.

Things started to go badly wrong in the early 70s. The system was based on dollars, which, according to IMF

rules, could be converted into gold at the price of $35 an ounce at any time. The USA, on whose gold the

whole system was based, started to run up huge current account deficits, partly due to the Vietnam War.

Countries panicked, saw that the USA's gold reserves were running down and tried to convert as many of their

dollar reserves into gold as possible. This could not go on. The USA announced that the dollar would no

longer be convertible into gold.

To cut a long story short, the system broke down after this. The UK pulled out of the system in 1972 and a few

years later, just about all countries were part of a floating exchange rate system.

Floating exchange rates

The UK has had a floating exchange rate for every year since 1972 except for the two years of the ERM (see

below). Basically, the laws of supply and demand dictate the value of the pound on any given day.

As explained in the last Learn-It, a floating currency should automatically eliminate any current account

deficits or surpluses. Of course, nowadays-capital flows far outweigh any currency flows required for trade so,

perversely, the value of the pound can be rising even if the current account deficit is rising (the situation in the

summer of 2000).

Textbooks often refer to 'dirty floating' exchange rate systems. This is where the exchange rate is technically

free to float, but governments may intervene from time to time, so the currency does not float in a pure 'clean'

market. The floating is 'dirty' to a certain extent.

Currencies rarely float totally free of intervention. The UK government will get nervous if the pound is too

high. Exporters will get very uncompetitive on price, which could cause firms to close down resulting in job

losses. In this case, the government might intervene by using pounds to buy foreign currencies and build up

their foreign reserves. This will artificially increase the demand for foreign currencies relative to the pound,

and so the value of the pound should fall.

The government will also be apprehensive if the pound is too low. This is great for exporters, but pushes

import prices up to a relatively high level, causing inflationary pressures. This time, the government will use

some of their foreign reserves to buy pounds in the foreign exchange markets. This will artificially increase the

demand for pounds relative to other currencies, and so the value of the pound should rise.

Advantages and disadvantages of fixed and floating systems

As you have seen, each system has its good and bad points. We shall summarise them below, starting with

fixed exchange rate systems.

The advantages of a fixed exchange rate system

Stability

Some economists would argue that this is the most significant advantage. If exchange rates are stable over a

given period of time, exporting firms will be able to plan ahead without worrying about huge swings in the

value of the pound eliminating their profit margin. This will encourage more investment and trade between

countries, both of which are important if economies are to grow in the long term.

Discipline

If a country is part of an exchange rate system, they cannot devalue their currency at the first sign of trouble

(i.e. a large current account deficit). They have to try and cure the fundamental problem by, for example,

improving the competitiveness of their exporters through increased productivity and improved quality.

One can also argue that fixed exchange rate systems discipline countries into keeping inflation down. Again,

there is no option to devalue if increasing inflation leads to reduced competitiveness. This was the case with

the UK in the ERM. Their actions were effectively dictated by the actions of the strongest member of the

system, Germany. They were notoriously strict on inflation, perhaps keeping interest rates higher than they

needed to be. The UK was forced to follow suit and keep interest rates relatively high to keep the pound within

the ERM. The system almost forced the UK to keep inflation down. Others would argue that the ERM simply

forced the UK to stay in a recession. Anyone can keep inflation low by having a recession!

Avoid speculation?

Theoretically, fixed exchange rates should eliminate speculation because there is no point buying and selling

currencies that will not change in value. In the real world, this is not always the case. The story of the pound

falling out of the ERM is a classic example where this theory went a bit wrong!

Having said that, in the run up to the introduction of the euro (a totally fixed exchange rate system!) the rates

were fixed six months before the start date of the 1st January 1999 and lots of speculation against these rates

was predicted. In this case, it simply did not happen. Speculators believed the politicians when they said that

these rates were forever, and so did not see the point in buying or selling the currencies involved. Of course,

the euro was sold after its introduction, but that is a different story (see the next Learn-It).

The lesson, therefore, is that systems that are credible will experience less speculation. Systems, or members

within systems, that do not inspire confidence may well have to put up with lots of speculative buying and

selling.

The disadvantages of a fixed exchange rate system

The loss of monetary policy

As the UK government found when they were part of the ERM, a commitment to a fixed exchange rate means

that you lose control over all other instruments of monetary policy. Although the government pretended that

UK interest rate decisions we still their own (and technically they were) any movement of the German interest

rate was usually quickly followed by a similar change in the UK. Today the Monetary Policy Committee

(MPC) can set interest rates at whatever level they want, but they cannot control the value of the pound at the

same time. Controlling one of these two instruments means a loss of control of the other.

The need for a large pool of reserves

To maintain the pound's value within the ERM, the government had to have a large pool of foreign reserves

with which to buy the pound when it fell to the floor of the bottom band. Apart from being expensive in itself,

some countries may find it hard to get their hands on sufficient stocks of reserves to support their currency.

One of the main jobs of the IMF in the Bretton Woods system was to help poor countries in times of trouble

and lend them reserves when they were short.

Problems of uncompetitiveness

With a freely floating currency, a deteriorating trade situation should automatically cause the pound to fall

(speculators permitting!), which, in turn, would improve the competitiveness of British exporters and improve

the trade balance.

Economies stuck in a fixed exchange rate system with a deteriorating trade balance may feel that they joined

the system at too high an exchange rate. Although they may be allowed to devalue eventually, the exchange

rate may be at the wrong rate for significant periods of time. This can cause permanent job losses and

recession. Some economists feel that the recession of 1990-92 in the UK was prolonged due to membership of

the ERM.

Advantages of a floating exchange rate system

Theoretical elimination of trade imbalances

As we have stated before, floating exchange rates should adjust automatically to trade imbalances, which, in

turn, will eliminate the trade imbalance. Of course, it has also been noted that this does not always work in the

real world because so few currency transactions that take place are for trade.

No need for reserves?

On the whole, foreign reserves are used to help maintain a currency's position within a fixed exchange rate. If a

currency is freely floating, then there is no need to use reserves to affect its value. In the real world,

governments will always have some reserves, in case of a crisis in the balance of payments, or if they feel that

their currency is getting a bit too high or too low.

More freedom over domestic policy

As was stated above, if the government is not controlling their exchange rate, then they cancontrol their rate of

interest. The evidence of the past five years suggests that, although exporters suffer with a strong pound, the

economy as a whole is best served when the authorities can control domestic monetary policy.

The disadvantages of a floating exchange rate system

Speculation

Again, there are two ways of looking at this. You could argue that with floating exchange rates, speculation is

less likely because an exchange rate can move freely up or down, so it is more likely to be at its true level. But

the very fact that it does move up and down easily means it can move a long way if speculators think that it is

at the wrong level. The quick rise in the value of the pound in the second half of 1996 showed that big swings

in currencies do not just happen when speculators force them out of fixed exchange rate systems.

Uncertainty

The biggest advantage of fixed exchange rate systems was their stability and certainty. This tended to increase

investment and trade, both good things. The biggest disadvantage of floating exchange rate systems is their

uncertainty, reducing the rate at which investment and trade increase. Firms often use the currency markets to

hedge against large fluctuations in the exchange rate, which helps to a certain extent, but there is still felt to be

too much uncertainty.