Principles of Economics II 20/12/2021

SAC 303/STA 307 - PRINCIPLES OF ECONOMICS II

3RD YEAR ACTUARIAL SCIENCE

Presented by:
Margaret Amondi
Monday, 20 December 2021 1

Course Outline

Lesson Topic
1 ➢Introduction to Macroeconomics
2-4 ➢Macroeconomic Variables
5 ➢ AD – AS Model
6 ➢ International Trade
7 ➢ Exchange Rates
8 ➢ Balance of Payments
9 ➢ Fiscal Policy
10 ➢ Monetary Policy
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Principles of Economics II 20/12/2021

Course Outline

Exchange Rates
➢ Definition
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➢ Determination of Exchange Rate
➢ Pros and Cons of Exchange Rate Determination Methods

Exchange Rate
Definition
An exchange rate is the rate at which one currency trades for another on the foreign exchange
market.
Below is an extract of exchange rates from Equity bank.

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Principles of Economics II 20/12/2021

Exchange Rate
Determination of Exchange Rate: Free Market
In a free foreign exchange market, the rate of exchange is determined by supply and demand.

A floating exchange rate occurs

when the government and
central bank do not intervene in
the foreign exchange markets, so
that the exchange rate is
determined solely by supply and
demand.

A fall in the free-market exchange rate of the domestic currency in terms of a foreign currency is
called a depreciation.
A rise in the free-market exchange rate of the domestic currency in terms of a foreign currency is
called an appreciation. 5

Exchange Rate
Causes of a currency depreciation
1. A shift of demand curve to the left – Lower demand
2. A shift of the supply curve to the right – Higher supply
3. Both

Factors
i. A fall in domestic interest rates –thus increasing the supply of the domestic currency and
decreasing the demand for it.
ii. Relative investment prospects improving abroad – so investment moves abroad
iii. Higher inflation in the domestic economy than abroad – so home-produced goods are less
competitive
iv. A rise in domestic incomes relative to income abroad – so the demand for imports increases
v. Speculation resulting from the expectation that the exchange rate will fall – so dealers sell
the currency.

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Principles of Economics II 20/12/2021

Exchange Rate
Exchange rates and the balance of payments
Floating Exchange Rate

As the supply and demand of the currency balances, the debits and credits on the balance of
payments must also balance. Hence a floating exchange rate will ensure that the balance of
payments will automatically balance.

For example, consider a country that has successfully increased its exports. The current account will
move towards a greater surplus.
Increased exports will increase the demand for the domestic currency, which puts upward pressure
on the exchange rate.
However, this makes investments in the country appear relatively more expensive, which leads to a
net outflow of investment funds and an increasing financial account deficit.

The current account surplus will be matched by an equal financial account (plus capital account)
deficit, ensuring an overall balance.
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Exchange Rate
Government/Central Bank Intervention
Adjustable Peg

Under the adjustable peg system, exchange rates are fixed for a period of time, but may be
devalued (or revalued) if a balance of payments deficit (or surplus) becomes too great.
Managed Flexibility

Under managed flexibility exchange rates are allowed to float. However, governments
may intervene to prevent excessive fluctuations or to maintain an unofficial exchange
rate target.

Exchange rate mechanism (ERM)

A group of countries may agree to keep their exchange rates with each other within
certain bands. These currencies continue to float freely against all other currencies.

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Principles of Economics II 20/12/2021

Exchange Rate
Government/Central Bank Intervention
Countering downward pressures on the exchange rate
Short term strategies
Selling gold and foreign currency reserves to increase demand for the domestic currency
Borrowing in the form of a foreign currency loan in order to buy the domestic currency and so
increase demand
Raising interest rates to increase deposits from overseas savers (increasing demand) and reduce
deposits overseas by domestic savers (decreasing supply).
Long term strategies
Supply-side policies - policies can be used to improve the quality and/or the price
competitiveness of domestic goods, which will increase exports and the demand for the
domestic currency.
Control imports

Exchange Rate
Fixed versus floating exchange rates
Advantages of free-floating exchange rate

Balance of payments disequilibria are automatically corrected by movements in the exchange

rate
There is no problem of international liquidity and no need for central bank reserves
Countries are not tied to the (possibly unacceptably high) inflation rates of others
External shocks can be dealt with rapidly by a depreciation or appreciation of the exchange rate
Domestic macroeconomic policy isn't constrained by the need to maintain a fixed exchange rate

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Principles of Economics II 20/12/2021

Exchange Rate
Fixed versus floating exchange rates
Disadvantages of free-floating exchange rate

Unstable exchange rates can be a problem for firms with contracts with overseas suppliers or
distributors
Speculation can lead to high levels of exchange rate volatility
Exchange rate uncertainty can discourage international trade and investment
Governments may lack the discipline of maintaining a stable exchange rate and allow the
economy to fall into a cycle of expansion and contraction.

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Exchange Rate
Fixed versus floating exchange rates
Advantages of fixed exchange rates

International trade and investment are less risky as profits are not affected by the
exchange rate
A reduction in speculation on exchange rate movements if everyone believes that
exchange rates will not change

Disadvantages of fixed exchange rates

Exchange rate policy may conflict with the interests of domestic business and the
economy as a whole e.g an economy in recession may require interest rate cuts to stimulate
consumer spending and investment, but increases in interest rates may be required to
maintain the exchange rate.

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Principles of Economics II 20/12/2021

Exchange Rate
Fixed versus floating exchange rates
Disadvantages of fixed exchange rates

Competitive contractionary policies leading to world depression

Countries may aim to achieve a balance of payments surplus in order to build up their reserves.
As we have seen, one way to do this is to adopt contractionary policies that decrease aggregate
demand in the domestic economy. However, countries in surplus must be balanced by countries
in deficit. If each country attempts to have lower demand than the next, a world depression
may result.

Speculation
If a devaluation is expected, due to a large balance of payments deficit for example,
then speculators will sell the currency now, hoping to buy it back at a profit after the
devaluation. These additional currency sales will add further downward pressure on the
exchange rate making a devaluation more likely.
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Course Outline

Lesson Topic
1 ➢Introduction to Macroeconomics
2-4 ➢Macroeconomic Variables
5 ➢ AD – AS Model
6 ➢ International Trade
7 ➢ Exchange Rates
8 ➢ Balance of Payments
9 ➢ Fiscal Policy
10 ➢ Monetary Policy
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Principles of Economics II 20/12/2021

THANK YOU

CONTACT: [email protected]
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