Market forces are the determinant of exchange rates in a freely floating exchange rate system

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journal article

The Review of Economics and Statistics

Vol. 61, No. 3 (Aug., 1979)

, pp. 327-333 (7 pages)

Published By: The MIT Press

https://doi.org/10.2307/1926061

https://www.jstor.org/stable/1926061

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The Review of Economics and Statistics is an 84-year old general journal of applied (especially quantitative) economics. Edited at Harvard University's Kennedy School of Government, The Review has published some of the most important articles in empirical economics. From time to time, The Review also publishes collections of papers or symposia devoted to a single topic of methodological or empirical interest.

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There are many different currencies in the world. What currency do you use? Is it the euro, pounds, dollars or something else? While there are many different currencies, there are also many different types of exchange rates a country can choose between. In this explanation, we will look at one of these exchange rate types.

Types of exchange rates

There are three different types of exchange rates:

1. Floating exchange rate
2. Fixed exchange rate
3. Managed exchange rate

Here we will focus on the floating exchange rate, although we will also discuss the managed exchange rate.

A free-floating exchange rate system is one where the government does not intervene, whatsoever, in determining the exchange rate.

Demand and supply from the free market determine the exchange rate.

A managed exchange rate system is similar to a free-floating exchange rate because demand and supply value the currency and determine its exchange rate. The only difference is that the government or central bank can intervene.

These interventions usually happen in response to volatility and to smooth out fluctuations in the currencies. This system is also called ‘Dirty float’.

To understand the floating exchange rate, you should also keep the following definitions in mind:

The depreciation of a currency is the fall in the value of a currency due to free-market forces.

The appreciation of a currency refers to a rise in the value of a currency due to free-market forces.

Depreciation and appreciation are only used in the context of a floating exchange rate.

How is a floating exchange rate determined?

Simply put, free-market forces determine the value of a floating exchange rate. However, the main free market determinants are:

1. Trade
2. Investment
3. Speculation

These market determinants are influenced by supply and demand.

Let’s look at an example for each main market determinate using the United States Dollar (USD) as our base currency.

Trade

Let’s imagine that the USA’s small to medium enterprise exports rise by 60% and that China is its top buyer this year.

How will this impact the USD?

Figure 1 below illustrates this for us.

Figure 1. Exchange rate $ to ¥, StudySmarter Originals

More US exports will be sold to China. This increase in demand for US exports will also increase the demand for US dollars. This is why the demand curve shifts outwards from D1 to D2. The exchange rate of US dollars to the Chinese Yuan rises, so the US dollar appreciates.

Investment

Imagine that Nigeria attracts $40 billion (USD) in foreign direct investment (FDI).

Figure 2 illustrates the impact on the USD.

Figure 2. Exchange rate $ to ₦, StudySmarter Originals

Remember that for Nigeria, it is an inflow of $40 billion while for the US it is an outflow. Because of this, the supply for US dollars increases, thus the supply curve shifts outward from S1 to S2. This leads to a depreciation of the US dollar.

Speculation

Let’s imagine that the US is having an election and people believe that due to the uncertainty, the US dollar is going to fall in value.

Figure 3 illustrates the impact on the USD.

Figure 3. Exchange rate of $, StudySmarter Originals

Due to this speculation, investors will avoid buying the dollar. This causes the demand for the dollar to fall from D1 to D2. Investors will sell the dollar and this increases the supply of US dollars in the money market, so the supply curve shifts from S1 to S2. Due to the fall in demand and increase in supply, there is a double shift with both curves: the demand curve shifts inwards, whilst the supply curve shifts outwards. This results in a depreciation of the US dollar.

Fluctuation in the free market forces and the floating exchange rate

As we know, a floating exchange rate is determined by free-market forces. However, these forces are based on demand and supply which can fluctuate at any moment.

Some fluctuations in the free market that can influence a floating exchange rate are:

• Inflation rates: higher inflation rates make a country's exports less price competitive in comparison to other countries. Exports will fall and imports will rise. Demand for a country's currency will fall and its supply will increase, thus its currency will depreciate.
• Interest rates: high interest rates lead to 'hot money inflows'. This means that investors will exchange their currency for that of the country with higher interest rates because they gain more investment returns. All of this leads to increasing demand for that currency. Supply will fall, causing an appreciation of that currency.
• Economic growth: economic growth will cause an appreciation in a currency. This is because markets will expect interest rates to rise when a country is experiencing rapid growth. Higher interest rates lead to hot money flows that increase demand for a currency.
• Government and other authorities: fluctuations in the exchange rate could also happen due to the central bank or the government buying and selling currency. When they sell their currency, they increase the supply of that currency causing it to depreciate. Appreciation of their currency occurs when they buy their currency back. This only applies to a managed exchange rate, as governments won't intervene if they have a floating exchange rate.

Countries with a floating exchange rate

From past examples in this article, we know that the US has a floating exchange rate. Some other countries with a floating exchange rate are:

• Australia - AU dollar (AUD)
• Canada - CA dollar (CAD)
• Japan - JP yen (JPY)
• Chile - Chilean pesos (CLP)
• Mexico - Mexican pesos (MXN)

Countries are free to adopt whichever system works better for their macroeconomic policy planning. Sometimes, countries move from one system to the other as they grow or change the course of their economic planning.

Advantages of a floating exchange rate

Many countries and governments opt for a floating exchange rate for many different reasons. Some of the advantages of that system are:

• Partial correction for a current account deficit. Due to the frequent changes in the free market, a currency doesn't stay over- or under-valued for long. With an overvalued rate, exports become uncompetitive and market forces adjust the rate by pushing it downwards and towards a new equilibrium. Likewise, an undervalued rate is adjusted by being pushed upwards.
• No government effort or intervention. Governments and central banks don't have to intervene to fix the exchange rate. In free float, exchange rates respond, self-correct, and reach equilibrium automatically. This frees the governments to focus their resources on achieving other economic objectives.
• Freedom to set monetary policyinterest rates. A floating exchange rate system operates independently. This means that the events of the world have less weight and resources can be freed up to focus more on the domestic economy.

  In a fixed exchange rate system, interest rates are established for keeping the exchange rates fixed rather than due to their impacts on the local economy.

• Reduces large currency reserves. Governments and central banks don't need to hold large amounts of currency reserves to buy back or sell their currency. The cost of holding these reserves are very expensive so the government can use this money elsewhere in the economy.

Disadvantages of a floating exchange rate

The floating exchange rate system has some disadvantages too. Some of them are:

• Volatility. The free market is prone to sharp fluctuations and this also impacts a floating exchange rate. These fluctuations can wipe out the value of a currency in a single day. Because of how volatile it can be, investors might stay clear of these currencies. Deterring investment can severely impact a country's economic growth and development.

• Instability. Due to internal and external factors, such as speculation, there is no guarantee that a floating exchange rate will be stable. This instability in a currency can impact both consumer and business confidence which will ultimately lead to lower consumption and investment which will restrict economic growth.

• Doesn't correct a current account deficit. One advantage of a floating exchange rate was that it was a partial correction for a currency account deficit. However, this only holds true if the Marshall Lerner condition holds true. If this condition is not met, then a current account deficit will not be corrected automatically.

The Marshall Lerner condition and the J curve

The Marshall Lerner condition states: ‘A depreciation of the exchange rate will eventually lead to an improvement in the current account provided the sum of the price elasticity of demand (PED) for exports and imports > 1’.

Why is this the case?

Remember that there is a link between total revenue and PED. Total revenue increases when prices decrease when the demand curve is elastic. When the demand curve is inelastic, and prices are still increasing, total revenue decreases. You can see this in the table below.

Table 1. The link between PED and total revenue.

This can be applied to the PED of exports and imports.

Imagine the PED for exports is inelastic. A country wants its exports to be price competitive so it has low prices. From the bottom row of the table, we can see that a decrease in price leads to a decrease in total revenue. Thus, export revenue will fall.

If the PED for imports is inelastic, and import prices are high, a country spends more on imports. For their trading country, their total revenue will increase.

PED(X-M) inelastic will worsen the current account deficit and depreciate a currency.

The J curve also illustrates this point graphically.

Figure 4. J curve, StudySmarter Originals

Initially, the current account deficit worsens in the short term. This is because Marshall Lerner's condition is not met. But in the long term, the current account starts to improve as the condition holds true and consumers start to realise the gains in the change in the exchange rate.

Floating Exchange Rate - Key takeaways

• A free-floating exchange rate system is one where the government does not intervene, whatsoever, in determining the exchange rate.
• A floating exchange rate can either depreciate or appreciate.
• A floating foreign exchange rate is determined by free-market forces. The main free market determinants are trade, investment, and speculation.
• Some countries with a floating exchange rate are the US, Australia, Canada, Japan, Chile, and Mexico.
• Factors that affect a floating exchange rate are inflation rates, interest rates, economic growth and governance.
• The advantages of a floating exchange rate system are that it is a partial correction for a current account deficit, it doesn’t require any government effort or intervention, governments are free to set monetary policyinterest rates, and it reduces the need for large currency reserves.
• The disadvantages of a floating exchange rate system are that it can be volatile, unstable and it doesn't automatically correct a current account deficit if the Marshall Lerner condition is not met.

Is exchange rate determined by market forces?

What determines the value of a freely floating exchange rate?

What are the forces that determine exchange rates?

Are floating exchange rates market determined?