Fiscal Policy

Question

What is the importance of exchange rates?
Who benefits and who loses when a country’s currency appreciates?
Who benefits and who loses when a country’s currency depreciates?
In the long run, what are the major factors that impact exchange rates?
Understanding central banks impact exchange rates, select three central banks and demonstrate/ explain how this occurs.

Sample paper

Fiscal Policy

            Importance of exchange rates

Exchange rates are a major influence on a country performance in international trade. A country’s currency valuation or devaluation and volatility will affect its balance of payment and the overall economic performance. Exchange rates serve the following.

Assist the government in formulating trade policies.

Exchange rates influence the trade policies to be executed in respect to international trade. Long periods of overvalued exchange rates are often associated with an increase in the use of protectionist trade policies, especially anti-dumping (Oatley, 2010). An appreciation in the domestic currency will result to domestic firms losing their competitiveness resulting to formulation of restrictive trade policies.

 Exchange rates influence level of international trade.

Exchange rate volatility will result to a decrease in international trade due to un-certainty and transaction costs that result from the variability in the rates. An appreciation in the domestic currency will result to decreased levels of international whereas depreciation will result to increased levels of international trade.

 Exchange rate affects tourism and decision of investors.

An appreciation in the currency exchange rate will result to decreased tourism into the country whereas a depreciation in the currency will  result to an  increased number of tourist visiting the country .Investors will invest into a country when its currency depreciates in speculation of its appreciation in future.

Beneficiaries and losers when a country’s currency appreciates

Appreciation refers to an increase in the value of a currency in respect to another currency. When a currency appreciates, it is more valuable and therefore buys more of another foreign currency (Abdel-Khalik, 2013). Appreciation in foreign currency results into decrease in the cost of investing in the foreign currency. This in turn results to an increase in the expected returns in the foreign currency. An appreciation translates to imports being cheaper and exports being more expensive. It will help consumers of import since they will obtain good and services at cheaper prices whereas producers of export will be hurt since their commodities will be more expensive. Investors will also benefit in case of an appreciation of the currency in which they have invested. Lenders will also gain, as they will receive more in value in comparison to the amount they lend others (Abdel-Khalik, 2013). The consumers will be the ones to gain whereas the exporters will be the losers. The exporters lose because they receive less money when the foreign currency is converted into local currency.

Beneficiaries and losers when a country’s currency depreciates

A depreciated currency is in which is less valuable and therefore can buy less of foreign products and services. In this particular case, the domestic produced goods and exports are cheaper in comparison to the imports (Abdel-Khalik, 2013). A current depreciation in the domestic currency will result to an increase in the cost of investing in the foreign currency. This will in turn result to a decrease in the expected return in the foreign currency. A depreciation in the currency will be advantageous to the exporters of a product as its products will be cheaper in bother the domestic and foreign market but disadvantageous to the consumers of the imports as they will be more expensive. In this particular case, the investors will be the losers

Major factors that impact exchange rates in the long run

Exchange rates are affected by various different factors in respect to whether it is in the short run or long run. In the long run, movements of the currency is in response to differences in prices which results to long run prices of similar goods being the same. The theory of purchasing power parity is used in explaining the determination of the long run exchange rates. It gains its validity on the law of one price (LOOP) (Boykorayev, 2008). Purchasing power parity holds that, in the long run, prices of identical products or services are the same in different locations. This is based on the principle that exchange rates will adjust to eliminate the arbitrage opportunity of buying cheaper goods or services in one country and selling it at increased prices in another.

Other factors that affect exchange rates in the long run are relative price levels, trade barriers, preferences of domestic verses foreign goods and productivity. Changes in relative price levels affect a country currency in that an increase in prices will result to depreciation in its currency and vice versa. Trade barriers involve the imposition of tariffs and quota in order to restrict trade between countries. By increasing the barriers, a country’s currency appreciates.           Preference for domestic goods verses foreign goods. An increase in demand of domestic goods will result to an appreciation in the domestic currency whereas an increase in demand for foreign goods will result to depreciation in the domestic currency.

Productivity levels of a country. If a country is relatively productive in comparison to another country, its currency appreciates.

                           Central banks impact on exchange rates

The federal reserve bank of New York

It intervenes in the exchange rates by either increasing or decreasing the value of the dollar price over another currency. To increase its value, it buys dollars and sells foreign currency. On the other hand, it decreases value by buying foreign currency and selling dollars. The intervention signals the intended exchange rate movement affecting the behavior of investors in the foreign exchange market. The foreign currencies used in executing the intervention are issued by the Federal Reserve holdings or the exchange stabilization funds from the treasury. The intervention is in conjunction with the central banks of countries whose currencies are being used.

Iceland

The Central Bank of Iceland may intervene directly in the foreign exchange market. In this case, the bank holds the mandate to control exchange rates during periods of inflation (Ilker & Mendoza, 2004). The central bank adjusts exchange rates to fit inflation targets. The Central Bank of Iceland may also intervene when it perceives currency exchange fluctuations as a potential threat to the economic stability of the country.

Bank of Canada

This is the Canadian central bank. The exchange rates in Canada are largely under the influence of external factors. The external factors are those that touch on supply and demand of goods between the country and others. The various external forces include the volume of trade (imports and exports), inflation rates, economic performance, commodity prices in the global market, and other factors. Nonetheless, the bank may step in to control exchange rates under exceptional circumstances (Ilker & Mendoza, 2004).

 

                                                        References

Abdel-Khalik, A. R. (2013). Accounting for risk, hedging and complex contracts. United Kingdom, UK: Loutledge.

Boykorayev, B. (2008). Factors that determine nominal exchange rates and empirical

Evidence of cross-sectional analysis, Aarhus School of Business. Retrieved from:

http://pure.au.dk/portal/files/3262/Bahodir_Boykorayev._Master_thesis.pdf

Ilker, D., & Mendoza, A. (2004). Is there room for foreign exchange interventions under an         inflation targeting framework?: Evidence from Mexico and Turkey. World Bank      Publications.

Oatley, T. (2010). Real Exchange Rates and Trade Protectionism, Business and Politics. 12.

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