Reflective Exercise: Joining the Euro: the effect on the exchange rate
1
Scenario
If the UK was aiming to adopt the euro in the near future we would be expected to
‘shadow’ the euro for a while (the £:€ exchange rate would change only between
very narrow margins). This exercise considers how the equilibrium £:€ exchange rate
is currently determined and how variation only between very narrow margins can be
achieved.
Section 1: Setting the framework for investigating this question
A
a
b
c
B
a
b
c
d
C
a
b
c
d
Tick however many of the following you think appropriate
In examining the foreign exchange market we will start from
considering demand, supply and equilibrium as these are
important in any market.
It depends on whether the government intervenes in the
exchange rate as to whether we can use demand and supply
analysis.
The price of pounds can be expressed as how much of another
currency we will get in exchange for £1.
feedback page 4
Tick however many of the following you think appropriate
It does not matter from which currency’s point of view we are
examining the situation as they are the same.
An appreciation of the pound against the euro is when the £:€
exchange rate rises.
An appreciation of the euro against the pound is when the €:£
exchange rate rises.
We must be careful to specify from which currency’s point of view
we are examining the situation.
feedback page 4
Tick however many of the following you think appropriate
We will start by comparing changes in floating and fixed
exchange rate regimes for simplicity.
We need to know how much the margins that were mentioned in
the question are before we can proceed with the analysis.
We will be considering how market forces move us towards
equilibrium.
We will start and finish with a disequilibrium situation.
feedback page 4
Copyright: Embedding Threshold Concepts Project 23/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Joining the Euro: the effect on the exchange rate
D
2
Comparing fixed and floating exchange rate mechanisms
These questions refer to figure 1 which shows the foreign exchange market from the
£’s point of view. Assume the £:€ exchange market was originally at equilibrium of
£1:€1.5 and N1, but then there is an increase in the demand for £s and the demand
curve moves to D2.
Tick however many of the following you think appropriate
If the exchange rate is floating, the exchange rate automatically
appreciates to £1:€1.6.
If the exchange rate is fixed the exchange rate automatically
stays at £1:€1.5 without any intervention by the monetary
authorities.
If the exchange rate is fixed there will an excess demand of £s of
N1-N3.
If the exchange rate is fixed there will an excess demand of £s of
N2-N3.
If the exchange rate is floating, the exchange rate will stay at
£1:€1.5 as market pressures will automatically reduce the demand
curve back to its original position.
The number of pounds demanded will be the same under fixed
and floating exchange rates; it will only be the exchange rate
that differs.
feedback page 4
a
b
c
d
e
f
Figure 1: The foreign exchange market
Things to look for on the
diagram:
↑
Appreciation
S
• the labelling of the axis
Exchange rate
• the initial equilibrium
• the disequilibrium caused
by the shift in demand
£1:€1.6
£1:€1.5
•the new equilibrium with a
floating exchange rate
D2
D1
N1
N2
N3
Numbers of pounds (£s)
Copyright: Embedding Threshold Concepts Project 23/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Joining the Euro: the effect on the exchange rate
3
Section 2
For the cases outlined in (a) and (b) below explain, using a diagram, what would
happen in the foreign exchange market with an increase in the supply of £s.
(a) Currently the pound floats against the euro. Assume it is a free float in your
answer.
(b) If the UK was aiming to adopt the euro in the near future we would be expected
to shadow the euro (that is the exchange rate would change only between very
narrow margins). Assume that the exchange rate is fixed (that is the band widths are
zero) in your answer for simplicity.
Remember to apply what we have covered in section 1 in answering the question
.----------------------------------------------------------------------------------------------------------------
Your answer…
You can continue your answer on another sheet if needed…….
feedback page 6
Copyright: Embedding Threshold Concepts Project 23/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Joining the Euro: the effect on the exchange rate
4
Feedback Section 1: Setting the framework
A
People and firms want to obtain foreign exchange for various purposes and this
gives rise to a demand for (and supply of) currencies, in much the same way as for
other goods and services. Although governments can affect the functioning of
markets, this does not stop market forces from being important: thus (a) is correct
and not (b). On the foreign exchange market we are buying and selling £s for
foreign currency. If someone wants to exchange £1 for the € how much will it cost:
that is how much foreign currency has to be paid? This is the price and is given by
the exchange rate, thus (c) is correct.
B
Since buying pounds is equivalent to selling euros it is very important when
examining the foreign exchange (or FOREX) market to always be clear from which
currency’s point of view we are examining the situation (thus (d) is correct, not (a)).
When we write currencies, we mean how much of 1 unit of the first is worth in terms
of the second (in writing £:€, it will be £1 is worth so many €s). If the exchange rate
rises so that, for instance £1: €1.6 instead of £1: €1.5, the £ is worth more euros and
this is an appreciation of the £. Given this, both (b) and (c) are correct, as (b) is from
the point of view of £s and (c) from the point of view of euros. (We can also write
€/£, which means euros per £, and is 1.6 € per £1.)
C
It is always good to start with a simplification, if that will enable us to concentrate on
important aspects of the analysis that we are undertaking. Here we will consider
floating (because that is close to the current exchange rate regime of the £) and
fixed exchange rates. The ‘shadowing’ regime referred to is close to a fixed rate
and requires the Bank of England to act in the same way. We do not have to know
all the details and these may obscure the basic mechanisms (thus (a) is correct).
We shall be analysing changes in equilibrium situations, because if we started from
disequilibrium the exchange rate would still be changing owing to market pressures!
Thus (c) is correct but not (d).
Copyright: Embedding Threshold Concepts Project 23/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Joining the Euro: the effect on the exchange rate
5
D Comparing fixed and floating exchange rate mechanisms
Under a floating exchange rate the market mechanism is allowed to work freely and
the excess demand caused by the shift in the demand curve will be eliminated by
the appreciation in the exchange rate, so (a) is correct.
These market forces are still at work under a fixed exchange rate and so this will not
automatically stay at £1:€1.5, but it requires the Bank of England to provide the extra
supply of £s. (It exchanges £s for foreign currency, adding to the nation’s reserves.)
The excess demand is N1-N3 if the exchange rate is fixed and the number of pounds
is N3 (i.e. (c) is correct, not (d)). This is not the same number as under floating
exchange rates, as in that case the increase in the exchange rate lowers the
quantity demand (to N2) through the movement along the demand curve.
Notice the way we refer to the points on the axis in our answer – this is important
because it is what we are drawing the diagram to find out.
Copyright: Embedding Threshold Concepts Project 23/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Joining the Euro: the effect on the exchange rate
6
Feedback Section 2: The approach of economics
Figure 2: The foreign exchange market
appreciation
↑
S1
Exchange rate
S2
£1:€1.5
£1:€1.4
D
N1
N2
N3
Numbers of pounds (£s)
What happens to the demand and supply curves?
We use a similar diagram to figure 1, starting at the initial equilibrium which is at N1
and £1:€1.5 for example. Now the supply curve shifts to the right, as more quantity is
supplied. The shift creates an excess supply of £s equal to N1-N3. What happens
then depends on the exchange rate regime.
What happens under floating exchange rates?
In a floating exchange rate regime this immediately puts pressure on the exchange
rate to depreciate until it reaches the new equilibrium point, at £1:€1.4 and N2
pounds demanded and supplied.
What happens under fixed exchange rates?
Under a fixed exchange rate the pressures are still there towards equilibrium and the
rate would decline if nothing was done. The Bank of England will have to intervene
to stop the exchange rate falling, buying N1-N3 pounds. It stops the market adjusting
to the new equilibrium position by buying the £s, removing the excess supply using
the country’s reserves of foreign currency to do so.
If we are shadowing the € within narrow bands, the exchange rate will be able to
fall slightly, but as the exchange rate nears the bottom of the band, say at £1:€1.47,
the Bank of England will have to intervene in the same manner as with a fixed
exchange rate to stop the exchange rate depreciating further.
Reflection In your explanation do you:
1.
2.
Yes
Partly
No
Correctly label the axis on the diagram?
Why is this important?
Use your diagram in your answer by referring to labelled
changes
Do you understand why the concept of equilibrium is so important answering this
question?
Copyright: Embedding Threshold Concepts Project 23/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.
Reflective Exercise: Joining the Euro: the effect on the exchange rate
7
Lecturer’s Notes
Objectives of the exercise and prerequisites
Learning Focus: developing an understanding of the foreign exchange markets.
The exercise considers how demand and supply analysis can be applied to this
market and how equilibrium is achieved under floating and fixed exchange rates.
The Threshold Concept that is pivotal to this learning is economic modelling, in
particular equilibrium.
Prior Knowledge Required
This exercise can be used as supporting material if fixed and floating
exchange rates have been covered in lecturers. However, it is also possible
to use it to introduce this area with a little additional explanation from the
lecturer during the session.
Sequencing and timing
1.
With this exercise, the feedback to section 1 parts A, B and C is better
given to students before they attempt section 1 part D. You will have to
weight up the extra photocopying costs of providing these separately or
initially provide oral feedback.
2.
In section 2 getting students to relate their answer to the diagram is
important and may be something you wish to draw attention to, in
particular that they have used the diagram to show the changes in the
exchange rate.
3.
The exercise will take around 30 minutes to complete.
Copyright: Embedding Threshold Concepts Project 23/08/07
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment and
Learning (DEL) under the Fund for the Development of Teaching and Learning.