Essay About Dollar Exchange Rate And Exchange Risk

Should Britain Join the European UnionShould Britain Join the European UnionWith the change over to the Euro notes and coins now complete across the “Euro-zone”, twelve countries that have adopted the Euro as their currency, the debate over whether to adopt the single currency in Britain continues. There will be those who argue that the introduction of the single currency is merely the next logical step in the development of a truly single market, and that by joining, Britain would gain a voice in what could eventually become the world’s most powerful economic zone. Others believe that a successful common market is not dependant on the adoption of a single currency, which they see as merely another irrevocable step towards the political union of Europe. But the main focus of the debate centers on the parameters of macro economic objectives.

So, assuming exchange risk is a big factor, consider whether joining the Euro will actually reduce it or not and if so by how much. Here we immediately trip over the key point that joining the Euro is not to join a world currency but a regional one. Unfortunately for our exchange risk we trade very heavily with the dollar area. Let us not get tied up in the vexed question of the exact shares of our trade with Europe and with the USA, and what sorts of trade should be counted (in goods? in goods and services? or in all cross-border transactions including foreign investment and earnings on them?). The point is that if we regard exchange risk as a sort of tax on transactions involving exchanging currency, then it is plain that the broadest definition should be used for the ‘trade’ affected by this tax. Most of the world outside Europe either uses the dollar or is tied to it in some formal or informal way. We might then say, in a rough and ready way, that we trade and invest half with the Euro area and half with the dollar area.

It so happens that the Euro/dollar exchange rate has been highly variable for a very long time – see Figure 1 which shows the DM/dollar rate up to January 1999 and thereafter links on the Euro-dollar rate (this linkage assumes that the DM would have been the dominating element in the behavior of the Euro, had it existed before). Nor have the sources of that variability been removed. They include the very different philosophies of regulation which lead to swings in market sentiment about likely future success; differences in business cycle timing which cause swings in interest rates; and differences in adoption of new technologies. It is true that differences in inflation are now small but that has been so now for at least a decade and a half; this has not stopped very large swings in the exchange rate due to these other reasons which affect the ‘real exchange rate’ (that is, the exchange rate adjusted for relative inflation.)

The problem then for the UK is that if they join the Euro they thereby increase their exchange risk against the dollar as the Euro swings around against it. If they remain outside, the pound can as these swings occur ‘go between’ the two, rather like someone sitting on the middle of a seesaw. The chart of the UK’s own effective (or average) exchange rate – Figure 2 – juxtaposed against the Euro/dollar exchange rate shows rather clearly that we have been able to enjoy less volatility in our overall exchange rate by tying to neither of these two big regional currencies.

To start, I will discuss the arguments against the UK joining the Euro. The UK government has 3 major macro economic objectives and 2 on a slightly smaller scale: i) a high, but stable rate of economic growth within the UK’s potential ii) high, but stable employment iii) low inflation iv) balance of payments equilibrium and v) fair and equal distribution of income.

In order to balance these objectives, governments use policies to control various aspects of the economy, however, in the analysis that follows, it will be shown that the most important of these policies, Monetary policy, would be rendered unusable to control the UK economy should the single currency be adopted and others will be curtailed.

The monetary policy today is used to control inflation, because low and stable inflation is the best background to achieve economic growth in terms of real GDP. Fig 3 shows a shift to the left of the Aggregate Demand (AD) curve caused by a rise in interest rates, this leads to a lower equilibrium price level. Loosening monetary policy by lowering interest rates shifts the AD curve to the right and leads to a higher equilibrium levels of prices (fig 4). In this situation, this would lower consumer expenditure since there would be a higher incentive to save and more costly to borrow. This is useful because in the future should we find ourselves in the position of deflation the lowering of interest rates would help to rise

Figure 4. View largeDownload slide Financial prices are higher in the long run and lower in the short run than in the short run (<4 or <7 years)? Figure 4. View largeDownload slide Financial prices are higher in the long run and lower in the short run than in the short run (<4 or <7 years)? Although the trend is clearly visible in Figure 4, low interest rates reduce the profitability of the government's credit rating (CDS) by 1.2% in April 2009. Figures 5 – 6 show a trend in interest rates since 2008 that is about 0.7% during the 4 years from May 2009 to May 2011, the maximum for which was 3% in April 2009, 0.6% in April 2010 to May 2011, and 3% in September 2012 to March 2013. This shows the greatest improvement in interest rates since 2008. The trend in the level of interest rates is consistent with the higher levels of the two previous three years of the same magnitude for the same time frame, which are: July 2009, when the economy experienced a downturn but a gain of 10 percentage points in consumer spending over the same time frame, and November 2011, when the rate was 9.7%, which is about 1.6%-0.4 percentage points

Figures 5 – 6 show a trend in interest rates since 2008 that is about 0.7% during the 4 years from June 2008 to January 2009, the maximum for which was 3% in April 2008, 0.6% in April 2009, and 3% in September 2012 to March 2013. This shows the greatest improvement in interest rates since 2008. The trend in the level of interest rates is consistent with the higher levels of the two previous three years of the same magnitude for the same time frame, which are: July 2008, when the economy experienced a downturn but a gain of 10 percentage points in consumer spending over the same time frame, and November 2011, when the rate was 9.7%, which is about 1.6%-0.4 percentage points

In sum, we see that the growth in interest rates during the past 3 years has come to a positive pace for the same time period, which contrasts significantly with the contraction in the CDS. Therefore, from the perspective of the policy position the ECB should continue to increase its rate of interest policy and in the interest rate markets under such conditions. As far as the policy positions are concerned, the monetary policy positions of the ECB have had no impact on inflation pressures. For this reason, inflation remains high across the entire market. The negative response to the ECB’s monetary policy is because the interest rate policy accommodates demand, because the money supply is kept relatively high, and because prices at the ECB are stable enough to allow the ECB to lower the interest rates in a timely fashion.

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