Economics and Philosophy

Exchange rate- the price of one currency in terms of another.

Exchange rate regimes: there are two types of exchange rate.

First one is Fixed exchange rate- government maintain the convertibility of their currency at a fixed exchange rate.

A currency is convertible if the central bank will buy or sell as much of the currency as people wish to trade at fixed exchange rate.




Suppose the exchange rate is fixed at E1. When demand for pounds is DD1, there is an excess demand AC. The Bank of England intervenes by supplying AC pounds in exchange for dollars, which are added to UK foreign exchange reserves. When demand is DD2, the Bank sells foreign exchange reserves in exchange for pounds. It demands EA pounds to offset the excess supply EA. When demand id DD, the market clears at the exchange rate E1, and no intervention by the bank is required.

When demand schedule is DD1, the UK is adding to its foreign exchange reserves. When the schedule is DD1 it is running down its resources. If the demand for pound fluctuates between DD1 and DD2 the Bank of England can sustain the exchange rate E1 in the long run.

If demand is DD2, reserves start to run-out, the governments may try to borrow from the International Monetary Fund (IMF)

At best this is only a temporary solution. Unless the demand for pound increases in the long run, it is necessary to devalue the pond. Fixing by devaluation is possible only if both governments will do it for “Fixed exchange rate”

 Floating exchange rate- the exchange rate that is determined in the foreign exchange market by the forces of demand and supply.

 The Foreign exchange reserves are foreign currency held by the domestic central bank.
 Balance of payments- record of money flows coming in and out of a country.
 Current account of the balance of payments records international flows of goods and services and current transfer.

What is on the current account?

• Visible goods
• Invisible goods
• IPD ( interest, profit and dividence)

When inflow equals to outflow, balance of payments is zero.

 Financial account of the balance of payments records international purchases and sales of financial assets.

 Purchasing Power Parity-exchange rate path is the path of the nominal exchange rate that maintains a constant real exchange rate.

The UK balance of payments.

The UK has had a persistent current account deficit for the past 17 years. The deficit has never gained much concern from politicians or Economists. However, with the recent increase in the size and significance of the deficit there are an increasing number of Economists warning that a current account deficit can pose a threat to long term growth.