Holding the exchange rate above or below the market clearing level

Overview

Overvalued exchange rate affect the domestic price level, undervalued exchange rate affect import prices and living standards and persistently undervalued currency lead to friction with trading partners.

What you need to know

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Questions from this subtopic

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1. 1

   What does it mean to say a currency is being held above its market clearing rate?

   Model answer

   It means the authorities are keeping the currency at a value higher than the one that would otherwise prevail given the trade and investment flows in and out of the country, so the currency is overvalued. Because more of the currency would be offered at that price than others wish to acquire, the authorities must take the excess off the market themselves, buying their own currency using their holdings of foreign currency, and they may also keep domestic interest rates high to make holding the currency attractive. The rate is therefore sustained by policy rather than by underlying conditions.

2. 2

   What does it mean to say a currency is being held below its market clearing rate?

   Model answer

   It means the currency is being kept at a value lower than the one that would otherwise prevail, so it is undervalued. To hold it there the authorities must supply more of their own currency to the market, selling it in exchange for foreign currency, which causes their foreign currency reserves to accumulate. Domestic exporters are made artificially cheap in world markets while imports are made artificially expensive at home.

3. 3

   Analyse the effects of an overvalued exchange rate on exporters and on employment.

   Model answer

   An overvalued currency means that every domestically produced good carries a higher price in foreign currency than the underlying costs of production justify, so exporters lose orders to competitors abroad and must either accept lower volumes or cut their domestic prices and margins to stay in the market. Firms competing with imports at home face the same squeeze from the other direction, as imported substitutes are artificially cheap. Output in tradable sectors such as manufacturing, tourism and agriculture falls, and because the demand for labour is derived from the demand for output, employment in those sectors falls and regions dependent on them suffer most.

4. 4

   Who gains from an overvalued exchange rate?

   Model answer

   Consumers gain, because imported goods, foreign holidays and imported food and fuel are all cheaper in domestic currency, so real living standards are higher than the economy’s underlying productivity would support. Firms that import raw materials and components gain from lower input costs, and anyone servicing a debt denominated in foreign currency finds it cheaper to repay. Savers gain if the overvaluation is being sustained by high interest rates. These gains are real, which is why an overvalued rate can be politically popular even while it damages the tradable sector.

5. 5

   How does an overvalued exchange rate affect the domestic price level?

   Model answer

   Imported finished goods, raw materials, energy and food are all cheaper in domestic currency, so the direct contribution of import prices to the consumer price index falls and firms’ unit costs fall, shifting short-run aggregate supply right. At the same time weaker net exports shift aggregate demand left. Both effects push the general price level down, so an overvalued currency suppresses inflation, which is one reason a government fighting inflation may tolerate or even seek one.

6. 6

   Why is holding a currency above its market clearing rate difficult to sustain?

   Model answer

   To keep the rate up the authorities must buy their own currency with foreign currency reserves, and those reserves are finite, so a persistent imbalance drains them until the policy cannot be continued. Raising domestic interest rates to make the currency more attractive can help, but it is costly because high rates depress domestic consumption and investment at a time when the tradable sector is already suffering. Once holders of the currency conclude that the reserves or the political will are running out, the overvaluation is likely to end abruptly rather than gradually.

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