Exchange Rates

Question 1

Foreign exchange

Answer 1

Exchange of currencies in international transactions

Question 2

Relationship between supply and demand of currencies

Answer 2

Demand for foreign currency causes supply of domestic currency

Question 3

Exchange rate

Answer 3

The value of a currency expressed in terms of another currency

Question 4

Floating exchange rate

Flexible Exchange rate system

Answer 4

Exchange rate determines by market forces (supply and demand)

   (Forces of demand and supply also determine the
       equilibrium point)

Question 5

Apprection

Answer 5

Increase in the value of currency in a floating exchange rate system

(Stems from an increase in demand for a currency
or a decrease in supply of a currency)

Question 6

Depreciation

Answer 6

Decrease in the value of a currency in a floating exchange rate system

(Stems from a decrease in demand for a currency
or an increase in supply of a currency)

Question 7

Appreciation and Depreciation relativism

Answer 7

When a countries currency appreciates, all other currencies depreciate relative to it

When a countries currency depreciates, all other currencies appreciate relative to it

Question 8

Causes of changes in Exchange rates due to changes in demand for a currency

Answer 8

Factors lead to changes in Demand of a currency
1. foreign demand for a countries exports
(Increased demand — increased demand for
currency — (rightward shift of demand curve)
– appreciation)

2. Rate of inflation relative to other countries
   (Low inflation relative to other countries —
   increased demand for exports — relatively
   cheaper)
3. Relative growth rate
   (High economics growth — higher incomes –
   Increased demand for this countries exports)
4. Foreign Direct and Portfolio investments
   (Foreign invest in a country — demand of domestic
   currency increases – appreciation)
5. Relative Interest rates
   (High interest rates — relative to another country
   —- more in flow of financial capital( funds that are used to make a financial investment) – increased demand of
   domestic currency — appreciation)
6. Central Bank intervention
   (Central bank holds reserves of foreign currency it can
   either buy or sell — central bank buys domestic
   currency – demand of currency increases —
   appreciation)

Question 9

Causes of changes in Exchange rates due to changes in supply of a currency

Answer 9

Factors that impact supply of currency
1. Domestic demand for imports
(More cars imported in the a country than bought
domestically —- more domestic currency in
foreign exchange market — depreciation)

2.The rate of inflation relative to other countries
(Country with low rate of inflation relative to other
countries — decreased demand for imports
(more expensive than domestic goods) —-
appreciation)

3. Relative growth rate
   (HIgh economic growth — high incomes — more demand
   for imports — increased in supply for currency —–
   depreciation)
4. Foreign Direct and Portfolio investments
   (Increased for foreign investment — increase in supply of the currency of the home country of these investors
   —- depreciation in foreign currency)
5. Relative Interest rates
   (If interest rates increase in a country relative to other
   countries — financial capital outflow decreases —-
   (domestic investors what to maximize high domestic
   interest rates) — supply of domestic currency falls
   —- appreciation)

6. Central Bank intervention
  (Central Bank sells domestic currency --- supplies more
   domestic currency (buys foreign currencies) ---
     depreciation)

Question 10

Consequences of a currency appreciation

Answer 10

more unit of the currency can be used to buy other currencies —— leads to cheap imports —— imports increase

Also foreigners can buy fewer domestic goods with this currency —- leads to more expensive domestic goods and exports for foreigners (decreased net exports)

Question 11

Consequences of a currency depreciation

Answer 11

Less unit of the currency can be used to buy other currencies —— leads to more expensive imports —— imports decrease

Also, foreigners can buy more domestic goods with this currency —- leads to cheaper domestic goods and exports for foreigners (increased net exports)

Question 12

Consequence of Exchange rate changes on Inflation

(Demand-Pull Inflation)

Answer 12

Currency depreciation leads to more exports (cheaper) and less import (expensive) causing an increase in net exports

Leads to increase in aggregate demand (demand-pull inflation) —– rightward shift in AD

(Rightward shift in AD = demand-pull inflation on Keynesian —- when the economy isn’t in a recession —- (producing at all close to full employment)

Question 13

Consequence of Exchange rate changes on Inflation

(Demand-Cost Inflation)

Answer 13

Currency depreciation leads to less import (expensive)

If domestic producers are dependent on FOP’s from imports —— cost of production increases —– stagflation occurs

Persistent stagflation could cause decrease in LRAS

Question 14

Consequence of Exchange rate changes on Economic growth

Answer 14

Currency depreciation leads to more exports (cheaper) and less import (expensive) causing an increase in net exports

Leads to increase in aggregate demand (demand-pull inflation) —– rightward shift in AD —– increase in real GDP —– leads to short term growth

Increased exports —- leads to increased domestic investment —- could lead to an increase in LRAS

Question 15

Consequence of Exchange rate changes on Unemployment

Answer 15

Currency depreciation leads to more exports (cheaper) and less import (expensive) causing an increase in net exports —- causing fall in unemployment — opposite is true

(fall in cyclical unemployment if the economy is in recession — fall in natural unemployment is close to or at full employment)

However, If domestic producers are dependent on FOP’s from imports —— cost of production increases —– stagflation occurs —- increased unemployment

Question 16

Consequence of Exchange rate changes on Current account balance

Answer 16

Currency depreciation leads to more exports (cheaper) and less import (expensive) causing an increase in net exports —- leads to trade surplus (opposite is true)

Currency appreciation leads to more imports (cheaper) and less exports (expensive) causing an decrease in net exports —- leads to trade deficit

Question 17

Consequence of Exchange rate changes on foreign Debt

Answer 17

Depreciation lowers the value of a countries currency —- causing foreign debt to increase

(big problem form LEDC)

Question 18

Consequence of Exchange rate changes on living standards

Answer 18

Currency appreciation leads to more imports (cheaper) and less exports (expensive) — residents standard of living likely to increase (Example US – trade deficit but high standards of living)

However, leads to decrease in aggregate demand (demand-pull inflation) —– leftward shift in AD —– decrease in real GDP

Question 19

Fixed Exchange rate system

Answer 19

Exchange rates fixed by the central bank of a country at a given level which are not allowed to change freely according to forces of demand and supply of currency

(still determined by market forces but can only be changed by the central bank)

Question 20

How does the central bank change the fixed exchange rate?

Answer 20

Buying and selling of currencies

Question 21

How do fixed exchange rates respond to changes in the supply and demand of a currency?

Answer 21

Do not change — what occurs is either an excess supply of currency or a shortage of currency (exchange rate is fixed)

To maintain exchange rate —- central bank uses reserves to buy the excess supply (demands domestic and sell foreign currency) —- (vice versa)

If reserves a currency run out overtime — to correct excess supply (domestic currency) — central bank can increase interest rates —– leads to increased foreign financial investment domestically — higher demand for currency — lower imports — maintains fixed exchange rate
(limitation — involves contractionary monetary policy – could. cause recession)

The government could also limit imports through trade protection — to maintain fixed exchange rates

Question 22

Terms for changing fixed exchange rates

Answer 22

Devaluation – lowering the value of a currency (usually government intervention)
- leads to cheaper exports and more expensive imports (depreciation)

Revaluation – increasing value for a currency (usually government intervention)
- leads to cheaper imports and more expensive exports (appreciation)

Question 23

Managed exchange rate system

Answer 23

a system with the combination of both floating and fixed exchange rate elements

(Exchange is most free-floating but central bank can intervene if necessary)

Question 24

What is the goal of the central bank in Managed exchange rate systems?

Answer 24

to prevent abrupt fluctuation in the exchange rate
(abrupt fluctuation – indicators — unstable economic environment – low investment — could also disrupt international trade)

Question 25

Pegging exchange rates

Example of a Managed exchange rate

Answer 25

Pegged currency fluctuates and within a range target currency
(e.g an African country fixing its currency to the US dollar )
(Central bank of the African country will keep exchange rate within the range)

Countries may pegged exchange rate to US dollar to have currency stability (No abrupt fluctuation)

Question 26

Consequences of overvaluing and undervaluing a currency

Answer 26

Overvaluing a currency — set its value to high relative to its equilibrium free market value
- causes imports to be very cheap (the main reason behind policy — desirable for costs of imported FOP to be low) — speed up manufacturing and production

However, causes exports to be more expensive – harming exporters
also, worsen current account balance (create a significant trade deficit)
also harms domestic producers — more competition

Undervaluing a currency – lower its value to low relative to its equilibrium free market value
– exports become really cheap – imports become very expensive (developing countries do this to expand exports industries — thus also their economies)

However, doing this gives countries an unfair comparative advantage (may lead foreign countries to have lower exports) — thus, currency devaluing is considered “cheating”

(overvaluation and undervaluing cannot occur in free-floating exchange rate systems — market forces will cause demand and supply to return to equilibrium )