Exchange rate systems Flashcards
Define foreign exchange market
Global 24/7 markets where currencies are traded
What is the difference between devaluation and depreciation ?
Devaluation is the deliberate downward adjustment of a currency, where as depreciation is decline in the value due to market powers
What is a floating exchange rate ?
Rise and fall of a currency due to market forces
What is a fixed exchange rate ?
Where the gov intervenes in the market to stabilise a currency’s value
What is the range of exchange rate systems ?
freely floating - dirty floating (unofficial intervention by govs) - adjustable peg - rigidly fixed
What are the key features of a floating exchange rate ?
1.Currency value set by market forces
2.Currency can appreciate or depreciate
3.No intervention by central banks
4.External value of currency is not an explicit target of monetary policy
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What are the factors that impact supply and demand for a currency and explain them ?
- Speculation
2.Official buying and selling - reserves
3.Relative inflation rates - low - more exports - appreciation
4.Relative interest rates - high - hot money - appreciation and vice versa
5.Confidence in the economy
6.Foreign trade
7.FDI- through increased demand for the pound to fund projects, signals economic growth which attracts more FDI and it increases the competitiveness of exporting industries so there is more demand for them.
What are the key features of a fixed exchange rate system ?
- Adjustable peg
2.Central banks fixes the currency value
3.Central bank must hold enough reserves
4.Pegged rate becomes official rate
How is a fixed exchange rate managed ?
The governments have to directly intervene to fix the mismatch in the supply and demand for that currency
What are the 2 ways a central bank can intervene to maintain the exchange rate within floor and ceiling ?
After setting the peg, floor and ceiling if the currency leaves this boundary then:
1.Exchange equalisation - where the bank buys and sells its own currency to affect the exchange rate
2.Manipulation of exchange rates - e.g higher interest rates attract hot money and so currency appreciates
What are the advantages of floating exchange rates ?
- Balance of payment equilibrium -market mechanism automatic power to restabilise equlibrium so value of imports (supply) equals value of exports (demand). Never overvauled or undervalued in the long run.
- Efficient resource allocation
- Governments do not need to be concerned with balance of payment objectives as it is monitored and adjusted by free market forces.
- Protection against importing inflation. Bcs if there is high inflation in other countries a fixed exchnage rate system will mean that people will imprt with higher prices. But with free floating system, the currency will appreciate making imports cheaper.
- Independent monetary policy - focuing only on domestic objectives e.g low inflation
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What are the disadvantages of floating exchange rates ?
1.Speculation and capital flows making exchange rates vulnerable
2.International trading uncertainty
3.Cost push inflation
4.Demand pull inflation
What are the advantages of fixed rates ?
1.Certainty and stability
2.Anti-inflationary discipline- iterest rates are tied with exchange rates so there is less risk of inflationary policies by the government to get more votes
What are the disadvantages of fixed rates ?
1.Continued overvaluation and undervaluation can lead to misallocation of resources
2.Balance of payment imbalances
3.Loss of monetary sovereignty - interest rates are only tied with exchange rates
Define currency union
an agreement between a group of countries to share a common currency and usually share a single monetary and foreign exchange policy