15.1 Exchange Rate Systems

Question 1

When is exchange rates usually mentioned?

Answer 1

In the balance of payments

Question 2

What are domestic currencies used to pay for?

Answer 2

Internal trade within countries

Imports are usually paid for in the currency importing the goods and services

Question 3

What does an exchange rate measure?

Answer 3

How much of another currency a particular currency can buy

Question 4

What are exchange rates usually measured against?

Answer 4

Gold

Question 5

Exchange rate def

Answer 5

The external price of a currency, usually measured against another currency

Question 6

What currencies are the pounds exchange rates quoted against

Answer 6

Euro or the dollar

Question 7

What is the real exchange rate

Answer 7

Measures the weighted average value of a country’s currency relative to a basket of other major currencies adjusted to the effects of inflation

Question 8

How do you calculate the real exchange rate?

Answer 8

Striking index X (index of domestic price level/index of weighted foreign price levels)

Question 9

What is the most extreme form of managed exchange rates?

Answer 9

Fixed exchange rates

Question 10

What is the least extreme form of managed exchange rates?

Answer 10

Freely floating exchange rates

Question 11

What is in between the two extremes of exchange rates?

Answer 11

Managed exchange rates

Question 12

What are the two forms of managed exchange rates?

Answer 12

-adjustable peg exchange rates
-managed floating exchange rates

Question 13

Describe adjustable peg exchange rates?

Answer 13

Resemble fixed exchange rates in many aspects but the rate at which the exchange rate is fixed may be changed from time to time

Question 14

What does a formal devaluation do to an exchange rate?

Answer 14

Reduces a fixed exchange rate (while revaluation increases the fixed rate)

Question 15

Freely floating exchange rate definition

Answer 15

The exchange rate is determined solely by the interplay of demand for and supply of the currency

Question 16

Diagram for an exchange rate in equilibrium

Answer 16

Question 17

What happens when the exchange rate of the pound falls

Answer 17

UK exports become more competitive in overseas markets

-greater overseas demand if it is price elastic which explains downward sloping demand curve

Question 18

Describe point A(freely floating system)

Answer 18

The money value of exports(paid in sterling) equals the money value of imports (paid in overseas currency)

Question 19

Describe the diagram

Answer 19

Shock disturbs initial equilibrium (improvement in quality Goode produced overseas causes UK residents to increase demand for imports whatever the exchange rate

Question 20

What are the advantages of freely floating exchange rates

Answer 20

Automatically achieving balance of payments equilibrium

Improving resource allocation

Freedom to achieve domestic policy objectives

Making it easier to control inflation

Ability to peruse an independent monetary policy

Question 21

What is a freely floating currency

Answer 21

Where the value of a currency depends only on supply and demand forces

Question 22

What is a managed floating currency

Answer 22

When the central bank may choose to intervene in a foreign exchange market to affect the value of currency to meet specific macroeconomic objectives

Question 23

What is a fixed exchange rate system

Answer 23

A currency peg as part of a currency board system

Question 24

Freely floating exchange rates

Automatically achieving balance of payments equilibrium

Answer 24

The exchange rate should move up and down to correct a payments imbalance (a currency will never be over or under valued for too long)

Question 25

Freely floating exchange rate Freedom to achieve domestic policy objectives

Answer 25

Market forces look after the current account in the balance of payments -govs can concentrate on domestic economic policy

Question 26

Freely floating exchange rate Easier to control inflation

Answer 26

Are protected from importing inflation (a fixed exchange rate doesn’t do this)

Question 27

Freely floating exchange rate Ability to pursue an independent monetary policy

Answer 27

Monetary policy purely focused on domestic objectives

Question 28

What are the disadvantages of freely floating currencies?(4)

Answer 28

The adverse effects of speculation and capital flows International trading uncertainty Cost push inflation Demand pull inflation

Question 29

disadvantages of freely floating currencies Adverse effect of speculation and capital flows

Answer 29

In the short run they are vulnerable to speculative money (hot money) movements into our out of currencies -does not reflect competitiveness of a country’s goods and services

Question 30

disadvantages of freely floating currencies Cost-push inflation

Answer 30

-trading competitiveness and current account in the balance of payments both worsen, causing the exjzngr rate to fall in order to restore competitiveness -may trigger a vicious cumulative downward spiral of faster inflation and exchange rate depreciation -falling exchange rate increases import prices which raise the rate of domestic cost-push inflation -workers react by demanding pay rises to restore the real value of the eroded wage Increased inflation itself erodes the export competitiveness initially won by thr fall of the exchange rate Triggers a fall in exchange rate to recover the lost advantage Resulting downward spiral can eventually destabilise large parts of the domestic economy causing unemployment and reducing economic growth

Question 31

What is a fixed exchange rate

Answer 31

An exchange rate fixed at a certain level by the country’s central bank and maintained by thr central bank’s intervention in foreign exchange market

Question 32

Diagram for the ceiling, central floor and peg of a fixed exchange rate

Answer 32

Question 33

Key features of a fixed exchange rate

Answer 33

Country’s gov or central bank announces it at a certain rate and the central bank takes responsibility for maintaining that rate (peg it to another currency)

Question 34

What are the advantages of a fixed exchange rate(2)

Answer 34

-achieve stability in foreign exchange markets -impose anti-inflationary discipline on a country’s domestic economic management on the behaviour or its workers and firms

Question 35

Disadvantages of fixed exchange rates

Answer 35

-increase uncertainty rather than certainty -likely I’d there is a devaluation or revolution -if fixed exchange rate is significantly overvalued-may impose deflationary costs , lost output and unemployment -if fixed exchange rate is significantly undervalued inflation may be imported from the rest of the world -an independent monetary policy cannot be implemented -both over and under valuation of currency can lead to miss allocation of resources

Question 36

What are the two ways a central bank can intervene in markets to maintain a fixed exchange rate?

Answer 36

Buying or selling its own currency on the foreign exchange market (exchange equalisation) Increasing or decreasing bank rate to alter pounds exchange rate

Question 37

What are the two different managed exchange rates?

Answer 37

Adjustable peg exchange rates Dirty floating exchange rates(abandoned in most parts of the world)

Question 38

Currency union

Answer 38

An agreement between a group of countries to share a common currency-usually have a single monetary and foreign exchange rate policy

Question 39

What is the impact of a currency union (think of the Euro)

Answer 39

Mobility of labour Common fiscal policy

Question 40

Why is a common fiscal policy important

Answer 40

Allows wealth to be transferred by a centralised fiscal authority from the richer to the wi poorer parts of the union Used to reduce inequality but improve competitiveness of poorer regions Without this countries build up a lot of gov debt