balance of payments

Question 1

What happens in a floating exchange rate system?

Answer 1

• when there is a deficit, market forces create a downward pressure on currency to eliminate deficits
• when there is a surplus, market forces create an upward pressure on currency to eliminate surpluses

Question 2

What happens in a fixed exchange rate system?

Answer 2

balance of payments are balanced by policies that can change currency supply or demand to keep rates fixed

Question 3

How can they compare on a degree of certainty?

Answer 3

fixed - high degree of certainty - can plan for future investments easily
floating - low levels of certainty, leading to inability to plan and make decisions quickly

Question 4

How can they compare on the role of official reserves?

Answer 4

fixed - requires large amount of reserves to maintain rates
floating - doesn’t require central bank to keep hold of reserves

Question 5

How can they compare on current account imbalances?

Answer 5

fixed - hard to correct imbalances and would require reserves or borrowing
floating - can automatically adjust

Question 6

How can they compare on inflation?

Answer 6

fixed - encouraged to use fiscal policy which may create recession
floating - cost push inflation due to currency depreciation

Question 7

How can they compare on speculation?

Answer 7

fixed - removes instability and fixed
floating - risky

Question 8

How can they compare on flexibility?

Answer 8

fixed - range of policies to maintain rates
floating - automatic corrections

Question 9

What are advantages and disadvantages of a managed exchange rate system?

Answer 9

advantages - flexible, prevent large fluctuations, speculation difficult
disadvantages - doesn’t eliminate large trade imbalances, many not be enough to avoid fluctuations

Question 10

What is a monetary union?

Answer 10

when members of a common market adopt a common currency and a common central bank for higher economic integration

Question 11

What are the advantages and disadvantages of monetary union?

Answer 11

advantages - eliminates exchange rate risk and uncertainty, encourages price transparency, eliminates transaction costs, promotes a higher level of inward investment, low interest rates increase output
disadvantages - loss of domestic monetary policy, impacts members differently, loss of exchange rate as a mechanism for adjustment, constrained by convergence requirements, loss of decision making

Question 12

What is inward investment?

Answer 12

investment from outsiders towards member countries with a common currency