4.1.8 Exchange Rates

Question 1

What is an exchange rate?

Answer 1

An exchange rate is the rate at which one country’s currency can be exchanged for other currencies in the foreign
exchange (FX) market. There is no such thing as “the” exchange rate – so if £ depreciates against the $, it could still be
appreciating against the Euro or the Japanese Yen.

Question 2

What is an effective exchange rate?

Answer 2

This is a weighted index of sterling’s value against a basket of currencies the weights are based
on the importance of trade between the UK and each country

Question 3

What are the main exchange rates?

Answer 3

Free floating
Managed-floating
Fixed

Question 4

What is a free floating currency?

Answer 4

where the external value of a currency depends wholly on market forces of supply
and demand – there is no central bank intervention

Question 5

What is a managed floating currency?

Answer 5

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

Question 6

What is a fixed exchange rate?

Answer 6

e.g. a hard currency peg either as part of a currency board system or
membership of the ERM Mark II for those EU countries eventually intending to join the Euro.

Question 7

What is depreciation?

Answer 7

• Depreciation is a fall in the value of a currency in a floating exchange rate system

Question 8

What is devaluation?

Answer 8

• Devaluation is a fall in the value of a currency in a fixed exchange rate system

Question 9

What is appreciation?

Answer 9

• Appreciation is a rise in the value of a currency in a floating exchange rate system

Question 10

What is revaluation?

Answer 10

• Revaluation is a rise in the value of a currency in a fixed exchange rate system

Question 11

What are characteristics of free floating exchange rates?

Answer 11

• The external value of the currency is set by market forces
  o The strength of currency supply and demand drives the external value of a currency in the markets
  o The currency can either appreciate (rise) or depreciate (fall)
• There is no intervention by the central bank
  o Central bank allows the currency to find its own market level
  o It does not alter interest rates or intervene directly by buying/selling currencies to influence the price
• There is no target for the exchange rate
  o External value of currency is not an intermediate target of monetary policy (i.e. interest rates not set
  to influence the currency)

Question 12

What factors cause changes in the currency in a floating system?

Answer 12

1. Trade balances
2. Foreign direct investment (FDI) – an economy that attracts high net inflows of capital investment (i.e. longterm
   capital flows) from overseas will see an increase in currency demand and a rising exchange rate.
3. Portfolio investment – strong inflows of portfolio investment into equities and bonds from overseas can cause
   a currency to appreciate
4. Interest rate differentials - countries with relatively high interest rates can expect to see ‘hot money’ (i.e. shortterm
   capital) flowing coming in and causing an appreciation of the exchange rate.
5. Speculation – this is responsible for much of the day-to-day volatility

Question 13

Explain how trade balances can cause changes in the currency in a floating system

Answer 13

Countries that have strong trade and current account surpluses tend (other factors remaining
the same) to see their currencies appreciate as money flows into the circular flow from exports of goods and
services and from investment income
* A good ‘rule of thumb’ is that demand for exports tends to affect the demand for currency curve
(because if people overseas want to buy UK exports they will need to buy £s in order to pay for
them), whereas demand for imports tends to affect the supply of currency (because we need to
supply £s to the foreign exchange market to buy foreign currencies to pay for imports)

Question 14

Explain, using a diagram, the impact of higher interest rates on a floating exchange rate.

Answer 14

Question 15

Explain, using a diagram, the effect of a fall in export demand on a floating exchange rate

Answer 15

Question 16

Give examples of managed exchange rates?

Answer 16

Question 17

Explain the characteristics of managed exchange rates

Answer 17

• Currency is usually set by market forces
  o Central bank gives a degree of freedom for market exchange rates on a daily basis
• A central bank may intervene occasionally to influence the price:
  o Buying to support a currency (i.e. selling their FX reserves)
  o Selling to weaken a currency (i.e. adding to their FX reserves)
  o Changes in policy interest rates to affect hot money flows i.e. increase rates to attract inflows of
  money into the banking system looking for a favourable rate of return
• In a managed floating system, the currency becomes a key target of monetary policy
  o Higher exchange rate might be wanted to control demand-pull and cost-push inflationary pressures
  o A government might want to engineer a competitive devaluation to improve export competitiveness

Question 18

Explain policy tools for managing floating exchange rates

Answer 18

• Changes in monetary policy interest rates
  o Changes in interest rates e.g. lower interest rates to depreciate the exchange rate
  o Causes movements of “hot money” banking flows into or out of a country
• Quantitative easing
  o Increase liquidity in the banking system leading to lower interest rates, usually causes outflow of
  money – depreciation of the exchange rate
• Direct buying / selling in the currency market (intervention)
  o Direct intervention in the currency market
  o Buying and selling of domestic / foreign currencies
• Taxation of overseas currency deposits and capital controls
  o Taxation of foreign deposits in banks cut the profit from hot money inflows
  o Controls on the free flow of capital into and out of a country

Question 19

How can a central bank influence the value of a currency?

Answer 19

Question 20

Explain competitive devaluations

Answer 20

• Competitive devaluations occur when a country deliberately intervenes to drive down the value of their
  currency to provide a competitive lift to demand, output and jobs in their export industries.
• They may try this when faced with a deflationary recession or perhaps to attract extra foreign investment
• For nations with persistent trade deficits and rising unemployment, a competitive devaluation of the exchange
  rate can become an attractive option - but there are also risks involved
• Devaluing an exchange rate can be seen by other countries as a form of trade protectionism that invites some
  form of retaliatory action such as an import tariff
• Cutting the exchange rate makes it harder for other countries to export negatively affecting their growth rate
  which in turn can damage the volume of trade that takes place between nations
• Competitive devaluations of a currency go against the principles of trade based on comparative advantage

Question 21

What are examples of countries with a fixed exchange rate?

Answer 21

Question 22

Explain the characteristics of a fixed exchange rate system

Answer 22

In a fixed exchange rate system:
* The government / central bank fixes the currency value
o External value is pegged to one or more currencies (known as the anchor currency)
o The central bank must hold sufficient foreign exchange reserves in order to intervene in currency
markets to maintain the fixed peg
§ i.e. they may need to buy domestic currency using foreign currency to push up the value of
their domestic currency
§ holding foreign exchange reserves can create an opportunity cost
* Pegged exchange rate becomes official rate
o Trade takes place at this official exchange rate
o There might be unofficial trades in shadow currency markets
* Adjustable peg
o Occasional realignments may be needed
o E.g. a devaluation or revaluation depending on economic circumstances – the currency may have
drifted from the fundamental value

Question 23

How does a currency depreciation affect inflation?

Answer 23

Higher import prices feed into increased consumer prices – may help a country to avoid
deflation and it also lowers real interest rates. But higher inflation threatens real living standards
especially for groups with weak bargaining power in the labour market who are unable to bid
for higher wages

Question 24

How does a currency depreciation affect economic growth?

Answer 24

A weaker currency is usually a stimulus to GDP growth e.g. from higher net exports but much
depends on the price elasticity of demand for exports. Also, many exports require imported
components which will have become more expensive as a result of the depreciation

Question 25

How does a currency depreciation affect unemployment?

Answer 25

A more competitive currency will help to increase domestic production and perhaps create a
positive export multiplier effect which will further stimulate aggregate demand and jobs. There
might also be an upturn in tourism / demand from overseas students to come to a country’s
universities

Question 26

How does a currency depreciation affect balance of trade?

Answer 26

Dependent on price elasticities of demand for X&M – possible J curve effect in the short run
The impact on export sales also depends in part on the strength of GDP growth in key export
markets

Question 27

How does a currency depreciation affect business investment?

Answer 27

Should help to improve profitability e.g. a fall in the external of the £ increases the overseas
earnings of UK plc in US dollars and Euros which will be now be worth more in £s.

Question 28

How does a currency depreciation affect FDI ?

Answer 28

Depreciation of a currency makes a country’s FDI assets (i.e. investments abroad that are
denominated in foreign currency) appear more valuable when converted into the domestic
currency. Likewise, FDI liabilities (i.e. investments in the domestic economy from overseas,
denominated in the domestic currency) appear less valuable to overseas investors. This can
ultimately therefore reduce inwards FDI.

Question 29

How might a currency depreciation affect international competitiveness?

Answer 29

Question 30

What does a stimulation of AD from a depreciation of the exchange rate depend on?

Answer 30

1. The variable length of time lags as consumers and businesses respond
2. The scale of any change in the exchange rate i.e. a 5%, 10%, 20%
3. Whether the change in a currency is temporary or longer-lasting
4. The coefficients of price elasticity of demand for X&M (relate this back to the Marshall-Lerner condition)
5. The size of any second-round multiplier and accelerator effects
6. When the currency movement takes place – i.e. Which stage of an economic cycle (recession, recovery etc.)
7. The type of economy (e.g. the impact will be different for small developing nations v large advanced countries)
8. The degree of openness of the economy to international trade i.e. measured by the value of trade as a % of GDP

Question 31

What are the advantages of floating exchange rates?

Answer 31

o Reduces the need for a central bank to hold large amounts of currency reserves
o Freedom to set monetary policy interest rates to meet domestic objectives
o May help to prevent imported inflation
o Insulation for an economy after an external shock especially for export-dependent countries
o Partial automatic correction for a current account deficit
o Less risk of a currency becoming significantly over/undervalued

Question 32

What are the disadvantages of floating exchange rates?

Answer 32

o No guarantee that floating exchange rates will be stable
o Volatility in a floating currency might be detrimental to attracting inward investment
o A lower (more competitive) exchange rate does not necessarily correct a persistent balance of
payments deficit - consider the J curve theory and also the importance of non-price competitiveness

Question 33

Show the impact of an appreciation in the exchange rate on AD-AS diagram

Answer 33

Question 34

What are the advantages of fixed exchange rates?

Answer 34

o Certainty of currency value gives confidence for inward investment from overseas businesses
o Reduced costs of “currency hedging” for businesses such as airlines
o Currency stability helps to control inflation – i.e. it is a discipline on businesses to keep labour costs
low
o A stable currency can lead to lower borrowing costs (i.e. lower yields on government bonds)
o Imposes responsibility on government macro policies e.g. to keep inflation under control
o Less speculation in the currency market if the fixed exchange rate is regarded by traders as credible

Question 35

What are the disadvantages of fixed exchange rates?

Answer 35

o Reduced freedom to use interest rates for other macro objectives such as stimulating GDP growth
o Many developing countries do not have sufficient foreign currency reserves to maintain a fixed
exchange rate
o Difficult for countries to use a competitive devaluation of their fixed exchange rate – this creates
political tensions and might lead to a protectionist response
o Devaluation of a fixed exchange rate can lead to a surge in cost-push inflation – this is damaging for
competitiveness and has regressive effects on poorer families