4.1.8 Echange Rates

Question 1

4.1.8a
Define Exchange Rate

Answer 1

The value of a currency in one country compared with the value in another

Question 2

4.1.8a
Types of Exchange Rate Systems

Answer 2

• floating
• fixed
• managed

Question 3

4.1.8a
Floating Exchange Rate

Answer 3

• set by market through S/D without any intervention
• Impacted by : X, M, IR%, FDI flows , speculation

Question 4

4.1.8a
Fixed Exchange rate systems

Answer 4

Fixed value against another currency / commodity
E.g Gold Standard

Question 5

4.1.8a
Managed Exchange Rate

Answer 5

• Govt intervention in buying / selling currency
• uses foreign currency reserves
• raising / decreasing IR%

Question 6

4.1.8b
Difference between revaluation and appreciation

Answer 6

Revaluation = value rises due to govt intervention
Appreciation = value rises due to marker forces

Question 7

4.1.8c
Difference between devaluation and depreciation

Answer 7

Devaluation = value falls due to govt intervention
Depreciation = value falls due to market forces

Question 8

4.1.8d
Factors influencing floating exchange rate

Answer 8

• imports / exports
• D/S if £
• IR%
• FDI / investment
• speculation

Question 9

4.1.8d
Factors influencing floating exchange rate : Imports

Answer 9

Increase in imports → more £ needed to buy foreign goods → S of £ increases on forex market → £ depreciates (value falls) → imports become more expensive → import demand decreases → supply of £ falls → exchange rate stabilizes.

Question 10

4.1.8d
Factors influencing floating exchange rate : Exports

Answer 10

Increase in exports → higher D for the country’s currency (foreign buyers need £ to pay) → D for £ rises → £ appreciates (value rises) → exports become more expensive abroad → exports eventually slow down → currency demand decreases → exchange rate stabilizes.

Question 11

4.1.8d
Factors influencing floating exchange rate : IR% increasing

Answer 11

IR% in UK ↑ → higher returns on UK assets (+) → foreign investors demand more £ to invest (+) → demand for £ ↑ → £ appreciates (+) → exports less competitive (−) → export demand ↓ → demand for £ ↓ → £ depreciates (−) → exchange rate stabilizes.

Question 12

4.1.8d
Factors influencing floating exchange rate : IR% decreasing

Answer 12

IR% ↓ → UK assets less attractive (−) → demand for £ ↓ → £ depreciates (−) → exports cheaper (+) → exports increase (+) → demand for £ ↑ → £ appreciates (+) → exchange rate stabilizes

Question 13

4.1.8d
Factors influencing floating exchange rate : Speculation of appreciation

Answer 13

Speculators expect £ to appreciate → buy £ now (+) → demand £ ↑ → £ appreciates (+) → other speculators join (+) → demand £ further ↑ → £ appreciates more → may cause currency bubble → eventual correction leads to sharp depreciation.

Question 14

4.1.8d
Factors influencing floating exchange rate : Speculation of depreciation

Answer 14

Speculators expect £ to depreciate → sell £ now (+ supply £) → supply £ ↑ → £ depreciates (−) → further selling → £ depreciates more → may cause currency crash → government may intervene

Question 15

4.1.8e
Government Intervention into exchange rates

Answer 15

• change IR%
• foreign currency transactions

Question 16

4.1.8e
Government Intervention into exchange rates : Foreign Currency Transactions

Answer 16

Government wants to support or strengthen its currency (£) → government or central bank uses foreign currency reserves to buy its own currency (£) → this means it sells foreign currency (like $ or €) and buys £ → foreign currency supply in the market increases while demand for £ increases → demand for £ rises relative to supply → £ appreciates or depreciation slows down → exchange rate stabilises or strengthens → this helps prevent excessive currency depreciation → market confidence improves → government achieves its exchange rate policy goal

Question 17

4.1.8f
Competitive devaluation

Answer 17

Country intervenes in foreign markets and depreciates £ = cheaper exports + expensive imports = better current account balance

Question 18

4.1.8f
Problems with Competitive devaluation

Answer 18

• inflation
• reduce competitiveness (tariffs)
• other countries may follow = currency war = relative prices stay similar + volatility / uncertainty due to changes

Question 19

4.1.8g
Impact of changes in exchange rates : current account

Answer 19

• Marshall Lerner condition
• J curve

Question 20

4.1.8g
Impact of changes in exchange rates : economic growth + unemployment

Answer 20

Weak exchange rates = more exports + less imports = higher demand = more jobs domestically = economic growth

Question 21

4.1.8g
Impact of changes in exchange rates : inflation

Answer 21

£ weak = less imports as more expensive = higher prices = less SRAS

Question 22

4.1.8g
Impact of changes in exchange rates : FDI

Answer 22

Weak £ = more FDI as cheaper to invest
BUT
Continually falling = less FDI as lower rate of return