4.1.8 Exchange Rates Flashcards
(19 cards)
1
Q
What are the different exchange rate systems?
A
- managed
- fixed
- floating
2
Q
What is a managed exchange rate?
A
- when the govt intervenes to manipulate the value of the exchange rate
- the aim is to avoid volatility of the exchange rate, promote stability + lower inflation
- thereby providing a better environment for investment + economic growth
3
Q
How does a managed exchange rate get lowered?
A
- if the govt wants to lower the exchange rate they sell that currency and/or lowers interest rates
4
Q
How does a managed exchange rate get increased?
A
- if they want to increase the exchange rate they buy more of that currency with foreign exchange reserves
- and/or they may increase interest rates
5
Q
How does a managed exchange rate assist LEDCs?
A
- LEDC might seek to depreciates their currency
- this helps exports to be more price competitive so net exports improve
- this may encourage investment which is crucial for growth + development
6
Q
How can a managed exchange rate assist development + economic growth?
A
- if country/central bank might seek to lower the exchange rate = export prices cheaper + imports more expensive
- increased demand for exports, fall in demand for imports = improved trade balance
- (X-M) increases = AD increases = rightward shift
- increase in real GDP, fall in unemployment + inflationary pressures
7
Q
What is a floating exchange rate?
A
- set by the forces of demand + supply - no govt intervention
- value of exports influences demand
- value of imports influences supply
8
Q
Impact of an increase in demand for pounds on a floating exchange rate
A
- increase in demand for pounds due to value of exports increasing
- other country e.g. US buyers demand pounds to pay UK exporters
- this leads to an appreciation of the pound
9
Q
Impact of an increase in supply of pounds on a floating ER
A
- increase in supply of pounds due to increase value of imports
- UK buyers supply more pounds to foreign exchange markets for euros/dollars to pay exporter
10
Q
Factors that influence demand for the pound
A
- value of exports
- inflows of FDI
- speculation
- inflows of ‘hot money’
- IF MONEY IS COMING INTO THE COUNTRY = DEMAND INCREASES FOR THE CURRENCY
11
Q
Factors influencing supply of pound
A
- value of imports
- outflows of FDI
- speculation = loss in confidence in currency = increased selling
- outflows of ‘hot money’ = lower interest rates
- MONEY LEAVING THE ECONOMY = INCREASE SUPPLY OF CURRENCY
12
Q
Impact of floating exchange rate on current account
A
- a fall in value of exports and/or increase in value of imports will lead to a deterioration of the trade balance
- this will lead to a depreciation of the currency in a floating exchange system
- BUT = self-correcting theory = weaker exchange rate means exports are cheaper + imports more expensive = ‘self-corrects’ the trade deficit
- however this theory is limited as it is unlikely to happen due to different PEDs
13
Q
Advantages of a floating exchange rate
A
- automatic adjustment of bop
- flexibility = govt isn’t tied into maintaining a specific exchange rate which can be expensive + constrictive
- low requirements to hold large foreign exchange reserves = fixed rate requires large reserves of both pounds + foreign currency
- freedom to pursue other macro objective = govt not using its resources to meet an ER target
14
Q
Disadvantages of a floating exchange rate
A
- uncertainty = price of a currency can vary on a daily basis = discourages investment
- speculation = no upper or lower limit on price of a currency (like fixed + managed) = subject to speculation by investors
- inflation = ER weakens = increases price of imports = inflation, especially true for countries reliant on import of raw materials
- damage to investment due to uncertainty
15
Q
What is a fixed exchange rate?
A
- govt tries to maintain its exchange rate against that of another country
- often implemented to promote trade + exports
- necessary for the central bank to hold large reserves of foreign currency which they either buy or release onto foreign exchange markets to maintain fixed rate
16
Q
How does the UK maintain a fixed rate?
A
- if there is an increase in demand for pounds due to increase in demand for uk exports, the exchange rate should naturally rise
- the central bank instead intervenes by buying pounds from its currency reserves in order to maintain the fixed rate
- OR the central bank could lower interest rates to reduce demand for the pound
17
Q
How did china use a fixed exchange rate?
A
- the Chinese yuan was fixed against the US$ until 2005 to keep the Chinese currency low in order to boost exports
- china fixed the exchange rate below its natural free market equilibrium
- in order to maintain this rate china increases the supply of the yuan on foreign exchange markets
- they were able to do this by utilising the large reserves of currency they had built up through exports
18
Q
Advantages of fixed ER
A
- reduces uncertainty = doesn’t not change = raises confidence + investment, trade economic growth
- economic growth = greater certainty means greater investment = increases supply side capacity + improves competitiveness leading to export led growth
- low inflation = if er kept relatively high = exports less price competitive + imports relative,y cheaper which helps reduce cost push inflation
- discipline on costs = firms aware there can’t be depreciation so need to be disciplined in keeping costs low as to not become uncompetitive
19
Q
Disadvantages of a fixed exchange rate?
A
- maintenance + wrong value = if too high or too low it can create macro problems = too high uk goods less competitive + too low = inflation pressures
- speculation = investors might sell extra currency in order to make short term profit since govt intervenes to buy back currency
- conflict of objectives = if currency depreciates, central bank may have to raise interest rates to attract hot money = damages consumption + AD
- no automatic adjustment of bop like floating exchange rate
