4.5b Other Exchange Rate Systems

Question 1

What is a “Fixed Exchange Rate”?

Answer 1

A system of exchange rate where the value of the currency is tied or fixed against another currency.
Eg. In the UAE 1 dirham - 0.27 USD ALWAYS! (does not CHANGE!)

Question 2

How is the exchange rate kept fixed?

Answer 2

1. Sells/ supplies domestic currency in the currency market by buying foreign exchange
2. Central bank buys/ creates a demand for domestic currency by selling foreign exchange

Question 3

Example of how fixed exchange rate markets work:

Answer 3

increase in demand for GBP
–> shortage/ excess demand
–> to solve this the CB will increase the supply of GBP (sell domestic currency in the market) to keep exchange rate fixed

Question 4

What should the CB do if there is a fall in the demand for the currency? (fixed-exchange?)

Answer 4

Fall in demand for GBP
–> Surplus/ excess supply of domestic currency is the resulting problem
–> the central bank buys the surplus, shifting D2 back to D1 –> keeping exchange rate fixed

Question 5

What should the CB do if there is an increase in supply for the currency? (fixed-exchange?)

Answer 5

An increase in supply of GBP
–> A problem of surplus of GBP is created in foreign exchange market
–> The central bank will buy this excess supply of GBP, keeping the exchange rate fixed

Question 6

What should the CB do if there is a fall in the supply for the currency? (fixed-exchange?)

Answer 6

A fall in supply of GBP
–> shortage of GBP
–> Central bank will supply GBP to get rid of shortage –> keeps exchange rate fixed
–> builds up foreign exchange reserve

Question 7

What are some other ways the CB can intervene to maintain a fixed exchange rate?

Answer 7

1. Increase in interest rates
2. Borrowing from abroad
3. Efforts to limit imports

Question 8

How would “increase in interest rates” maintain a fixed exchange rate?

Answer 8

The central bank can increase interest rates, which attract financial investments from other countries.
This leads to a higher demand for the domestic currency, shifting the demand for currency.

Question 9

How would “borrowing from abroad” maintain a fixed exchange rate?

Answer 9

If the country borrows from abroad, its loans will come in the form of foreign exchange, which when converted into boples will cause an increase in the demand for bples and hence a rightward shift in the demand curve.

Question 10

How would “efforts to limit imports” maintain a fixed exchange rate?

Answer 10

The government could use policies to limit imports, because this reduces the supply of the domestic currency (since it reduces demand for foreign exchange needed to buy imports), causing a leftward shift in the currency.

Question 11

What is a “Managed-Floating” exchange rate?

Answer 11

In between the two extremes of floating exchange rates and fixed exchange rates.

Exchange rates are for the most part free to float to their market levels over long periods of time; however, central banks periodically intervene to stabilise them over the short run.

Question 12

What is an advantage of an overvalued exchange rate?

Answer 12

Cheap imports of raw materials

Question 13

What are some disadvantages of an overvalued exchange rate

Answer 13

• Exports become more expensive for foreigners, so lowers (AD shift inwards?)
• Producers for the domestic market might be worse off as consumers might prefer importing cheaper goods and services

Question 14

What are some advantages of an undervalued exchange rate?

Answer 14

• Cheaper exports encourage trade
• Boosts investment –> more jobs (as FDI becomes attractive)

Question 15

What are some disadvantages of an undervalued exchange rate?

Answer 15

• Expensive imports
• Costs of production increases as import costs are higher