Exchange Rate

Question 1

State the three ER regimes

Answer 1

1. Fixed
2. Floating
3. Managed

Question 2

Which terms are used to describe increase/decrease in the value of a currency in a fixed ERR?

Answer 2

revaluation/devaluation

Question 3

Which terms are used to describe increase/decrease in the value of a currency in a managed/floating ERR?

Answer 3

appreciation/depreciation

Question 4

Advantages of high ER

Answer 4

1. Strong purchasing power –> imported goods and services become relatively cheaper –> improved living standards (foreign holidays)
2. Downward pressure on inflation: competition from low-priced imports forcing domestic firms keeping prices low + cheap imported inputs reduce firms’ costs of inflation
3. Increased competition from imports forces domestic + exporters to improve their efficiencies + productivity

Question 5

Disadvantages of high ER

Answer 5

1. Exporters + domestic firms are worse-off –> may not survive from the aggressive competition from abroad –> unemployment
2. CA deficits are more likely to occur
3. Reduced circular flow of income in the domestic economy for investment purposes

Question 6

Advantages of low ER

Answer 6

1. Exporters are better-off: export industry is more likely to thrive –> employment
2. Encourages foreign investments

Question 7

Disadvantages of low ER

Answer 7

1. Inflation (imported inputs + prices of imports)

2. Artificially low ER may cause trade disputes and retaliation

Question 8

Pros of fixed ERR

Answer 8

1. Reduces uncertainties: Bs are able to predict future market changes, and plan ahead much more easily
2. Ensures sensible government policies on inflation management: in a fixed ERR, higher inflation increases P of exports more significantly, as the free-market forces in foreign exchange market is not able to reach equilibrium
3. Reduces speculation

Question 9

Cons of fixed ERR

Answer 9

1. Trade disputes (dissatisfaction from other countries): as artificially low ERs are perceived as an unfair trade advantage
2. Dependence on government: what if the government is poorly-managed/inefficient? What if the government does not have enough reserves of foreign currencies/gold?
3. Difficult to find the right fixed ER because there are too many factors to be taken into consideration (export/import, employment/inflation/CA/government budget/amount of foreign reserves available/investment): any mistakes can lead to distrastrous impacts
4. Only applicable if the G has monopolistic power on the exchange of currencies (e.g. China devaluating RMB in 1990s to promote exports)
5. Emergence of black markets
6. Domestic macroeconomic objestives might be sacrificed: if the G relies on manipulating IR to peg ER (e.g. higher IR to revaluate the currency) –> low growth/output + high unemployment

Question 10

Pros of floating ERR

Answer 10

1. Does not require highe levels of foregin reserves of the government
2. Macroeconomic objectives are not sacrificed
3. Self-adjusting ER corrects CA deficits (deficit –> high demand for import –> high supply of the currency –> depreciation –> export becomes more price competitive)
4. IR is free to be employed as a monetary tool

Question 11

Cons of floating ERR

Answer 11

1. Prone to be speculated
2. Uncertainties –> reduces investment and FDI
3. May not self-adjust to correct CA deficits because there are too many other factors that determines ER
4. May worsen exisitng levels of inflation (high inflation –> low demand for exports –> low demand for the currency –> depreciation –> price of exports become higher)

Question 12

Reasons why G wish to intervene the foreign exchange market

Answer 12

1. Reduce inflation
2. Maintain a fixed ERR
3. Correct CA deficits
4. Achieve ER stability to increase business confidence and boost FDI
5. To avoid large fluctuations

Question 13

How can G intervene the foreign exchange market?

Answer 13

G can intervene by either INCREASING the demand/supply of its own currency using:

1. Its reserves of foreign currencies + gold (D)
2. IR (central bank) (S+D)