6.3 Foreign Exchange Rates

Question 1

What is the foreign exchange rate?

Answer 1

The foreign exchange rate is the value or price of a currency expressed in terms of another currency. For example, £1 = $1.2.

Question 2

How is the foreign exchange rate determined?

Answer 2

The foreign exchange rate of each currency is determined by the market demand and supply of the currency.

Question 3

What causes the demand for a currency?

Answer 3

Demand for a currency exists when foreign consumers want to buy and import goods and services, or when overseas companies buy the currency to invest in the country.

Question 4

What causes the supply of a currency?

Answer 4

Supply of a currency exists when domestic consumers want to buy and import goods and services, or when domestic companies buy foreign currencies to invest abroad.

Question 5

What is equilibrium in foreign exchange rates?

Answer 5

The price at which the demand and supply of the currency equals is the equilibrium market foreign exchange rate value.

Question 6

What causes exchange rates to fluctuate?

Answer 6

Factors include changes in export/import demand, inflation, interest rates, foreign direct investment (FDI), speculation, and government intervention.

Question 7

What is the effect of inflation on exchange rates?

Answer 7

If inflation in a country is higher than in others, its goods become more expensive internationally, causing a decrease in demand for the currency and a fall in the exchange rate.

Question 8

How do interest rates affect exchange rates?

Answer 8

Higher interest rates may attract foreign investment, increasing demand for the currency and causing the exchange rate to rise. Lower interest rates have the opposite effect.

Question 9

What is the effect of foreign direct investment (FDI) on exchange rates?

Answer 9

Inward FDI increases the demand for a country’s currency, while outward FDI increases its supply, affecting the exchange rate.

Question 10

What is speculation’s effect on exchange rates?

Answer 10

Speculation can lead to currency fluctuations as foreign exchange traders move money based on anticipated changes in interest rates or exchange rates.

Question 11

How can government intervention affect exchange rates?

Answer 11

The government can intervene by buying or selling its currency in the foreign exchange market to adjust its value.

Question 12

What is appreciation in foreign exchange rates?

Answer 12

Appreciation occurs when the demand for a currency increases, or the supply decreases, causing its exchange rate to rise.

Question 13

What is depreciation in foreign exchange rates?

Answer 13

Depreciation occurs when the demand for a currency decreases, or the supply increases, causing its exchange rate to fall.

Question 14

What are the consequences of a falling exchange rate?

Answer 14

A falling exchange rate causes import prices to rise and export prices to fall, making imports more expensive and exports cheaper.

Question 15

What are the consequences of a rising exchange rate?

Answer 15

A rising exchange rate causes import prices to fall and export prices to rise, making imports cheaper and exports more expensive.

Question 16

What is the effect of exchange rate fluctuations on trade balance?

Answer 16

A fall in the exchange rate improves the trade balance by boosting exports, while a rise worsens it by increasing imports.

Question 17

What is a floating foreign exchange rate?

Answer 17

A floating exchange rate is determined by market demand and supply and fluctuates regularly.

Question 18

What is appreciation in a floating exchange rate system?

Answer 18

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

Question 19

What is depreciation in a floating exchange rate system?

Answer 19

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

Question 20

What are the advantages of a floating exchange rate?

Answer 20

Advantages include automatic stabilization of the balance of payments, freedom for internal policy objectives, insulation from external changes, and no need for large foreign reserves.

Question 21

What are the disadvantages of a floating exchange rate?

Answer 21

Disadvantages include uncertainty, lack of investment due to exchange rate volatility, speculation, and lack of discipline in addressing short-term issues.

Question 22

What is a fixed foreign exchange rate?

Answer 22

A fixed exchange rate is controlled by the central bank, which intervenes in the market to maintain the set rate.

Question 23

What is devaluation in a fixed exchange rate system?

Answer 23

Devaluation is the deliberate fall in the value of a fixed exchange rate.

Question 24

What is revaluation in a fixed exchange rate system?

Answer 24

Revaluation is the deliberate rise in the value of a fixed exchange rate.

Question 25

What are the advantages of a fixed exchange rate?

Answer 25

Advantages include certainty in the economy, stability that encourages investment, low inflation, and balance of payments stability.

Question 26

What are the disadvantages of a fixed exchange rate?

Answer 26

Disadvantages include conflicts with other macroeconomic objectives, lack of flexibility to respond to shocks, and the risk of overvaluation or undervaluation.