7- Exchange rates

Question 1

Free floating exchange rate system

Answer 1

• Value of the currency determined by supply and demand.
• No target set by the government.
• No government intervention

Question 2

Advantages of floating exchange rate

Answer 2

• Central bank does not need to try and maintain a particular exchange rate and therefore will not need to use reserves to buy (pounds) to keep at target.
• Interest rates can be reserved for independent monetary policy to control inflation rather than maintaining the exchange rates.
• Partly able to correct a trade deficit as a large trade deficit will cause a fall in the value in the pound since the supply is high and demand is low making exports cheaper, exports more expensive (Marshall Lerner Condition).
• Reduces risk of currency speculation- which is most attractive when the currency is over or undervalued.

Question 3

Managed floating exchange rate

Answer 3

• Value of the currency is determined by supply and demand.

- But Central Bank will try to prevent large change in the exchange rate on a day-to-day basis.

Question 4

How do governments/central banks change the value of its currency?

Answer 4

• By buying and selling currency

- Changing interest rates

Question 5

Fixed exchange rate

Answer 5

• When a government sets their currency against another and the exchange rate doesn’t change.
• The country can decide to devalue its currency overnight to improve its international competitiveness of its industry.

Question 6

Advantages of appreciaiton

Answer 6

• Lower inflation
• Cheaper imports- higher living standards
• Potential efficiency gains for domestic producers

Question 7

Disadvantages of appreciation

Answer 7

• Lower growth- current account deficit

- Higher unemployment for exporting industries and in domestic industries

Question 8

Advantages of depreciation

Answer 8

• Higher employment in exporting industries and domestic industries
• Growth

Question 9

Disadvantages of depreciation

Answer 9

• Higher inflation