Exchange rate systems

Question 1

Define foreign exchange market

Answer 1

Global 24/7 markets where currencies are traded

Question 2

What is the difference between devaluation and depreciation ?

Answer 2

Devaluation is the deliberate downward adjustment of a currency, where as depreciation is decline in the value due to market powers

Question 3

What is a floating exchange rate ?

Answer 3

Rise and fall of a currency due to market forces

Question 4

What is a fixed exchange rate ?

Answer 4

Where the gov intervenes in the market to stabilise a currency’s value

Question 5

What is the range of exchange rate systems ?

Answer 5

freely floating - dirty floating (unofficial intervention by govs) - adjustable peg - rigidly fixed

Question 6

What are the key features of a floating exchange rate ?

Answer 6

1.Currency value set by market forces
2.Currency can appreciate or depreciate
3.No intervention by central banks
4.External value of currency is not an explicit target of monetary policy

VISIT PAGE 343

Question 7

What are the factors that impact supply and demand for a currency and explain them ?

Answer 7

1. Speculation

2.Official buying and selling - reserves

3.Relative inflation rates - low - more exports - appreciation

4.Relative interest rates - high - hot money - appreciation and vice versa

5.Confidence in the economy

6.Foreign trade

7.FDI- through increased demand for the pound to fund projects, signals economic growth which attracts more FDI and it increases the competitiveness of exporting industries so there is more demand for them.

Question 8

What are the key features of a fixed exchange rate system ?

Answer 8

1. Adjustable peg
   2.Central banks fixes the currency value
   3.Central bank must hold enough reserves
   4.Pegged rate becomes official rate

Question 9

How is a fixed exchange rate managed ?

Answer 9

The governments have to directly intervene to fix the mismatch in the supply and demand for that currency

Question 10

What are the 2 ways a central bank can intervene to maintain the exchange rate within floor and ceiling ?

Answer 10

After setting the peg, floor and ceiling if the currency leaves this boundary then:

1.Exchange equalisation - where the bank buys and sells its own currency to affect the exchange rate

2.Manipulation of exchange rates - e.g higher interest rates attract hot money and so currency appreciates

Question 11

What are the advantages of floating exchange rates ?

Answer 11

1. Balance of payment equilibrium -market mechanism automatic power to restabilise equlibrium so value of imports (supply) equals value of exports (demand). Never overvauled or undervalued in the long run.
2. Efficient resource allocation
3. Governments do not need to be concerned with balance of payment objectives as it is monitored and adjusted by free market forces.
4. Protection against importing inflation. Bcs if there is high inflation in other countries a fixed exchnage rate system will mean that people will imprt with higher prices. But with free floating system, the currency will appreciate making imports cheaper.
5. Independent monetary policy - focuing only on domestic objectives e.g low inflation

VISIT PG 345 FOR EXPLANATIONS

Question 12

What are the disadvantages of floating exchange rates ?

Answer 12

1.Speculation and capital flows making exchange rates vulnerable
2.International trading uncertainty
3.Cost push inflation
4.Demand pull inflation

Question 13

What are the advantages of fixed rates ?

Answer 13

1.Certainty and stability
2.Anti-inflationary discipline- iterest rates are tied with exchange rates so there is less risk of inflationary policies by the government to get more votes

Question 14

What are the disadvantages of fixed rates ?

Answer 14

1.Continued overvaluation and undervaluation can lead to misallocation of resources
2.Balance of payment imbalances
3.Loss of monetary sovereignty - interest rates are only tied with exchange rates

Question 15

Define currency union

Answer 15

an agreement between a group of countries to share a common currency and usually share a single monetary and foreign exchange policy

Question 16

What are the advantages of joining a currency union ?

Answer 16

1. Non fluctuating exchange rate - important for less developed countries as it becomes easier to trade
   2.Reduced costs from currency conversions - both for consumers and businesses
   3.Increased business confidence - greater investment as they can plan
   4.Currency is more stable against speculation
2. Easier to compare prices between countries - greater competition

Question 17

What are the disadvantages of joining a currency union

Answer 17

1. Loss of monetary policy autonomy - both printing money and interest rates
   e.g if the UK was in the eurozone during the 2008 GFC they would not have been able to employ quantitate easing

2.No potential for countries to alters their exchange rate to boost trade

3. The cost of adopting a new currency is VERY EXPENSIVE - opportunity cost

4.Lack of fiscal union - some countries are reckless with their fiscal policies which destabilises the entire union i.e overspending - increased debt e.g Greece. This becomes a burden on other countries.- Eurozone is not an optimal currency area because they are not integrated like the UK and USA where mobility of factors of production is high and a shared fiscal policy

Question 18

What is a managed exchange rate system ?

Answer 18

This is when the market is not entirely clean so central banks use reserves smooth out fluctuations

Question 19

What is an adjustable peg exchange rate ?

Answer 19

Adjusting exchnage rates so that it is within a floor or a ceiling.

The bank sets a central peg and then either uses exchnage rate manipulation or equalisation to ensure rate is within floor or ceiling

Question 20

How is exchange equalisation represented on a diagram ?

Answer 20

1. Draw the axes
   2.Draw s and D
   3.Draw the result of fall in rate e.g increase in supply
   4.Then draw increase in demand to restore it back to within floor and ceiling