Exchange Rate Systems

Question 1

What is an exchange rate ?

Answer 1

The exchange rate of a currency is the weight of one currency relative to another

Question 2

What are the 2 types of exchange rate systems ?

Answer 2

Fixed and floating exchange rate

Question 3

What is a floating exchange rate system ?

Answer 3

The value of the exchange rate in a floating system is determined by the forces of supply and demand

Question 4

What is a fixed exchange rate system ?

Answer 4

A fixed exchange rate has a value determined by the government compared to other countries

Question 5

How can interest rates affect the exchange rate ?

Answer 5

An increase in interest rates makes it more attractive to invest funds in the country (hot money) because of the high rates of return. This increases demand for the currency causing an appreciation

Question 6

How does Quantitive easing (QE) affect the exchange rate ?

Answer 6

Used by banks to help stimulate the economy when standard monetary policy is no longer effective. This has inflationary effects since it increases the money supply, and reduce the value of the currency. QE is used when inflation is low and it’s not possible to lower interest rates further

Question 7

What are the advantages and disadvantages of a fixed exchange rate system ?

Answer 7

Advantages - Allows firms to plan investment, because they know they won’t be affected by harsh fluctuations in the exchange rate
- Gives monetary policy a focused policy to work towards
Disadvantages - The government and central bank don’t necessarily know better than the market and where the currency should be
- Balance of payments doesn’t automatically adjust to economic shocks
- It can be difficult / costly for the government to hold large reserves for foreign currency

Question 8

What are the advantages and disadvantages of a floating exchange rate system ?

Answer 8

Advantages - The exchange rate automatically adjust to economic shocks
- Fives monetary policy more freedom to focus on other macroeconomic objectives
Disadvantages - Fluctuations can be unpredictable so harder planning investments
- Can effect imports / exports of a country which can cause unemployment
- Can make the exchange rate vulnerable speculative shocks

Question 9

Advantages and disadvantages for a country joining a currency Union e.g. eurozone ?

Answer 9

Members of a monetary Union share the same currency
Monetary Union use the same interest rates

Advantages:
- Participating countries have more currency stability, currency less prone to speculative shocks. This gives future market more certainty thus more investment and growth potential
- Less red tape / admin when travelling abroad
- Small firms benefit from the time and money saved trading on a common currency

Disadvantages:
- The exchange rate is not flexible to meet individual countries needs such as if they need to boost exports
- Member nations lose sovereignty when there is a common monetary Union. This means that countries with a strong economy have to co-operate with counties with a weaker economy. They can’t adopt their policies to meet individual requirements