exchange rates

Question 1

what is a fixed exchange rate?

Answer 1

when the official exchange rate is fixed to another countrys currency

Question 2

what is needed for a fixed exchange rate to be maintained?

Answer 2

govt/ central bank needs to hold large amounts of domestic and foreign currency reserves

Question 3

what does the govt need to do if the exchange rate equilibrium is higher than the fixed exchange rate?

Answer 3

• use the currency reserves its got (needs to sell the pound currency reserves its got)
• buy foreign currencies instead
• this will increase the supply of the pound and reduce the exchange rate
• this reduced value of the exchange rate at equilibrium should equal the fixed exchange rate

Question 4

draw a diagram to show the reduction in the value of the exchange rate?

Answer 4

this is how you can reduce the value of the exchange rate when there is a fixed exchange rate or when theres pressure on it rising

Question 5

how would the govt push up the exchange rate if the initial equilibrium is lower than the fixed exchange rate?

Answer 5

• govt needs to increase demand for the pound by using their foreign currency reserves to buy up more of the pound in the market
• this increases the value of the pound
• this increase in the exchange rate (which is the exchange rate at initial equilibrium) should now equal the fixed exchange rate

Question 6

draw a diagram to show the value of the exchange rate decreasing

Answer 6

Question 7

how can the govt change the fixed exchange rate?

Answer 7

if the UK govt decides they want to change the fixed exchange rate they can devalue the pound

Question 8

what is depreciation of exchange rate?

Answer 8

depreciation is when the floating exchange rate falls in value

Question 9

what is appreciation of the exchange rate?

Answer 9

appreciation is when the floating exchange rate increases in value

Question 10

what do you say when referring to the change in the value of the exchange rate

Answer 10

when it comes to fixed exchange rate you say devalue or revalue

Question 11

what is a floating exchange rate?

Answer 11

floating exchange rate is when a nations currency is set through supply and demand

Question 12

what does it mean when theres a trade imbalance/ current account deficit?

Answer 12

• importing more than exporting
• more supply of the pound than demand for the pound
• (have to exchange the pound in order to buy foreign imports by exchanging the pound for a foreign currency
• this depreciates the pound

Question 13

what happens when a currency depreciates in terms of the CA?

Answer 13

• whenever a currency depreciates, imports become more expensive and exports become cheaper
  
  • this, in theory, should reduce the demand for imports which could help resolve the current account deficit

Question 14

what determines the supply and demand of a currency

Answer 14

speculation tends to drive the demand and supply of a currency
investment (FDI)
sale of exports

Question 15

what are the arguments for using a floating exchange rates?

Answer 15

reduces the need for currency reserves
freedom for domestic monetary policy
useful instrument for macroeconomic adjustment
partial automatic correction for a trade deficit
reduced risk of currency speculation
resource allocation

Question 16

why do floating exchange rates reduce the need for currency reserves?

Answer 16

a floating exchange rate doesnt need large levels of currency reserves whereas fixed exchange rates do in order to maintain them which can be costly and may not be viable

Question 17

why do floating exchange rates cause freedom for monetary policy?

Answer 17

• some fixed exchange rate systems will require the manipulation of interest rates in order to keep an exchange rate fixed to a certain currency
• whereas in a floating exchange rate there is no need to change interest rates to keep the exchange rate fixed
• you can use monetary policy to deal with domestic issues in the economy such as inflation

Question 18

why is floating exchange rates a useful instrument for macroeconomic adjustment?

Answer 18

reduction in exchange rate could help e.g increase growth by increasing exports

Question 19

how do floating exchange rates cause partial automatic correction for a trade deficit?

Answer 19

-for example if a country has a large current account deficit/ trade deficit a floating exchange rate increases the supply of the currency which will reduce the value of the currency
- makes imports more expensive and exports cheaper
- this could help partially correct a current account deficit

Question 20

what is speculation

Answer 20

when someone who invests in foreign currency buys some currency in the hopes of selling it at an appreciated rate when market fluctuations happen

Question 21

how do floating exchange rates reduce the risk of currency speculation?

Answer 21

• in a floating exchange rate system, exchange rates should reach an equilibrium which reflects purchasing power parity
• the currency is valued perfectly (not over or undervalued)
• therefore the risk of speculative attacks are less likely to occur especially if a currency is overvalued
• more stability as exchange rate is at equilibrium

Question 22

recall the arguments against floating exchange rates?

Answer 22

self correction of trade deficits unlikely to occur
inflation rates causes issues with export competitiveness
volatility

Question 23

why is self correction of trade deficits using floating exchange rates unlikely to occur?

Answer 23

• theoretical
• in reality its unlikely to occur
• this is because imports and exports are only two of the factors that affect the supply and demand of a currency
• speculative flows are more likely to affect demand and supply and change the exchange rate value

Question 24

how can inflation rates be used as an argument against floating exchange rates?

Answer 24

• if an economy is suffering from high levels of inflation rates they may be struggling to export
• may mean that net exports are negative
• high inflation causes issues with export competitiveness
• this will put downward pressure on the exchange rate
  
  • this is because supply of currency will be increasing more than demand for the currency which lowers the exchange rate
• lower exchange rate may push up inflation through higher import prices and demand pull inflation

Question 25

how can volatility be used as an argument against floating exchange rates?

Answer 25

- no guarantee that floating exchange rates will be stable - can reduce the incentives for foreign investors to invest in the domestic country if exchange rates are very volatile - foreign investors dont know what they’re getting in terms of currency - puts off foreign investment, trade

Question 26

recall the arguments for a fixed exchange rate?

Answer 26

lowers exchange rate uncertainty which gives confidence for inward investment some flexibility is permitted reduce the cost of trade (reduced hedging) discipline on domestic producers

Question 27

how do fixed exchange rates lower exchange rate uncertainty?

Answer 27

exporters and importers know that the exchange rate will be fixed at this level they will be more confident that the returns from their investments wont be destroyed by fluctuations in the value of the currency

Question 28

how is some flexibility permitted with fixed exchange rates?

Answer 28

- in reality countries that have adopted a fixed exchange rate have a band within which the exchange rate can move up and down -> central peg - doesnt have to stay at one specific point central peg range can move up or down over time - also if a govt wants to reduce the exchange rate value they can devalue the currency - problem with doing this - politically not acceptable

Question 29

how can fixed exchange rates be used to reduce the cost of trade

Answer 29

- a foreign country who wants to buy domestic goods which may have a floating exchange rate may buy some of the countries currency now even if they dont want to buy any of the countries exports to hedge against the potential rise in their currency and this is costly - with fixed exchange rate theres no need to hedge

Question 30

how do fixed exchange rates discipline domestic producers?

Answer 30

- they know that they cant rely on an exchange rate falling in value as the exchange rate is fixed - if they are to maintain competitiveness the only way they can do that is to increase efficiency, invest, innovate

Question 31

what are the arguments against a fixed exchange rate?

Answer 31

interest rates effect large levels of foreign currency reserves needed to maintain a fixed exchange rate? speculative attacks if exchange rate is set too high or too low reduced freedom to use interest rates for other maco objectives conflict with other macro objectives need to revise fixed rates regularly

Question 32

using fixed exchange rates unlikely to occur?

Answer 32

- if interest rates are being used to maintain a fixed exchange rate - if the fixed is set at a level where the current exchange rate is lower, then the exchange rate needs to rise to meet the fixed exchange rate and this may be done by raising interest rates - however this may reduce growth, increase unemployment → macroeconomic consequences

Question 33

what my be needed to maintain a fixed exchange rate?

Answer 33

- large levels of foreign currency reserves needed to maintain a fixed exchange rate? - can a govt hold this? possibly not as it may not be viable for them - if not system may collapse

Question 34

how can speculative attacks be used as an argument against fixed exchange rates?

Answer 34

- with a fixed exchange rate there is no guarantee that the exchange rate that is decided is actually going to be the correct purchasing power value - may be undervalued in which case speculative attacks can destabilise the whole system is more likely

Question 35

what type of exchange rate do you tend to see?

Answer 35

you see floating exchange rates most of the time

Question 36

what does a managed floating exchange rate system allow the central bank to do

Answer 36

allows a nation's central bank to intervene regularly in foreign exchange markets to change the direction of the currency's float and/or reduce the amount of currency volatility

Question 37

how does depreciating the currency solve a current account deficit?

Answer 37

- with a weak exchange rate, imports become more expensive, exports cheaper (WIDEC) - export revenue should in theory increase

Question 38

what does the Marshall-Lerner condition state and how can this be used to evaluate the policy of using the exchange rate to solve a current account deficit?

Answer 38

the Marshall-Lerner conditions states that a currency depreciation will only correct a current account deficit if this equation holds: the price elasticity of demand of exports + the price elasticity for imports sum to greater than 1

Question 39

why is the marshall lerner condition important?

Answer 39

- so if a good is elastic, if you increase the price, total revenue will fall - if a good is price inelastic if you increase the price, total revenue will increase - this applies to demand for exports and imports

Question 40

what happens if export demand is very inelastic and the currency depreciates?

Answer 40

then total export revenue will also fall

Question 41

what happens if the demand for imports is inelastic and the exchange rate depreciates?

Answer 41

imports become more expensive so price increases, total expenditure on imports will increase

Question 42

what will happen is spending on imports are high and spending on exports is low

Answer 42

will worsen the current account position

Question 43

what happens if the overall elasticity of net exports is inelastic?

Answer 43

the equation above doesnt hold as the overall elasticity is less than one - price of exports are falling → weaker exchange rate - total revenue is also falling this will worsen a current account deficit money inflows will fall

Question 44

what happens if the elasticity for net exports is greater than one?

Answer 44

- (elastic) reducing the price of exports will lead to an increase in total revenue generated - leads to current account surplus

Question 45

in the short term, why doesnt the marshall-lerner condition hold?

Answer 45

- in the short term demand tends to be inelastic for both imports and exports so that the total elasticity for net exports is less than 1 - this is because consumers that tend to import take time to adust to the fact that imports are more expensive so they continue to buy/consume at the same rate as before - they dont understand what this depreciation means - also for foreign countries who may buy from e.g the UK it takes time for them to realise that their exports are cheaper - this leads to the J curve effect

Question 46

what is the J curve effect- draw the J curve?

Answer 46

j-curve effect- a current account will actually start to worsen before it improves because of this only as people start to adjust to an exchange rate and reduce import expenditure, only then will their current account start to improve

Question 47

what is the relationship between interest rates and the exchange rate

Answer 47

higher interest rates offer lenders in an economy a higher return relative to other countries higher interest rates attract foreign capital and cause the exchange rate to rise

Question 48

how does an investment affect the demand for a nation's currency

Answer 48

households and organisations may wish to invest in UK firms (either in the form of FDI or portfolio investment) or place funds in UK banks if interest rates are attractive this creates demand for the currency on the foreign exchange markets

Question 49

how does sale of exports affect the demand for a currency

Answer 49

exporters int he uk will expect to be paid in domestic currency so buyers from other countries will need to sell their currency on the foreign exchange market to buy pounds

Question 50

what factors affect the supply of a currency

Answer 50

speculative purposes to invest abroad as holders of pounds may buy shares in companies abroad to buy imports

Question 51

what happens to the value of the domestic currency if theres an improvement in non price factors of good produced abroad

Answer 51

supply of the domestic currency increases/ shifts outwards to buy the foreign countries goods / buy imports value of the currency decreases due to the exceess supply of the domestic currency increases price competitiveness of domestic imports

Question 52

what are the tools for managing the floating exchange rate

Answer 52

monetary policy buying and selling of its currency taxing foreign investments controls on the free flow of capital into and out of a country

Question 53

what is dirty floating/ competitive devaluation

Answer 53

when a country deliberately intervenes to drive down the value of their currency to gain an advantage in its international trade they may also do this to attract extra FDI

Question 54

how is the floating exchange rate useful for resource allocation

Answer 54

exchange rates must be correctly valued if the worlds resources are to be allocated efficiently between competing uses a freely floating exchange rate should respond and adjust to changes such as discovery of minerals whereas fixed ER may be over or undervalued in favour of the country different rates of inflation between countries mean

Question 55

how can the fixed exchange rate lead to a misallocation of resouces

Answer 55

different rates of inflation between countries mean that the fixed exchange rate leads to a misallocation of resources between economies

Question 56

what may be the effects of an appreciation of the exchange rate of a currency on current account

Answer 56

reduce demand for exports -> appear more expensive when converted into other currencies increased demand for imports as they appear cheaper

Question 57

how can the effects of an appreciation of the exchange rate of a currency be evaluated

Answer 57

currency may not have appreciated against all currencies currency may have appreciated against currencies of countries who dont recieve many of their exports value of currency may change in the long term marshall-lerner condition J-curve effect non price facos may be more important