Exchange rates Flashcards
(12 cards)
define depreciation
means that the value of the British pound falls relative to other currencies
adv of depreciation
- weaker pound makes UK exports cheaper for foreign buyers= increase demand for British goods abroad
e.g. UK exporters like car manufacturers may see rise in demand from overseas markets
= improve the UK’s export performance - price of foreign goods rises= can reduce the quantity of imports demanded
= this improvement in the trade balance (increased exports and reduced imports) could help boost the UK’s current account
disadv of depreciation
- imports become more expensive for UK consumers and businesses
factors that increase demand for currency
- demand for currency is a derived demand
= people will buy currency for what can be purchased with that currency - increase in foreign demand of domestic goods
= UK car exports to Europe and Chinese tourists rising and staying in UK hotels
= higher demand for UK cash - increase inwards FDI into UK
= overseas investors building factories etc= need to use domestic money to buy these factories etc - increase hot money inflow into UK banking system
= foreign investors and savers chasing highest rate of return
= higher IRs in UK increases hot money inflows - higher budget deficit as disproportional exports and imports
= increases national debt which decreases demand for sterling
examples of currency market analysis
- if central bank increases IRs= would be a relative increase in IRs as other country’s will be lower
= would make currency more attractive to investors due to higher rate of return made from UK sterling banking system
= attracts more hot money inflow
= higher demand for currency= increase value and appreciate against other currencies like euro - if major trading partner goes into recession, decrease demand for
What is a fixed exchange rate?
- where a country’s government or central bank sets and maintains its currency’s value at a specific level against another currency or a basket of currencies
- when the domestic currency is overvalued, central banks sell it and buy foreign currency to increase its supply thus reducing price
- When it’s undervalued, they buy the domestic currency to boost demand and support its value increasing its price
- Interest rates can be used to attract hot money inflows or outflows to help change ER
What is a floating exchange rate?
currency value is set purely by market forces
= strength of currency supply and demand driven the external value of a currency in the markets
NO INTERVENTION FROM CENTRAL BANK
What are the benefits of Fixed ER?
- Certainty in exchange rate → Less volatility → Investors face lower risk → Encourages foreign investment
-Reduces cost of trade → Stable rates reduce need for hedging → Lower transaction costs → Boosts cross-border trade
-Discipline on domestic producers → Can’t rely on depreciation → Must improve productivity/efficiency → Enhances competitiveness
What are some consequences of Fixed exchange rate?
1) it will clash with interest rates, IR affects hot money flows so if rates are increased to attract investments we will see affects of contractionary monetary policy (unemployment)
2) Large level of foreign currencies needed, cant increase demand for pound without selling foreign currencies
3) Speculative attacks if exchange rates are set too high or too low (think bubbles - bear run/ bull run)
Benefits of floating ER?
1) No need for currency reserves
2) Freedom for domestic monetary policy
3) Useful instrument for macro economic adjustment (if exchange rates fall exports become more competitive)
4) Automatic correction of trade deficit (trade deficit = more imports = selling of £ = increase in supply of £ = depreciation = exports cheaper = balancing deficit)
5) Reduce the risk of currency speculation (equilibrium should be reached that reflects ppp)
Consequences of floating ER?
1) Volatility - no guarantee that supply and demand wont change (foreign investors wont invest maybe lose trade aswell)
2) Self correction of a trade deficits are unlikely (speculation has greater affect on ER than a deficit would)
how is ER determined in floating system
- forces of demand and supply
= when demand is high, ER appreciates - demand for currency determined by imports and exports of country
