Exchange rates

Question 1

What is the exchange rate

Answer 1

The price of one currency in terms of another

Question 2

How is the exchange rate determined

Answer 2

Supply and demand of that currency in foreign exchange market

Question 3

Give 5 factors that cause changes in the demand for a currency

Answer 3

1. Changes in RELATIVE interest rates
2. Speculation that the currency will appreciate/depreciate
3. Changes in FDI
4. Changes in incomes abroad
5. Change in competitiveness

Question 4

How does an increased relative interest rate increase demand for the pound

Answer 4

• UK assets such as bonds and savings account are more attractive to foreigners as there is higher rate of return causing hot money to flow in
• Foreign investors need to buy £s to invest in UK assets, increasing demand for the £

Question 5

How would speculation anticipating a rise in the £ lead to increased demand for the £

Answer 5

• This speculation may be based on higher relative interest rates, strong growth or political stability
• They start buying £s now to profit from future appreciation, causing shift in demand

Question 6

How would increased FDI cause an increase in demand for the £

Answer 6

• The foreign firms need to exchange their currency for £s if they want to pay for factories and workers

Question 7

How does rising incomes abroad increase the demand for the £

Answer 7

• As incomes rise, marginal propensity to import rises as foreigners have more disposable income to spend on luxury/exotic goods and services from the UK e.g. education
• Need to exchange to £s to buy these goods and services

Question 8

How does increased international competitiveness of UK exports increase demand for £

Answer 8

• International competitiveness increase caused by lower union labour costs for businesses, lower inflation rates and more investment
• Means higher demand for UK exports so higher demand for £

Question 9

Give 5 factors that increase supply of currency

Answer 9

• Lower relative interest rates as hot money outflows
• Speculation in anticipation of a fall in the value of the £
• Firms moving from UK to another country (opposite of FDI)
• Incomes rise domestically

Question 10

How does firms moving from UK to another country increase supply of £

Answer 10

• When they leave, they exchange their £s for the new currency they need
• To exchange £s they need to increase supply of them in forex market

Question 11

How does incomes rising domestically increase supply of £

Answer 11

• Marginal propensity to import of UK citizens increases
• To trade £s for another currency (from the country they want to import from), they need to supply these £s to the forex market

Question 12

How does a country maintain a fixed exchange rate

Answer 12

Pick an exchange rate they want and manipulate supply and demand for the currency using domestic and foreign currency reserves to maintain that rate

e.g. if they want to increase the exchange rate, supply more foreign currency reserves to buy domestic currency

Question 13

What is the condition for a country to be able to have a fixed exchange rate

Answer 13

Large reserves of foreign and domestic currency

Question 14

What is devaluation and revaluation

Answer 14

Where a government decides to change the target set for the fixed exchange rate e.g. instead of fixing at £1 = $1.60 they want to change to £1 = $1.50

Revaluation is increasing the target and devaluation is decreasing the target

This is different from appreciation/depreciation which is for a floating exchange rate

Question 15

How can a government change the exchange rate to keep it fixed without currency reserves

Answer 15

Changing the interest rate as high interest rate increases exchange rate and low interest rate decreases exchange rate

Question 16

What are the drawbacks of changing interest rate to keep a fixed exchange rate

Answer 16

1. It is not directly changing the exchange rate so may not work
2. Could have side effects on the economy e.g. increasing interest rates reduces AD, unemployment

Therefore, using currency reserves is more common

Question 17

What are the drawbacks of an exchange rate appreciation

Answer 17

1. Lower economic growth as X-M is negative
2. Higher unemployment in exporting industries as exports are dearer and high unemployment in domestic industries as imports are cheaper so they can’t compete

Question 18

What are the benefit of an exchange rate appreciation

Answer 18

1. Lower demand pull inflation as AD falls and lower cost push inflation as SRAS increases (as cheaper imports reduces costs of production)
2. Cheaper imports improves choice and reduces costs for consumers buying foreign goods so improves living standards
3. If imports are cheaper, domestic firms will have to become more productively efficient to compete

Question 19

What are the benefits of a depreciation in the exchange rate

Answer 19

1. If the country has a strong exporting base, would lead to increased growth as X-M increases
2. Derived demand for labour in exporting industries and domestic industries increases as exports cheaper and imports dearer so unemployment falls

Question 20

What are the drawbacks of a depreciation in the exchange rate

Answer 20

Higher demand pull inflation as AD rise and higher cost push inflation as SRAS fall as imports dearer so firms cost of production rise

Question 21

What are the evaluation points when considering the impact of an appreciation or depreciation of the exchange rate

Answer 21

1. How much the exchange rate has changed
2. The change in revenue generated from exports and expenditure on imports depends on PED for exports and imports
3. Protectionism would reduce the benefits from a depreciation of exchange rate

Question 22

How could a current account deficit automatically correct

Answer 22

• CA deficit probably means high imports less exports as trade is a key component
• To import, you need to supply more of your domestic currency to exchange for the foreign one
• Supply shifts out means exchange rate falls, so export revenue might increase and import expenditure decrease, so reduced CA deficit

Question 23

Why does the theory of an automatically correcting CA deficit not happen in the real world

Answer 23

• There are other factors determining the supply and demand of a currency apart from trade
• e.g. speculation is the main driver of appreciation/depreciation and its effect overrides the impacts of trade

Question 24

What is the Marshall Lerner condition

Answer 24

A currency depreciation will only correct a CA deficit if the PED for exports + PED for imports is >1 (e.g. elastic)

Question 25

Explain why the Marshall Lerner condition is true

Answer 25

If PED is inelastic during a devaluation policy: - Exports are cheaper so price is falling but quantity demanded doesn't rise much as PED for exports is inelastic so total revenue (price x quantity) from exports will fall - Imports are dearer so price is rising but quantity demanded doesn't fall much so total expenditure (price x quantity) on imports will rise CA deficit measures the value of imports and exports (expenditure and revenue) so will worsen

Question 26

How does the J curve show the Marshall Lerner condition

Answer 26

- Graph of CA deficit against time where y>0 is surplus and y<0 is deficit - At lower times, the depreciation will cause current account deficit to worsen as PED is inelastic as firms and consumers don't have time to respond to price changes - As time increases, CA deficit changes to surplus as PED becomes more elastic

Question 27

What is purchasing power parity

Answer 27

Where the exchange rate is at the level where you can buy the same level of goods and services in each country so if £1 = $1.60 then PPP is if, for example, £1000 can buy the same amount in UK as $1600 can buy in the USA

Question 28

How does inflation affect purchasing power parity

Answer 28

- Before, £1 = $1.60 and £1000 can buy the same amount in UK as $1600 can buy in the USA - Inflation in USA could cause the same level of goods and services to cost $1700 dollars in the USA so nominal exchange rate no longer reflects PPP and the £ is undervalued against the dollar and $ is overvalued against £

Question 29

Why do economists use the real exchange rate instead of nominal

Answer 29

Takes into account inflation so shows how much you can actually buy with £s in the USA for example e.g. when nominal exchange rate was £1 = $1.60 and £1000 can buy the same amount in UK as $1700 can buy in the USA then the real exchange rate is £1 = $1.70

Question 30

How does the nominal exchange rate adjust to reflect purchasing power parity

Answer 30

- If the $ was overvalued against £ so £ was undervalued against $, then people in the USA would exchange their $s for £s as they can buy more goods and services in the UK with the same amount of money - Increased demand for £ causes £ to appreciate so £1 can now buy more than $1.60 so eventually will reflect purchasing power parity

Question 31

Why does the nominal exchange rate not adjust to reflect PPP in reality

Answer 31

Demand for imports and exports is not the only thing that determines the demand and supply of currency Speculation drives changes and overrides effects of trade

Question 32

What are the advantages of a floating exchange rate

Answer 32

1. Less need for currency reserves 2. More freedom for monetary policy 3. Could help automatically correct CA deficit 4. Less risk of speculative attacks

Question 33

How does a floating exchange rate mean more freedom for monetary policy

Answer 33

The country doesn't need to worry about changes to interest rates changing exchange rate and missing the fixed target Therefore, they have freedom to use monetary policy to fix issues like growth and unemployment`

Question 34

How does a floating exchange rate mean less risk of speculative attacks

Answer 34

- In theory, floating exchange rate adjusts to reflect purchasing power parity so currency is not over or under valued, which is what causes speculators to increase demand or supply

Question 35

What are the drawbacks of a floating exchange rate

Answer 35

1. Volatility of exchange rate puts of FDI and trade as it is too unstable for countries and businesses to trust 2. Self correction of CA deficits or purchasing power parity is unlikely as speculation overrides impacts of trade on demand and supply for a currency 3. Higher inflation caused less exports more imports so exchange rate falls, which increasing import costs and AD rising causes inflation to rise even more

Question 36

What are the advantages of a fixed exchange rate

Answer 36

- Less volatility of exchange rate means more FDI and trade - Still some flexibility permitted - Forces domestic producers to increase efficiency and innovate as they can't rely on exchange rate depreciation

Question 37

How is there still some flexibility with a fixed exchange rate

Answer 37

- Most countries with a fixed exchange rate allow a small band of exchange rates to be allowed - Country can devalue or revalue if it wants

Question 38

What are the drawbacks of a fixed exchange rate

Answer 38

- Country may need to change interest rates to bring exchange rate back leading to side effects - Government needs to hold large currency reserves which is expensive - Exchange rate may not reflect PPP so overvalued or undervalued leading to speculative attacks

Question 39

What is a managed exchange rate

Answer 39

Where the country uses a floating exchange rate most of the time but government intervenes to change exchange rate if necessary e.g. China (idea is best of both worlds)