Exchange Rates Flashcards
(18 cards)
What is an Exchange Rate?
The price of a currency in terms of another. It is determined by demand and supply in FOREX markets
What is a Bilateral Exchange Rate?
One currency in terms of one other currency. eg £1
= $1.05
What is a Multilateral Exchange Rate?
One currency in terms of a group of other currencies
e.g. effective or trade-weighted index = a weighted average exchange rate expressed as an index (Base year =100)
What is a Real Exchange Rate?
Effective exchange rate is adjusted for relative inflation rates
What is an Equilibrium Exchange Rate?
Equilibrium exchange rate: the rate which equates demand and
supply for a particular currency against another currency.
Changes in the equilibrium exchange rate happen when there are changes in currency demand and supply
Factors influencing the Supply of a currency?
Supply of a currency is an outflow of money into an economy.
• Domestic spending on imported goods and services
• Outflow of portfolio flows in property, shares and bonds
• Hot money flowing out of a country’s banking system
• Outflows of foreign direct investment (FDI)
• Speculative selling of a currency by market traders
Factors influencing the Demand of a Currency?
Demand for a currency is an inflow of money into an economy.
• Buying exports of goods and services
• Overseas portfolio inflows into property, shares and bonds
• Hot money flowing into a country’s banking system
• Inflows of foreign direct investment (FDI)
• Speculative buying of a currency by market traders
Types of exchange rates systems?
• Freely floating
• Managed floating
• Semi-fixed (adjustable/crawling peg)
• Fully fixed (hard peg) Currency board (hard peg)
What is a Freely Floating Exchange Rate?
Currency value is set purely by demand and supply of the currency i.e. market forces.
• Currency can either appreciate (rise) or depreciate (fall)
• No intervention by central bank
• There is no target for the exchange rate
• The external value of currency is not an explicit target of monetary
policy; interest rates are not set to influence the value of the currency)
What is a Managed Floating Exchange Rate?
Central bank gives freedom for market exchange rates on a day-to-day basis, supply and demand factors drive the currency’s value
• Central bank may intervene occasionally
• Buying to support a currency (selling their FX reserves or selling
to weaken a currency (adding to their FX reserves)
• Currency becomes a key target of domestic monetary policy
• Higher exchange rate to control inflationary pressures
• “Managed depreciation” to improve competitiveness & trade balance
What is a Fixed Exchange Rate?
Central bank pegs the currency value to one or more currencies
• The central bank must hold enough foreign exchange reserves to intervene in currency markets when needed to maintain the fixed
currency peg
• Pegged rate becomes the official rate
• There might be unofficial trades in shadow currency markets
• Adjustable peg: occasional realignments may be needed (must be officially sanctioned with the agreement of the IMF) leading to either a devaluation or revaluation
devaluation or revaluation
What is a Currency Board Exchange Rate? (Fully fixed)
A currency board: country’s domestic currency is fully backed by a foreign reserve currency or specific foreign asset, typically held in a fixed exchange rate relationship.
• Domestic currency is issued only when there are corresponding foreign currency reserves to back it up, and the currency in circulation is fully convertible into the foreign reserve currency at the established fixed exchange rate.
• The currency board must hold foreign currency reserves equal to the total amount of domestic currency in circulation.
Depreciation (currency falls in value in a _____ system) v devaluation
(currency’s value is deliberately reduced in a _____ system)
- Floating
- Fixed
Advantages of a Floating Exchange Rate?
• Independent Monetary Policy
- Interest rates and QE decisions can be used to influence domestic economy, not constrained by exchange rate considerations.
• Shock Absorption
- Free-floating exchange rates allow countries to absorb external economic shocks more effectively to help rebalance the economy.
• Reduced Speculative Attacks
- Since exchange rates are determined by market forces, speculative attacks on a currency are less likely
• Automatic ‘correction’ of trade imbalance
- If a country is running a large
trade deficit, its currency’s depreciation can over time make its exports more price competitive and imports more expensive, leading to a narrowing of the deficit.
• Currency reserves
- The central bank does not need to hold large foreign currency reserves because there is no specific currency target, financial capital can flow freely across countries seeking the best return
Appreciation (value rises in a ______ system) v revaluation (currency increased
in a _____ system)
- Floating
- Fixed
Disadvantages of a Floating Exchange Rate?
• Exchange Rate Volatility
- this causes uncertainty for businesses reducing international trade and investment.
• Currency Risk
- Volatility introduces currency risk for businesses and
investors.
• Inflation Pass-Through
- Exchange rate fluctuations can lead to changes in import prices, which can impact domestic inflation.
• Loss of Exchange Rate as a Policy Tool
- While countries gain monetary
policy autonomy, they lose the ability to manage the exchange rate as a deliberate policy tool.
Advantages of a Fixed Exchange Rate?
• Price Stability
- A fixed system provides price stability helping control inflation; provides a predictable environment for businesses and consumers.
• Reduced Exchange Rate Risk
- Fixed exchange rates eliminate the currency risk associated with fluctuating exchange rates.
• Discipline on Monetary Policy
- constrains a country’s central bank from pursuing an independent monetary policy. This can prevent excessive money supply growth and associated inflationary pressures.
• Foreign Investment
- A stable exchange rate can attract foreign investment. because there is less risk associated with currency fluctuations.
Disadvantages of a Fixed Exchange Rate?
• Lack of Flexibility
- a fully fixed system cannot respond to external economic shocks. Interest rate may be needed to keep exchange rate fixed rather than affect domestic economic indicators
• Balance of Payments Issues
- Persistent imbalances can lead to pressures on
the currency peg.
• Speculative Attacks
- Fixed exchange rate systems can be vulnerable to
speculative attacks if investors believe that the currency is overvalued or if
there are concerns about the country’s ability to maintain the peg.
• Dependence on Reserves To maintain a fixed exchange rate, a country needs to have sufficient foreign exchange reserves.
