Exchange Rates: 4.3 Flashcards
(9 cards)
Define exchange rates.
The value of one currency to another
Define freely floating exchange rates.
Demand and supply forces determine the equilibrium for exchange rates
Define fixed exchange rates.
- Maintain a fixed exchange rate pegged to another currency
- Done by manipulating D&S using foreign reserves
Factors of an increasing floating exchange rate
Demand increases
- increase in relative interest rates
- speculation
- increase in FDI investments
- rise in incomes abroad
- increase in competitiveness of exports
Factors of a decreasing floating exchange rate
Supply increases
- decrease in relative interest rates
- speculation
- firms moving away from domestic country
- increase in incomes domestically
Impacts of exchange rate
Strong currency - SPICED
* Strong pound, imports cheap, exports dearer
* Imports: demand increases, expenditure increases
* Exports: demand falls, expenditure falls
* (X-M) falls, AD falls
* Reduction in demand-pull inflation
Weak currency - WIDEC
* Weak, imports dearer, exports cheap
* Imports: demand falls, expenditure falls
* Exports: demand increases, expenditure increases
* (X-M) increases, AD increases
* Stimulates demand-pull inflation
* expensive imports -> expensive inputs/raw materials -> COP increases -> cost-push inflation
Evaluation of exchange rates
- depends on PED of exports and imports
- depends on the size of appreciation/depreciation
- trade barriers (foreign countries may be restricting domestic countries from exporting due to trade protectionism)
- offset by other factors
Pros and cons of freely floating exchange rate
Pros
- no need for gov intervention
- automatic correction of current account imbalances
- no need to hold foreign currency reserves
- gov can focus on using fiscal and monetary policies to deal with domestic problems
Cons
- sudden fluctuations cause instability
- uncertainty for firms, importers, exporters
- currency speculation creates more fluctuations
Pros and cons of fixed exchange rates
Pros
- Firms, importers, and exporters have a high degree of certainty over future exchange rates, positively benefit investment and trade
- More difficult for currency speculation
Cons
- Need for constant intervention by the central bank
- Need to hold foreign currency reserves
- Loss of monetary policy to deal with domestic problems
