Exchange Rates

Question 1

Define individual rate of exchange

Answer 1

The rate at which one currency trades for another in the foreign exchange market. Value of one currency about another currency

Question 2

Define exchange rate index

Answer 2

A weighted average of exchange rates expressed as an index

Question 3

Define appreciation

Answer 3

A rise in the free-market exchange rate of the domestic currency with foreign currencies

Question 4

Define depreciation

Answer 4

A fall in the free-market exchange rate of the domestic currency with foreign currencies

Question 5

What do the demand and supply curves between two countries look like for example dollar price of one pound

Answer 5

Demand curve and supply look like what weve seen before.
Demand by US is downward sloping
Supply by UK is upward sloping

Question 6

What happens when depreciation occurs - graphically speaking

Answer 6

If currency is overvalued (at a high price with lots of quanity (above the demanded quanity)) equilibrium will come back by depreciation coming into play

Question 7

What happens when appreciation occurs - graphically speaking

Answer 7

A situation where you start with a currency lower valued in relation to the other currency. Quantity supplied of currency will be much less than demand
Moves back to equilibrium by appreciation

Question 8

What causes depreciation

Answer 8

Fall in interest rate 
Change in the inflation rate
Rise in aggregate demand 
Inward investment less attractive  
Speculation against depreciation

Question 9

What types of policies (give three of variable extremism) could the government have for foreign exchange markets and intervention

Answer 9

No intervention- Exchange rates and balance of payments
Reduce short-term fluctuations - Intervention using reserves, borrowing from abroad, changes in interest rate
Maintain a fixed rate - Contractionary or expansionary policies, supply-side policies, import and foreign exchange controls

Question 10

What are the advantages of having a fixed exchange rate

Answer 10

Certainty
No speculation
Prevents irresponsible government policies

Question 11

What are the disadvantages of having a fixed exchange rate

Answer 11

Conflict between macroeconomic objectives
International liquidity
Adjustment to shocks

Question 12

What are the advantages of a floating rate

Answer 12

Automatic correction mechanism
Insulation from external events
Governments can choose the domestic policy

Question 13

What are the disadvantages of a floating rate

Answer 13

Unstable exchange rates
Speculation
Uncertainty for businesses
Lack of discipline in the economy

Question 14

Why are FX rates so volatile?

Answer 14

Use of inflation or money supply targets and the resulting changes in interest rates
Growth in international financial flows
The huge growth in trade and international investment
Abolition of exchange controls
Developments in IT
Preference for liquidity in times of uncertainty
Growing speculative activity

Question 15

Explain an adjustable peg regime

Answer 15

An adjustable peg regime is close to a fixed exchange rate regime with some variability around the fixed rate
The rate is fixed for some time but had bands of allowable fluctuation - range of degree of flexibility

Question 16

When would the peg need to be changed in an adjustable peg regime

Answer 16

If this prolonged intervention is used it shows revaluation may be necessary - peg will need to be moved
If there is a fundamental prolonged balance of payments deficit then eventually a devaluation of the central rate may be needed whereas if there is a fundamental; prolonged surplus in the balance of payments then a revaluation may be necessary

Question 17

What regime to most countries use in practice

Answer 17

Most countries have a relatively free exchange rate or one with managed flexibility (floating but with central bank intervention)