Exchange Rates ER

Question 1

How exchange rates are determined

Answer 1

Depends on what type of exchange rate system a country is using

Question 2

Fixed ER diagram

Answer 2

S and D
Fixed ER line above equilibrium
Supply surplus

Question 3

How can governments fix the rate

Answer 3

Intervene in the FOREX market by buying and selling large quantities of its currency/restrict currency flows/abandon use of MP to maintain price stability

Question 4

Fixed ER advantages

Answer 4

Reduced uncertainty
Reduce cost of trade
Imposed discipline on domestic firms
Gives MP a focused target to work towards

Question 5

Fixed ER disadvantages

Answer 5

Costly and difficult to hold large reserves in foreign currency 
External shocks 
Lost control over domestic MP
International retaliation 
Spillover effects

Question 6

Freely floating ER diagram

Answer 6

S and D

Increased ER will naturally adjust and fall

Question 7

Freely floating ER advantages

Answer 7

Freedom to set economic domestic policy to achieve other objectives
More effective control over AD and inflation
ER automatically adjusts to economic shocks

Question 8

Freely floating ER disadvantages

Answer 8

Fluctuations in price of ER can be unpredictable
Affect X and M of a country which could cause unemployment
Doesn’t impose financial discipline on individual countries
ER vulnerable to speculative shocks
Encourage inflow of hot money