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Open economy (exchange rates) Flashcards

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1
Q

What are exchange rates

A

One currency expressed in terms of another

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2
Q

What is an effective exchange rate

A

The pound compared to a basket of currencies made up of our main trading partners, weighted according to the amount of trade with the UK

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3
Q

Who supplies pounds to the foreign exchange market

A

The UK

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4
Q

Why does the UK supply pounds to the foreign exchange market

A

To buy foreign goods, services and assets

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5
Q

Explain how supplying pounds to the foreign exchange market is an import

A

It is an outflow of money to buy foreign goods and services to bring into the UK

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6
Q

Who demands pounds

A

Other countries

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7
Q

Why do other countries demand pounds

A

To buy British goods, services and assets

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8
Q

Explain how the inflow of money into the UK is an export

A

Money is coming into the UK so other countries can purchase British goods services and assets

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9
Q

What is a floating exchange rate system

A

Where a government only allows market forces to affect the exchange rate

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10
Q

What is a fixed exchange rate

A

Where a government chooses to fix its exchange rate against another currency, guaranteeing convertibility against a set exchange rate

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11
Q

Give an example of a fixed exchange rate

A

Cambodian Riel (KHR): 4,100 - 1 dollar

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12
Q

What must a government do if it has a fixed exchange rate and the demand for its currency rises

A

It must prevent the currency from getting stronger

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13
Q

If the UK becomes more competitive relative to the USA, what does this mean in terms of supply and demand for the pound and why

A

Demand for the pound rises as there is greater demand for British goods and services

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14
Q

Why does the government use foreign currency reserves

A

To supply pounds to the foreign exchange market or other currencies to the FEM

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15
Q

If demand for the KHR decreases, what can cambodia do to balance it

A

Uses FCR to demand KHR to the FEM

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16
Q

What is devaluation/revaluation

A

Changing a fixed rate

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17
Q

What is depreciation/appreciation

A

The value of a currency changing over time

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18
Q

What is a managed float

A

Officially having a floating exchange rate but the government may intervene behind the scenes of the FEM

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19
Q

How does a weaker pound affect the macro economy (3)

A
  • Weaker pound is inflationary
  • Weaker pound increases exports
  • Increases the price of imports
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20
Q

How does a weaker pound increase exports

A

British goods and services are relatively cheaper to other countries

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21
Q

How does elasticity determine the effects of a weaker pound on import spending

A

May not affect spending if specific imports are inelastic such as gas and electricity

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22
Q

Give an example of inelastic imports

A

Gas and electricity

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23
Q

What determines the value of a currency in the long run

A

Macroeconomic performance relative to other countries

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24
Q

How does a lack of competitiveness from the UK lead to a fall in the exchange rate

A

There will be less demand for pounds (to buy UK G&S), and it will supply more pounds (to import G&S due to better quality)

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25
How may a fall in the exchange rate cancel out a lack of UK competitiveness
The exchange rate falling means UK G&S are cheaper relatively, therefore increasing demand for pounds to purchase them
26
What is Purchasing Power Parity theory (PPP)
The path of the nominal exchange rate that keeps the real exchange rate constant over time In practice this means: However uncompetitive goods are due to poor macro performance, the fall in the exchange rate can cancel out the effects of high inflation and poor SSP’s which makes the goods seem competitive and restores macroeconomic equilibrium which allows 2 way trade to continue
27
In the short run, what causes exchange rates to deviate from their long run path
The effects of interest rates
28
Explain the effects of rising interest rates on the movement hot money
Provides the incentive for hot money to enter a country to take advantage of the higher returns on offer
29
How does entrance of hot money into the UK affect the exchange rate
Increased demand for pounds as in order to enter the country, the hot money must demand pounds. Therefore causes a temporary spike in the value of the pound
30
What is the balance of payments
A record of one country's transactions with the rest of the world
31
What is a current account
A record of all payments for trade in goods and services and investment incomes on the primary account, plus net current transfers on the secondary account
32
What 4 parts make up a current account
Balance of trade in goods (visibles) Balance of trade in services (invisibles) Net income flows (Primary income flows) Net current transfers (secondary income flows)
33
Give an example of a primary income flow
Wages and investment income (FDI is in financial account, but the money generated from FDI, ie profit, in the country is investment income)
34
Give an example of secondary income flows
Government transfers to the UN Payment for membership to the IMF
35
What is a financial account
A record of all transactions for financial investment
36
What does the financial account include
FDI Portfolio investment
37
What is portfolio investment
Financial flows such as the purchase of bonds or savings in banks (including hot money)
38
What is a capital account
Purchase and selling of land
39
What is the balancing item
The balancing item allows for statistical discrepancies
40
What are 5 causes of a current account deficit
Low investment and productivity High production costs Depletion of resources Strong domestic growth Strong exchange rate
41
How does an overvalued exchange rate lead to a current account deficit
It makes exports relatively more expensive
42
Give an example of how the structure of the economy may lead to a current account deficit
Deindustrialisation can harm the export sector
43
What 4 factors determine how impactful a current account deficit is
- How the deficit is financed (inflows on financial account or borrowing) - Causes of the deficit (Increased growth or being uncompetitive e.g. UK poor SSPs & productivity gap) - Whether a of depreciation in the value of currency can correct it (if not then theres key fundementals wrong in the supply side of economy and CAD is impactful) - Proportion of GDP - Whether money is coming in on the financial account (if we also have a financial account deficit then very bad, but in the uk we tend to have a financial account surplus)
44
What are 5 effects of a current account deficit
Leakage from circular flow Depreciation of exchange rate Sign of uncompetitive exports Increased levels of consumption Foreigners own more domestic assets (to finance debt through FDI)
45
When is a current account deficit seen as problematic
Over 5% of GDP
46
Give 3 advantages of a floating exchange rate
May help to automatically adjust current account deficit Can be a useful macro absorber when there is an external shock The central bank doesn't need to hold large F.C.R
47
How does a floating exchange rate automatically adjust a current account deficit
Trade leads to the value of the currency decreasing which leads to expenditure switching effects which reduces import spending In a CAD, Imports are greater than exports which means we supply more £ to FEM than other countries demanding £, which means supply is greater than demand. When S greater than D, price falls which means UK goods and servcices are relatively cheaper
48
Give an example of how floating exchange rates be a useful macroeconomic absorber when there is a shock
e.g. Currency decreases in a recession leading to a lift to export industries
49
Give 3 disadvantages of a floating exchange rate
Removes the option for a government to use the currency to achieve a competitive devaluation to improve international competitiveness Free floating currency may be volatile which may inhibit trade and long run FDI Floating exchange rates may invite more currency speculation from traders - currency may then move away from a suitable value for the domestic economy (post brexit there was a lot of this leading to a sharp drop in value of pound)
50
Draw the diagram for a fixed change rate
E & D are the free market equilibrium points (depending on which way D shifts) C to A and A to B show the extent to which the government must intervene (depending on which way D shifts) - the government must use FCR If there is too much demand, the government supplies AB pounds If there is too little demand, the government demands CA pounds
51
What 2 things determine macroeconomic performance in an economy which means the value of a currency changes. Give an example of this
Level of Inflation Effectiveness of supply side policies Poor UK SSPs means our currency has fell against our main trading partners
52
Give the 2 main disadvantages of a fixed exchange rate
No monetary policy autonomy Have to hold large FCR
53
What are expenditure switching effects
Where domestic prices decrease which means consumers spend on domestic goods than they do imports. Lower prices also mean an increase in demand for export
54
Give 3 advantages of a fixed rate
Price stability - provides a predictable environment for businesses and consumers (which may increase FDI) Discipline on monetary policy - constrains a country’s central bank from perusing an independent monetary policy Most nations which have a fixed rate heavily rely on trade as a main proportion of GDP, therefore there is certainty between trading due to the fixed rate. So a fixed rate maintains this high prop of GDP Also can lead to lower borrowing costs due to a fixed rate being a good indicator of macroeconomic performance relative to the nation of the currency it is fixed against (lower yield on bonds)
55
Give 3 disadvantages of a fixed rate
Lack of flexibility in responding to external economic shocks - country may be forced to adopt monetary policies that are not best suited to a specific circumstance (no monetary policy autonomy) Speculative attacks may occur if investors believe the currency is overvalued or if there are concerns about the countries ability to maintain the peg Dependence on FCR
56
What 2 things make up a financial account
FDI Portfolio investment (bonds etc)
57
What 5 things determine an exchange rate
RICCC Relative inflation Current account deficit Interest rates Competitiveness Confidence/speculation ## Footnote Overall its macro performance but can deviate due to I/R
58
Explain how inflation may determine an exchange rate
If inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive, and there will be an increase in demand for Pound Sterling to buy UK goods. Also, foreign goods will be less competitive and so UK citizens will buy fewer imports. Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency
59
Give a real world example of a country with a lower inflation rate seeing an appreciation in their currency
The long-term appreciation in the German D-Mark in the post-war period was related to the relatively lower inflation rate
60
Explain how interest rates may determine an exchange rate in the short run
Higher interest rates cause an appreciation If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK (Hot money inflows). You will get a better rate of return from saving in UK banks. Therefore demand for Sterling will rise and value will rise
61
Explain how speculation may determine an exchange rate
If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise
62
Why do exchange rates not always reflect economic fundamentals
Due to speculation Movements in the exchange rate do not always reflect economic fundamentals but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of the pound will probably rise in anticipation.
63
Give an example of speculation affecting the value of the pound
The fall in the value of the Pound post-Brexit was partly related to the concerns that the UK would no longer attract as many capital flows outside the Single Currency.
64
Explain how competitiveness may determine an exchange rate
If British goods become more attractive and competitive this will cause the value of the exchange rate to rise. For example, if the UK has long-term improvements in labour market relations and higher productivity, good will become more internationally competitive and in long-run cause an appreciation in the Pound.
65
Explain how a current account deficit may determine an exchange rate
A deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial account, then this is OK. But a country which struggles to attract enough capital inflows to finance a current account deficit will see a depreciation in the currency
66
What does a current account deficit mean essentially
A current account deficit always means imports of goods, services, and income exceed exports.
67
What are expenditure switching effects
Expenditure switching effects occur when exchange rate changes shift consumer spending from foreign to domestic goods or vice versa

Economics (Macro) (10 decks)

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