The international economy: exchange rates Flashcards
(24 cards)
What is the foreign exchange market (FOREX market) ?
A market for international transactions in which currencies can be exchanged for each other
FOREX matches up the demand for a currency with the supply of a currency and determines the equilibrium nominal exchange rate at which the total quantity of currency is supplied.
How is supply of a currency determined?
- Supply of a currency is the quantity of a currency that suppliers are willing to sell at any given exchange rate over a given period of time
- A currency is supplied by domestic residents who want to buy foreign goods, services and assets
How is demand of a currency determined?
- Demand for a currency is the quantity of currency buyers are willing to purchase at any given exchange rate over a given period
- A currency is demanded by foreigners who want to buy domestics goods, services and assets
What is appreciation & its consequences?
When the value of a currency is adjusted upwards due to the demand and supply of the currency
Foreign goods and services become relatively more expensive to non-residents so the quantity of exports falls. Less net exports = decrease in AD = decrease in aggregate output = greater unemployment = less inflation
What is depreciation & its consequences?
When the value of a currency is adjusted downwards due to the demand and supply of the currency
Foreign goods and services become more expensive to residents so the quantity of imports falls. Domestic goods and services become relatively cheaper to non-residents so the q of exports rises = AD increases = aggregate output increases = unemployment decreases = inflation increases
What is hot money?
The movement of short-term capital or funds that are invested in a country/region with the expectation to make quick profit based on exchange rates
What are factors influencing the demand of currency?
- Exports of goods and services
- Inflows of FDI
- Speculation
- Inflows of hot money
What are factors influencing the supply of currency?
- Imports of goods and services
- Outflows of FDI
- Speculation
- Outflows of hot money
What are advantages of a floating exchange rates?
- Flexibility
- Freedom to pursue other macroeconomic objectives
- Low requirement to hold large forex reserves
- Auto adjustment of BOP
- Improves resource allocation
What are disadvantages of a floating exchange rate?
- Uncertainty
- Speculation by investors
- Inflation risk
- Damage to investment
What is speculative demand?
Foreign currency dealers will speculate whether a currency will appreciate/depreciate in the future.
When a higher interest rate in one country attracts speculators to banks in that countries banks to achieve a higher return.
What is the Marshall Lerner condition?
MLC is satisfied when the PED(exports)+ PED(imports) >1
Currency depreciation will move the countries trade balance towards a surplus if the demand for imports is price elastic because the value of exports rise and the value of imports falls (WIDEC)
If the combined elasticity of exports and imports is inelastic, a depreciation in the exchange rates will worsen the current account balance
What is the J curve effect?
There is a time lag between the depreciation of the currency and any subsequent improvement in the current account balance
It takes time for firms and consumers to respond to changes in price
Once it becomes evident that price changes will last for a longer period of time, firms and consumers change their patterns
Therefore, initially, a countries trade deficit may increase/widen following a depreciation.
This only occurs when the marshall lerner condition is met
What are advantages of a fixed exchange rate system?
- Certainty and stability
- Anti-inflationary
What are disadvantages of a fixed exchange rate system?
- Potential over/under evaluation
- Cannot implement independent monetary policy
- Issues with BOP
- Large FOREX reserves required, resources could be used productively elsewhere.
- Misallocation of resources
What is a fixed exchange rate?
An exchange rate fixed at and maintained at this value by the central banks intervention in the foreign exchange market.
Explain quantitative easing/tightening?
What is a currency union?
An agreement between a group of countries to share a common currency, and usually to have a single monetary and foreign exchange policy.
e.g the Eurozone
What are the advantages of joining a currency union?
- Economic integration
- Price stability
- Increased trade and market access
- Enhanced monetary policy credibility
What are the disadvantages of joining a currency union?
- Limited monetary policy flexibility
- Loss of exchange rate control
- Fiscal constraints and policy coordination
What is a floating exchange rate system?
The exchange rate is determined solely by the interplay of demand for, and supply of, the currency
What is a fixed exchange rate system?
An exhange rate fixed at a certain value and maintained at this value by the central banks intervention in the FOREX market?
How can governments intervene to influence the exchange rate?
- Fiscal policy
- Monetary policy
What are managed exchange rates?
Where the government intervenes in the FOREX market to influence its value.
