Theme 4 CC5 - Exchange Rate Systems, TOT, International Competitiveness And Monetary Union

Question 1

What are the three exchange rate systems?

Answer 1

• Free floating exchange rate - no govt intervention directly in the FOREX
• (Intermediate) Semi-fixed/floating exchange rate - hybrid systems to achieve advantages of both fixed and floating systems.
• Fixed exchange rate - Fixed in relation to an anchor currency at a rate set by govt

Question 2

How is the exchange rate adjusted and why might governments wish to manipulate the exchange rate?

Answer 2

Adjusted through monetary policy.
- weak currency reduces export prices, ^ competitiveness and demand for X, ^AD
- Strong currency reduces import prices and inflation, ^Standard of living
- A stable currency creates certainty for businesses when exporting, importing and investing.

Question 3

Give example of fixed exchange rate system

Answer 3

Gold standard - major trading nations fixed exchange rate between gold and domestic currency

Question 4

What are the two main methods government use to influence value of their currency?
How are they used?

Answer 4

• Monetary policy: ^Interest rates will strengthen the pound as demand for pound ^ as hot money and savings are attracted to UK banks, leading to a decrease in supply of the pound. Falls in interest rates will decrease demand and incentive to save, hot money outflows, ^supply of pound and therefore weaken currency.
• Buying and selling reserves: Central banks can increase value of currency by selling foreign reserves and gold, and buying domestic currency on FOREX market. And Vice versa

Question 5

Give 3 benefits of fixed exchange rate systems

Answer 5

• Greater certainty for businesses about revenue from exports, cost of imports and profit from FDI.
- Encourages trade and FDI
• The exchange rates can be fixed at a high rate. Therefore reduces import prices and inflation.
•Exchange rate can be fixed at low rate
-Price of X falls, demand ^ AD^, GDP^ Employment ^, living standards ^

Question 6

Give 3 costs to fixed exchange rate systems

Answer 6

• Monetary policy cannot be used to manage AD.
- Interest rates and the money supply are set to fix the exchange rate.

• Central banks must keep large reserves of foreign currency.
- High opportunity cost (e.g. spending on NHS)

• If the exchange rate is fixed at high rate, an economics will be permanently uncompetitive.
-Price of X^, demand falls, AD and GDP falls

Question 7

Define Terms of trade and how is it worked out?

Answer 7

The ratio of X prices to M prices

(Index of X prices/Index of M prices) x100

Question 8

How do the following SR factors affect a country’s TOT in SR?
1. ^Exchange rate
2.High relative inflation
3. Increase in global demand for commodity which country specialises in
4. Increase in global supply for commodity which country specialises in

Answer 8

1. Imports cheaper, exports dearer - Improvement in TOT
2. Export prices rise relative to import prices - Improvement in TOT
3. Export prices rise -Improves TOT
4. Export prices fall - TOT worsens

Question 9

How do the following LR factors affect a country’s TOT?
1. Improved productivity rate
2. Increasing World incomes for country exporting

Answer 9

1. Export prices fall as can produce at lower prices, TOT worsen
2. ^Price of exports, TOT improves

Question 10

What is the impact of a change in a country’s TOT

Answer 10

Improvement: ^Living standards because less has to be exported to buy a given quantity of imports. However, depending on the factor causing the change, it could mean that the country’s g&s are less competitive and so may result in detoriation in BOP, depending on PED of the country’s X and M.

Question 11

Define international competitiveness

Answer 11

Refers to a country’s ability to sell its g&s in domestic and international markets at an attractive price & quantity.

Question 12

What are the measures of competitiveness?

Answer 12

Price factors:
- Relative unit labour costs
- Relative export prices

Non - price factors:
- Quality of g&s

Question 13

Explain relative unit labour costs and the effect on competitiveness

Answer 13

• Labour costs in one country relative to those in another (expressed by index number)
• A rise in relative unit labour costs results in country becoming less competitive

Question 14

Explain relative export prices and the effect on competitiveness

Answer 14

• Export prices of a country’s goods compared to prices of their main trading partners.
• A relative rise leads to fall in competitiveness

Question 15

Give factors influencing competitiveness

Answer 15

• Exchange rate - spiced
• Productivity - Skilled/motivated workforce, infrastructure, capital
• Regulation - Excessive regulation (red tape) can make it hard for firms to invest, and it could raise their average costs of production. UK Govt introduced the ‘red tape challenge’ to reduce regulation and increase competitiveness.
• R&D - Greater technology leading to new production methods ^ productivity. Also new; better quality goods which is more desirable for consumers ^ demand.
• Better quality goods means businesses can sell at greater prices to ^profit margins.
• Taxation - A lower tax rate provides an incentive to earn/spend more. The UK govt increase corp tax to 25% in 2023, leads to fall in profits, exports more expensive ^COP, less FDI.
• Low Interest rates encourage spending (less incentive to save), ^AD
  devaluation of pound makes exports more competitive, ^Int comp

Question 16

What are the benefits of being internationally competitive?

Answer 16

● By being competitive, a country will experience current account surpluses . This surplus allows them the opportunity to invest overseas and build up a surplus of assets overseas, on which interest, profit and dividends can be earned.
● A competitive economy is likely to attract inflows of foreign investment, whether this be by establishing new companies (creating jobs) or buying domestic firms. This will lead to a transfer of knowledge, skills and technology to firms.
● Employment is likely to increase because more goods are being produced, since more goods are exported and less are imported, so more are sold internationally and domestically. A rise in demand for labour will lead to a rise in wages.
● There will be economic growth, both by supply side improvements due to efficiency and investment and by demand side improvements relating to X-M

Question 17

What are the problems of being internationally competitive?

Answer 17

• The problem with being internationally competitive is that this competitiveness can be easily lost. Developing countries who have benefits due to lower costs of labour and costs of materials etc. could see this eroded when they experience export led growth due to their competitiveness. A current account surplus may lead to a rise in the exchange rate , reducing their competitiveness.
  ● Countries who are competitive may become more dependent on overseas countries and so this may mean they suffer from larger issues if there is a global recession.

Question 18

Explain monetary union and give example

Answer 18

A group of countries which share a common currency e.g. the euro

Question 19

What is the 4 convergence criteria for joining the euro?

Answer 19

1. Stable prices
2. Stable exchange rate
3. Sound Fiscal policy - Limit on govt debt (must not exceed 60% of GDP) and budget defecit (must not exceed 3% of GDP)
4. Low interest rates

Question 20

Give 3 advantages of a single currency (Monetary union)

Answer 20

1. Reduced transaction costs - No currency exchange costs, saves bank charges/commission. Beneficial to businesses that trade a lot with rest of EU.
2. Increased price transparency - Single currency allows for easier price comparisons for businesses/consumers between countries to buy from cheapest source. Resulting in increased comp and lower prices.
3. No exchange rate fluctuations (risk) - business certain of cost of imports and revenue from exports ^confidence and ^FDI
   - All leads to increased trade between countries, stimulating competition, specialisation by comparative advantage, ^productivity and EOS.

Question 21

Give 3 disadvantages of a single currency

Answer 21

1. Transition costs - Change-over process of introducing euro imposes costs on business e.g. tills, vending machines. Also conversion costs
2. Loss of monetary policy - European Central Bank (ECB) sets one interest rate for whole of eurozone causing problems e.g. one country may be in recession whilst another rapid SR growth with ^AD.
   -Too low interest rate for growing economy ^Borrowing ^AD, ^Inflation and debt
   - Too high interest rate for economy in recession: ↓Borrowing, ↓AD, ↓Growth and ^Unemployment
3. No exchange rate adjustment possible - If economy is uncompetitive, the exchange rate will fall to restore competitiveness. However, this may not happen if country adopts Euro. Furthermore constraints on fiscal policy mean they must limit budget deficit and government debt which may usually be manipulated to counter recessions etc.