Week 3 - Exchange Rate System and Gov. Influences Flashcards
What is the role of the central bank in modern economies? (3)
- Monitor inflation and employment
- Manage monetary policy
- Sometimes act as last resort lenders
What are the three main types of exchange rate systems (3)
- Freely floating exchange rate system
- Fixed exchange rate system
- Managed float exchange rate system
What is a freely floating exchange rate system? (2)
- Exchange rates are determined by market forces without government intervention
- Offers greater insulation from foreign economic problems
What are the advantages of a freely floating exchange rate system? (3)
Market-driven flexibility: The exchange rate adjusts based on market forces, reflecting changes in economic conditions without government intervention.
No need for reserves: Since the central bank doesn’t need to hold large reserves of foreign currency, the system is less costly.
Policy independence: Governments and central banks are free to set domestic monetary policies without worrying about maintaining a fixed exchange rate.
What are the disadvantages of a freely floating exchange rate system? (3)
- Exchange rates can fluctuate significantly, leading to uncertainty for international trade and investment.
- Frequent fluctuations may encourage speculative activities that can destabilize markets.
- Multinational corporations (MNCs) may face increased risks and costs related to exchange rate fluctuations, requiring them to manage currency risk actively.
How does a fixed exchange rate system operate? (2)
- Holds the currency’s value constant or within narrow bands
- The central bank must buy and sell foreign currency to maintain this rate
What are the benefits of a fixed exchange rate system? (3)
- Fixed rates reduce exchange rate volatility, providing more predictable conditions for international trade and investment.
- By pegging the currency to a stable foreign currency (e.g., the USD), inflation can be kept low, as the central bank is required to maintain the fixed rate.
- Governments are constrained in their ability to print money or run excessive deficits, which can lead to better long-term economic stability.
What are the drawbacks of a fixed exchange rate system? (3)
- The central bank may lose the ability to implement independent monetary policies, as they must focus on maintaining the fixed exchange rate.
- The central bank must maintain large foreign exchange reserves to defend the fixed exchange rate, which can be costly and impractical.
- If the fixed exchange rate is not aligned with market conditions, external shocks (e.g., changes in interest rates or inflation in the anchor country) can cause economic instability.
What is a managed float exchange rate system? (2)
- Central bank sets a target range for the exchange rate
- The currency is allowed to float in this range, and the central bank intervenes where necessary to keep the exchange rate within the limits
What are the advantages of a managed float exchange rate system?
- Flexibility - exchange rate can respond to market conditions while still being managed by the central bank
- Stability - it allows for some stability in the currency exchange rate while still accommodating market forces
- Controlled interventions - The central bank can intervene selectively, reducing the need for constant market management while preventing extreme volatility
What are the drawbacks of a managed float exchange rate system? (3)
- Market distortions - frequent intervention can lead to market distortions and mispricing of the currency
- Central bank dependency - the system relies on the central bank’s ability and willingness to intervene when needed, which may not always be effective
- Uncertainty - if interventions aren’t predictable then uncertainty arises which leads to investor concerns about currency risk
What is a currency board? (2)
- A system where the supply of domestic currency is directly tied to foreign currency reserves
- there is no discretion in monetary policy
What is the policy trilemma in exchange rate systems? (2)
- States that nations cannot simultaneously have free capital movement, a fixed exchange rate and an independent monetary policy
- A country can only have 2 of these 3
What happens when international interest rates increase under a fixed exchange rate system? (2)
- If the central bank does not match the interest rate increase, capital outflows occur
- The currency then becomes undervalued and speculation against the fixed rate occurs
What is a currency crisis? (2)
- occurs when a central bank runs out foreign currency reserves - leading to the devaluation of a currency
- results from economic mismanagement or speculative attacks
What is the risk of a fixed exchange rate in terms of speculative attacks?
A divergence between the true equilibrium exchange rate and the fixed rate can create profit opportunities for speculators - leading to a currency crisis
How can devaluation affect a country with a fixed exchange rate? (2)
- Devaluation can occur if the fixed rate is unsustainable due to economic imbalances
- This can lead to a currency crisis and a shift to a floating rate system
Why might a smaller or developing country prefer a fixed exchange rate system? (2)
- Provide transparency, monetary policy anchors and stability for countries with weaker economic institutions
- This helps to attract inward foreign investment
How does government intervention affect exchange rates in a managed float system?
The central bank intervenes to stabilise the currency when it outside the target range by either buying or selling foreign currency in the market
What is direct intervention by a central bank?
The central bank exchanging its own currency for foreign currencies in the market to stabilise or influence the exchange rate
What is indirect intervention by a central bank?
The central bank influencing factors that determine currency value, such as fluctuating the interest rates or altering the money supply
What is sterilised intervention?
The central bank intervenes in the foreign exchange market while offsetting the effects on the money supply by buying or selling treasury securities
What is a non-sterilised intervention?
When a central bank intervenes in the exchange market without taking action to offset changes in the money supply - affecting inflation and interest rates
What is the Economic and Monetary Union (EMU) in the EU?
Involves the coordination of fiscal policies, a common monetary policy and the adoption of the euro as a common currency amongst EU member states
