10.4 Macro Flashcards
What are exchange rates?
‘The price of one currency expressed in terms of another currency.’
The exchange rate is determined by demand and supply, with the eqm level being the current exchange rate.
What is a floating exchange rate?
A floating exchange rate is an exchange rate that is set purely by the forces of demand and supply, and free from gov intervention
Name some factors that influence floating exchange rates
Demand: Exports of goods and services Inflows of FDI Speculation Inflows of ‘hot money’ Supply: Imports of goods and services Outflows of FDI Speculation Outflows of ‘hot money’
What are some advantages of floating exchange rates?
Automatic adjustment of BoP
Countries with a large BoP deficit will find their currency weakens as they sell currency to buy imports. The weaker currency, then makes exports more price competitive, which helps to improve BoP deficit.
Flexibility
The government isn’t tied into trying to maintain a particular exchange rate, which can be expensive and constrictive.
Low requirement to hold large foreign exchange reserves
A fixed rate system requires a country to hold large reserves in the event of having to try to maintain value. A floating system negates this requirement.
Freedom to pursue other macroeconomic objectives
If the government is not using its resources to meet an exchange rate target, it can use its resources to pursue other objectives without constraint. It also means monetary policy can focus solely on inflation management, rather than exchange rate management.
What are some disadvantages of floating exchange rates?
Uncertainty
There is no certainty as to the exact price of a currency on a daily basis.
Speculation
With no upper or lower limit on the price of a currency, floating exchange rates might still be subject to speculation by investors.
Inflation
When an exchange rate weakens, it increases the price of imports, and potentially inflation. This is especially true for countries who rely on the import of primary raw materials.
Damage to investment
Due to the above factors, investment might be discouraged, particularly from abroad.
What are fixed exchange rates?
This occurs when a government tries to maintain its exchange rate against that of another currency
Why are fixed exchange rates implemented?
It is often implemented in order to promote trade and exports, and is typically used by countries with a degree of instability or high and rising levels of inflation
What are some advantages of fixed exchange rates?
Reduces uncertainty
If economic agents know how much a particular currency is worth, this can raise confidence and enhance trade creation.
Economic growth
With greater certainty comes greater investment, which may boost supply side capacity and improve competitiveness.
Low inflation
If the exchange rate is set relatively high, this means exports may become less price competitive and imports will become relatively cheaper which helps to reduce demand-pull and cost-push inflationary pressures.
Discipline of economic management
It can be argued that a fixed exchange rate requires sound financial management and a long-term view, rather than have to deal with the problems of exchange rate fluctuations.
What are some disadvantages of fixed exchange rates
Maintenance
A number of fixed exchange rate systems have been difficult to sustain in the long-term, as they are expensive in terms of the requirement to hold large foreign currency reserves.
Speculation
If investors know for example that a government might intervene to buy back currency to maintain its level, they might sell extra currency in order to make a short-term profit.
Conflict with other objectives
If a currency is depreciating, the central bank may have to raise interest rates to attract hot money flows to increase the exchange rate. This may damage consumption and other components of aggregate demand. As a result, there is loss of control over monetary policy.
No automatic adjustment of BoP
Under a floating system, there can be an automatic stabiliser effect on the BoP, but if there is a severe deficit, then this can only be rectified by stifling demand or devaluing the currency, which in turn, might invite further speculative pressures.
What are managed exchange rates?
Aims to gain the advantages of both floating and fixed systems, whilst minimising the disadvantages
This is sometimes called a managed float
If this is done deliberately to gain an advantage over trading partners, this is known as a dirty float
What are the four ways in which the government can intervene to manage for fix its exchange rate?
Change interest rates- (Increase)
This will increase the demand for sterling via the inflow of ‘hot money’ as currency investors move funds to the UK to take advantage of higher interest rates
Use foreign currency reserves
Borrowing-
Can borrow currency on foreign exchange markets. This may involve borrowing its own currency, or others depending upon what the government wants to achieve
Inflation- (Reduction)
UK exports more price competitive, which will boost the demand for sterling and cause an increase in the exchange rate
What are currency unions?
A currency union is a group of independent countries that share a single currency
What are some advantages of currency unions?
Price competition, transparency and efficiency
Inward investment
Eliminations of ER uncertainty
Elimination of currency conversion costs
What are some disadvantages of currency unions?
Economic shocks
“One size fits all” Monetary policy
Transition costs
What is ‘hot money’?
Capital frequently transferred between economies by investors
