14) exchange rates Flashcards
What are the 2 types of exchange rates and how do they work?
- fixed- a government fixes a an exchange rate at a target, and manipulates supply and demand for the currency by purchasing and selling their currency when necessary to keep it at the target
- floating- value of currency free to move with supply and demand of the currency, but governments can have some influence over this with interest rates
What are the 4 ways of measuring the exchange rate and what do they mean?
- Real- the exchange rate adjusted for inflation
- Nominal- the unadjusted comparison of currencies
- bilateral- the comparison of two unadjusted currencies
- effective- the value of a currency compared to a basket of other countries with a weighted average of the value of trade
What is devaluation and revaluation of a currency and how are they achieved by a government?
Devaluation is where the value of the currency falls ie the £1 goes from $1.5 to $1.2, achieved by the govt selling the currency
Revaluation is where the currency increases in value and makes it less competitive ie £1 worth $1.5 instead of $1.3, achieved by the government buying the currency
What is the difference between depreciation of devaluation of a currency?
Depreciation is determined by market forces (although interest rates may indirectly change this ie hot money)
Devaluation is formally achieved by the government
What are the advantages and disadvantages of floating exchange rates?
ADV- less need for foreign currency reserves
- floating exchange rate can help to reduce balance of payments deficits, deficit will lead to a fall in the value of the currency, so if elastic, imports will fall and exports will increase
- less stress on the interest rate to affect exchange rates and can be used for other things
DIS ADV- prone to fluctuating massively which can make it hard to plan for stuff
- speculation can artificially strengthen a currency which makes it less competitive
- falls in exchange rates can lead to inflationary pressures as imports get more expensive
- also prone to shock attacks on the market due to speculation
Advantages and disadvantages of fixed rates?
ADV- speculation should be reduced unless dealers feel the current rate is unsustainable
- competitive pressures put on firms to reduce their own costs and increase productivity to increase competitiveness instead of relying on exchange rates
- more certainty which could attract inwards FDI
DIS ADV- the country effectively loses control of interest rates because they are integral in keeping a fixed rate
-difficult to maintain due to other factors that put pressure on currencies to appreciate or depreciate
What 5 factors can affect the supply and demand of a currency?
- speculation
- government buying and selling currency
- relative inflation rates, if a countries inflation rate is relatively higher they may see a fall in their currency value, their prices become higher so foreign countries demand less of their currency to purchase products
- confidence; more demand for countries with stability and confidence in the economy
- BOP CA deficits mean there is an excess supply of the currency because they import relatively more than they export
What are some likely effects to the economy if the value of the currency falls?
- exports become cheaper, improving BOP CA deficits as more exports and less imports
- cost of living may increase if import dependent country, also cost push inflation
- less hot money flows into UK so excess supply of currency
- increase in economic growth due to affect on AD
- unemployment may also be reduced due to the growth, depending on output gap
What are some likely effects to the economy if the value of the currency increases?
- increase in the size of the current account deficit
- fall in AD and therefor output and employment
- impact on inflation depends on price elasticity of demand
