15.1 Exchange Rate Systems Flashcards
When is exchange rates usually mentioned?
In the balance of payments
What are domestic currencies used to pay for?
Internal trade within countries
Imports are usually paid for in the currency importing the goods and services
What does an exchange rate measure?
How much of another currency a particular currency can buy
What are exchange rates usually measured against?
Gold
Exchange rate def
The external price of a currency, usually measured against another currency
What currencies are the pounds exchange rates quoted against
Euro or the dollar
What is the real exchange rate
Measures the weighted average value of a country’s currency relative to a basket of other major currencies adjusted to the effects of inflation
How do you calculate the real exchange rate?
Striking index X (index of domestic price level/index of weighted foreign price levels)
What is the most extreme form of managed exchange rates?
Fixed exchange rates
What is the least extreme form of managed exchange rates?
Freely floating exchange rates
What is in between the two extremes of exchange rates?
Managed exchange rates
What are the two forms of managed exchange rates?
-adjustable peg exchange rates
-managed floating exchange rates
Describe adjustable peg exchange rates?
Resemble fixed exchange rates in many aspects but the rate at which the exchange rate is fixed may be changed from time to time
What does a formal devaluation do to an exchange rate?
Reduces a fixed exchange rate (while revaluation increases the fixed rate)
Freely floating exchange rate definition
The exchange rate is determined solely by the interplay of demand for and supply of the currency
Diagram for an exchange rate in equilibrium
What happens when the exchange rate of the pound falls
UK exports become more competitive in overseas markets
-greater overseas demand if it is price elastic which explains downward sloping demand curve
Describe point A(freely floating system)
The money value of exports(paid in sterling) equals the money value of imports (paid in overseas currency)
Describe the diagram
Shock disturbs initial equilibrium (improvement in quality Goode produced overseas causes UK residents to increase demand for imports whatever the exchange rate
What are the advantages of freely floating exchange rates
Automatically achieving balance of payments equilibrium
Improving resource allocation
Freedom to achieve domestic policy objectives
Making it easier to control inflation
Ability to peruse an independent monetary policy
What is a freely floating currency
Where the value of a currency depends only on supply and demand forces
What is a managed floating currency
When the central bank may choose to intervene in a foreign exchange market to affect the value of currency to meet specific macroeconomic objectives
What is a fixed exchange rate system
A currency peg as part of a currency board system
Freely floating exchange rates
Automatically achieving balance of payments equilibrium
The exchange rate should move up and down to correct a payments imbalance (a currency will never be over or under valued for too long)
Freely floating exchange rate
Freedom to achieve domestic policy objectives
Market forces look after the current account in the balance of payments -govs can concentrate on domestic economic policy
Freely floating exchange rate
Easier to control inflation
Are protected from importing inflation (a fixed exchange rate doesn’t do this)
Freely floating exchange rate
Ability to pursue an independent monetary policy
Monetary policy purely focused on domestic objectives
What are the disadvantages of freely floating currencies?(4)
The adverse effects of speculation and capital flows
International trading uncertainty
Cost push inflation
Demand pull inflation
disadvantages of freely floating currencies
Adverse effect of speculation and capital flows
In the short run they are vulnerable to speculative money (hot money) movements into our out of currencies -does not reflect competitiveness of a country’s goods and services
disadvantages of freely floating currencies
Cost-push inflation
-trading competitiveness and current account in the balance of payments both worsen, causing the exjzngr rate to fall in order to restore competitiveness
-may trigger a vicious cumulative downward spiral of faster inflation and exchange rate depreciation
-falling exchange rate increases import prices which raise the rate of domestic cost-push inflation
-workers react by demanding pay rises to restore the real value of the eroded wage
Increased inflation itself erodes the export competitiveness initially won by thr fall of the exchange rate
Triggers a fall in exchange rate to recover the lost advantage
Resulting downward spiral can eventually destabilise large parts of the domestic economy causing unemployment and reducing economic growth
What is a fixed exchange rate
An exchange rate fixed at a certain level by the country’s central bank and maintained by thr central bank’s intervention in foreign exchange market
Diagram for the ceiling, central floor and peg of a fixed exchange rate
Key features of a fixed exchange rate
Country’s gov or central bank announces it at a certain rate and the central bank takes responsibility for maintaining that rate (peg it to another currency)
What are the advantages of a fixed exchange rate(2)
-achieve stability in foreign exchange markets
-impose anti-inflationary discipline on a country’s domestic economic management on the behaviour or its workers and firms
Disadvantages of fixed exchange rates
-increase uncertainty rather than certainty -likely I’d there is a devaluation or revolution
-if fixed exchange rate is significantly overvalued-may impose deflationary costs , lost output and unemployment
-if fixed exchange rate is significantly undervalued inflation may be imported from the rest of the world
-an independent monetary policy cannot be implemented
-both over and under valuation of currency can lead to miss allocation of resources
What are the two ways a central bank can intervene in markets to maintain a fixed exchange rate?
Buying or selling its own currency on the foreign exchange market (exchange equalisation)
Increasing or decreasing bank rate to alter pounds exchange rate
What are the two different managed exchange rates?
Adjustable peg exchange rates
Dirty floating exchange rates(abandoned in most parts of the world)
Currency union
An agreement between a group of countries to share a common currency-usually have a single monetary and foreign exchange rate policy
What is the impact of a currency union (think of the Euro)
Mobility of labour
Common fiscal policy
Why is a common fiscal policy important
Allows wealth to be transferred by a centralised fiscal authority from the richer to the wi poorer parts of the union
Used to reduce inequality but improve competitiveness of poorer regions
Without this countries build up a lot of gov debt
