22. Y12 Exchange Rates

Question 1

What are Exchange rates?

Answer 1

Exchange Rates are a price.
The price of one currency, measured in terms of another.

Demand for a currency comes from exports
Supply of a currency comes from imports

Question 2

What are the 3 causes of Exchange rate fluctuations?

Answer 2

1. Demand for exports and imports changing
2. Levels of FDI and Outward Investment from an economy (FDI will mean upward pressure on exchange rates).
3. Speculation- traders buying and selling currencies (e.g. hot money- speculators moving money to wherever they get best return (highest interest rate).

Question 3

What is a hybrid (pegged) exchange rate?

Answer 3

Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual exchange rate will be allowed to fluctuate in a range around that initial target rate.

Pegged exchange rates are typically used by smaller countries. To defend a particular rate, they may need to resort to central bank intervention, the imposition of tariffs or quotas, or the placement of restrictions on capital flow.

Question 4

What is a semi-fixed exchange rate?

Answer 4

The Exchange rate is given a specific target. The currency can move between permitted bands of fluctuation on a day-to-day basis.

Question 5

What is a fully-fixed exchange rate?

Answer 5

The exchange rate is fixed and there are no fluctuations from the central rate.

A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable.

Question 6

Evaluation for fixed rates?

Answer 6

+ Fixed exchange rates can exert a strong discipline on domestic firms and employees to keep their costs under control in order to remain competitive in international markets. This helps the government maintain low inflation

• Fixed rates can be fragile and prone to wilting under pressure. Also, because they are inflexible they take away one of the great natural stabilisers of economic activity, the exchange rates.

Question 7

What are floating exchange rates?

Answer 7

The value of the currency is determined by market demand for and supply of the currency in the foreign exchange market. May (and does!) change from one minute to the next.

Demand for exports and imports (and FDI) are the main factors affecting the exchange rate.

Question 8

Evaluation of floating exchange rates?

Answer 8

+ Exchange rates are a natural stabiliser. E.g. fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit.

+ A second key advantage of floating exchange rates is that it gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands.

• Lack of economic discipline- may be inflationary e.g. if a government aims to make country more competitive by engineering lower exchange rate, meaning more expensive imports.

Question 9

What are the effects of lowering exchange rates? (devaluation)?

Answer 9

Raise aggregate demand

Increase national output (GDP)

Create jobs, amplified through the multiplier effect

Assuming the demand for imports and exports are price sensitive (price elastic), lead to an improvement in the balance of payments, though this can also lead to inflation.

Question 10

What are the effects of raising exchange rates (revaluation)?

Answer 10

Help reduce excessive aggregate demand

Keep inflation down

Though the export sector may suffer and jobs can be lost

Question 11

What are the consequences of exchange rate fluctuations? (3)

Answer 11

1. Think SPICED and its mate WPIDEC-changing competitiveness, effect on inflation etc
2. Uncertainty- lack of price transparency, transaction and hedging costs
3. Effect on Inward Investment (FDI)
   All depend on extent of change e.g. 1% change far less important than 10%.

Question 12

What is the ‘Marshall Lerner condition’?

Answer 12

This states that, for a currency devaluation to lead to an improvement (e.g reduction in deficit) in the current account, the sum of price elasticity of exports and imports (in absolute value) must be greater than 1.

Question 13

What is the ‘J curve effect’?

Answer 13

In the short term, demand is often inelastic. Therefore, cheaper exports fail to increase export revenue.

However, in the long term demand becomes more elastic so the trade deficit improves over time.

The J Curve effect says a trade deficit can actually worsen after a depreciation, but get better in the long term.

Question 14

Evaluate the effectiveness of using exchange rates to achieve macroeconomic objectives

Answer 14

+
Exchange rates can be used to affect AD.

This might change short term competitiveness.

For example, China has manipulated their currency to keep the Yuan low and ensure their products are ultra-competitive.

-
However, Long Run economic growth requires supply side policies. e.g.

Deregulation

Improved human capital

Infrastructure improvements

Promoting more competition and stimulate a faster pace of invention and innovation to improve competitiveness.