23. Exchange rates

Question 1

Define exchange rate

Answer 1

Exchange rate is a value of one currency expressed in terms of another currency.

Question 2

List the financial institutions in a country

Answer 2

1. Government account
2. Central bank
3. Private commercial banks

Question 3

What are the exchnage rate systems

Answer 3

1. Fixed
2. Floating
3. Managed

Question 4

Define fixed exchange rate

Answer 4

Fixed exchange rate - an exchange rate regime where the value of a currency is fixed to a value of another currency, to the average value of selected currencies or a commodity, such as gold.

Question 5

Who sets the fixed exchange rate?

Answer 5

1. The government
2. The central bank

Question 6

Define revaluation

Answer 6

Revaluation - an increase in the value of a currency of a fixed exchange rate

Question 7

Define devaluation

Answer 7

Devaluation - defined as a decrease in the value of a currency of a fixed exchange rate

Question 8

Define foreign exchange market

Answer 8

Foreign exchnage market - the largest market in the world in terms of cash movement

Question 9

How can a value of a currency be increased/decreased?

Answer 9

1. By increasing/decreasing the supply in forex: sell currency for other currencies; lower interest rate, so foreign investors wouldn’t invest
2. By increasing/decreasing demand in forex: buy currency in the foreign exchange market for foreign currencies from the foreign currency reservoir; increasing the interest rates so foreign savers would want to save in domestic banks

Question 10

Define floating exchange rate

Answer 10

Floating exchange rate - exchange rate regime where the value of a currency is let to be determined by the demand for and the supply of the currency in the foreign exchange market

Question 11

Define depreciation

Answer 11

Depreciation - decrease in the value of a currency of a floating exchange rate

Question 12

Define appreciation

Answer 12

Appreciation - increase in the value of a currency of a floating exchange rate.

Question 13

What causes changes in the value of a currency?

Answer 13

1. Change in interest in country’s exports
2. Change in foreign investors in that country
3. Change in saving money
4. Making money on speculating on that country’s currency

Question 14

Define managed exchange rate

Answer 14

Managed exchange rate - exchange rate regime where the currency is allowed to flaot freely but with some element of interference from the government

Question 15

Who maintains the floating exchange rate?

Answer 15

1. The government
2. The central bank (sets upper and lower values and lets it float freely within those boundries)

Question 16

Advantages of high exchange rate - disadvantages of low exchange rate (opposite statements)

Answer 16

1. More imports can be bought
2. Domestic producers must improve efficiency
3. Downwards pressure on inflation (costs of production will be lower due to lower prices of imported materials - domestic producers also have to keep low prices to be competitive)

Question 17

Disadvantages of high exchange rate - advatages of low exchange rate (opposite statements)

Answer 17

1. Damage to export industries (relatively higher prices than foreign - not competitive in foreign markets)
2. Damage to domestic industries (fall in demand in more expensive)

Question 18

Advantages - disadvantages of fixed exchange rate

Answer 18

Adv.:

• reduces uncertainty
• inflation has very negative consequences hence gov has to constantly maintain it, in theory should reduce speculations

Disadv.:

• gov has to keep it fixed, has to maintain high levels of foreign currencies
• setting the level of fixed exchange rate is hard
• international disagreement may arise if the set level is too low, so exports are very competitive (China)

Question 19

Advantages - disadvantages of floating exchange rate

Answer 19

Adv.:

• interest rates can be used to control demand
• in theory should adjust itself, not necessary to keep high levels of foreign currencies

Disadv.:

• uncertainty for businesses
• influenced by more factors than only supply and demand (world events like 9/11 or widespread opinions), may worsen the existing levels of inflation