2.6.4 Exchange rate systems Flashcards
1
Q
Types of exchange rates?
A
- Free floating ER
- Managed floating ER
- Fixed ER
- Currency board system ER
2
Q
Free floating exchange rate
A
- Currency value set purely by market forces.
- Strength of currency S=D derives external value of currency in markets.
- No intervention by central banks, finds own market level - no target.
- External value of currency not explicit target of monetary policy.
3
Q
Advantages of free floating ER
A
- Monetary policy anatomy = greater flexability, won’t be contrained by ER considerations.
- Shock absorbtion - more effective.
- Redcued speculative attacks.
- Trade balance adjustments.
- Currency reserves = doesn’t need to hold them as no specific targets.
4
Q
Disadvantages of free floating ER
A
- ER volatility = rapid and unpreeictable flucuations so uncertainty for businesses engaged in trade.
- Currency risk for businesses + investors.
- Inflation pass-through = leads to changes in import prices, impacts domestic inflation.
- Loss of ER as policy tool.
5
Q
Fixed exchange rate
A
- Banks fix currency value - pegged to one or more currencies.
- Must hold enough FX reserve to intervene when needed to maintain fixed currency peg.
- Pegged rate becomes official rate.
- Adjustable peg = occasional realignment may be needed, leading to either de or revaluation
6
Q
Advantages of fixed ER
A
- Price stability = since influcuations in ER are minimised, helps control inflation.
- Reduced ER risks, eliminated.
- Monetary disipline = adds credability and means less likely cuts in IR.
7
Q
Disadvantages of fixed ER
A
- Loss of monetary soverignty - IR can’t be used for domestic purposes.
- Large reserves of foreign currency may be needed for gov intervention.
- Lack of adjustments to current account imbalences through ER changes.
8
Q
Manages floating exchange rate
A
Where exchange rates are allowed to fluctuate freely in the foreign exchange market, but central banks may intervene occasionally to stabilize or influence the currency’s value.
9
Q
Advantages of managed floating ER
A
- Allows market forces to determine exchange rates, reflecting supply and demand.
- Offers flexibility for adjustments in response to economic conditions.
- May reduce speculative activities compared to fixed exchange rate systems.
10
Q
Disadvantages of managed floating ER
A
- Volatility: Can lead to exchange rate volatility due to market forces.
- Businesses face uncertainty as currency values can change rapidly.
- Requires effective coordination of monetary policies to avoid excessive currency fluctuations.
- Central bank interventions can be challenging to implement effectively.
11
Q
Currency union
A
Multiple countries sharing a common single currency e.g. EU and Euro
12
Q
Advantages of currency unions
A
- Greater certainty for businesses that trade with other members.
- No costs involved in converting currencies between members
- No worries about ER being over valued or under valued against other members.
- Greater price transapency for consumers.
13
Q
Disadvantages of currency unions
A
- Individual countries lose the right to set their own monetary policy.
- Businesses may be unable to compete with lower- cost producers therefore cannot benefit from a falling exchange rate.
- Fiscal policy needs to be used more widely to correct for imbalances across the currency union area (this is unpopular in the EU).
- Countries may have to ‘bail out’ other members that run into financial problems.
- Inflation target set in currency union zone may not be appropriate for UK - ‘deflationary bias’.
14
Q
Determinants of exchange rates
A
- Interest rate movements
- Foreign trade
- Relative inflation
- FDI
- Expectations
15
Q
Determinants of ER - explained
Interest rates
A
- IR increase = inflow of ST ‘hot money’ to take advantage of higher IR offered by UK financial institions.
- Higher IR = rise in ER
- Lower IR = fall in ER
