3.2 Exchange Rates

Question 1

What is an exchange rate?

Answer 1

The price of one currency measured in terms of other currencies.

Question 2

When does the demand for exports of gods and services fall?

Answer 2

If they become more expressive ceteris paribus.

Question 3

When does the demand for exports of gods and services rise?

Answer 3

If the price of imports become more expensive.

Question 4

What happens on the foreign exchange market?

Answer 4

Where national currencies can be bought or sold.

Question 5

What happens in a freely floating exchange rate system?

Answer 5

The value of a currency is determine by the demand for and supply of the currency on the foreign exchange market.

Question 6

When does an appreciation of the currency occur?

Answer 6

When there is an increase in the value of the exchange rate relative to another currency operating in a floating exchange rate system. Exports will tend to become more expensive whilst imports will tend to become relatively cheaper.

Question 7

When does a depreciation of the currency occur?

Answer 7

When there is a fall int he value of the exchange rate relative to another currency operating in a floating exchange rate system.

Question 8

What happens when the exchange rate is set above the equilibrium level?

Answer 8

Causes excess supply of the currency causing a subsequent fall in the exchange rate.

Question 9

What has an effect on the exchange rate?

Answer 9

A change in any factor that affects the demand for or supply of the currency.

Question 10

What are the factors that will have an effect on the exchange rate?

Answer 10

Foreign demand for a county's exports
Domestic demand for imports
Relative interest rates 
Relative inflation rates
Investment from overseas in a country's firms
Speculation

Question 11

How does foreign demand for a county’s exports affect the exchange rate?

Answer 11

An increase in the demand fo exports perhaps due to improved quality or successful advertising will increase the demand for the country currency. Hence there is an appreciation of the currency ceteris paribus.

Question 12

How does domestic demand for imports affect the exchange rate?

Answer 12

An increase in the demand for imports perhaps due to an increase in the competitiveness of foreign firms causes an appreciation of the foreign currency. The higher demand is required to facilitate the purchase of foreign goods and services.

Question 13

How does relative interest rates affect the exchange rate?

Answer 13

A cut in interest rates in the economy will tend to reduce incentives for investors so they sell the domestic currency in search of investments with better returns. This reduces the exchange rate ceteris paribus.

Question 14

How does relative inflation rates affect the exchange rate?

Answer 14

An increase in the price of goods and services caused by domestic inflation will tend to decrease the demand for exports. Therefore the exchange rate will tend to fall in value as a result of inflation.

Question 15

How does investment from overseas in a country’s firms affect the exchange rate?

Answer 15

Foreign direct investment, inward FDI boost the demand for currency, outwards FDI increases the supply of a currency.
Portfolio investment, foreign currency is demanded for the purchase of financial investment abroad such as stocks, shares and bonds of overseas firms and governments. Domestic currency is supplied when banks and the government lend money to overseas firms and government.

Question 16

How does speculation affect the exchange rate?

Answer 16

Foreign exchange traders and investment companies move money around the world to take advantage of higher interest rates and variations in exchange rates to earn a profit. As huge sums of money are involved it can cause exchange rate fluctuations.

Question 17

What causes an appreciation in the currency?

Answer 17

An increase in the demand for the currency and a fall in the supply of the currency.

Question 18

What causes a depreciation in the currency?

Answer 18

A decline in the demand for the current and an increase in the supply of the currency.

Question 19

How do exchange rates have an impact on employment?

Answer 19

An appreciation of the currency will tend to reduce the demand for esports leading to deteriorating profits. In the long run this will cause job losses unemployment in export oriented industries.

Question 20

How do exchange rates have an impact on inflation?

Answer 20

Unemployment caused by the currency appreciation leads to lower consumption in the economy, thus reducing the inflation rate. If the country relies heavily on certain imports the higher exchange rate helps to reduce the general price level even further.

Question 21

How do exchange rates have an impact on economic growth?

Answer 21

In the long run economic growth is likely to fall due to the combination of lower export sales and higher unemployment resulting from the higher exchange rate.

Question 22

How do exchange rates have am impact on the balance of payments?

Answer 22

A currency appreciation tends to cause a fall in exports because it is more difficult to sell goods and services in overseas markets at a higher price. Cheaper imports lead to rising imports penetration therefore the current account balance worsens.

Question 23

How do exchange rates have an effect on customers?

Answer 23

Customers have greater purchasing power when the exchange rate increases.

Question 24

How do exchange rates have an effect on exporters?

Answer 24

Face more difficult trading conditions when the exchange rate increases because the prices of their goods and services become more expensive for foreign customers.

Question 25

How do exchange rates have an effect on importers?

Answer 25

Potentially gain from a stronger currency as this makes it cheaper for firms to import raw materials, components and finished goods from abroad.

Question 26

When does a fixed exchange rate occur?

Answer 26

When the central banks or monetary authority buys or sells foreign currencies to ensure that the value of its currency stays at the pegged value.

Question 27

When does a revaluation occur?

Answer 27

When the price of a currency operating in a fixed exchange rate system is officially and deliberately increased.

Question 28

When does a devaluation occur?

Answer 28

When the price of a currency operating in a fixed exchange rate system is officially and deliberately lowered.

Question 29

What are some advantages of a devaluation of the currency?

Answer 29

The international competitiveness of a country can be improved by a currency devaluation as export become relatively cheaper.

Question 30

When does a government interfere in foreign exchange markets?

Answer 30

To maintain its fixed exchange rate at a predetermined level by buying or selling foreign currency reserves. The fixed exchange rate is achieved by the respective governments buying and selling foreign currencies to maintain the peg.

Question 31

What happens in a managed exchange rate system?

Answer 31

The government or central monetary authority intervenes periodically in the foreign exchange market to influence the change rate by affecting the demand fro and supply of the domestic currency.

Question 32

When is intervention used in a managed exchange rate system?

Answer 32

Intervention is used to prevent large and sudden fluctuation in the exchange rate which could happen if currencies were left entirely to the market forces of demand supply. This helps to create certainty and confidence in the economy.

Question 33

What are the advantages of an over valued currency?

Answer 33

Imported goods become cheaper so there is downward pressure on the rate of inflation.
Domestic producers are forced to be more efficient to compete with the cheaper foreign imports.

Question 34

What are the disadvantages of an over valued currency?

Answer 34

Exports become less competitive causing lower profits in export industries.
As imports become cheaper and exports more expensive there is a negative impact on the balance of payments.

Question 35

What are the advantages of an under valued currency?

Answer 35

Exports become cheaper leading to growth and employment in export industries.
Imports become expensive for consumers so they switch to buying domestic goods.

Question 36

What are the disadvantages of an under valued currency?

Answer 36

Imports become more expensive which can lead to imported inflation ie. imported raw materials and components are more costly thus affecting the general price level.

Question 37

What are advantages of fixing exchange rates?

Answer 37

It reduced uncertainties for international trade which allows both domestic and foreign firms to be certain about future costs and rices thereby encouraging international trade and exchange.
Fixed exchange rates remove uncertainties and volatility caused by currency fluctuations due to speculation in the foreign exchange market.

Question 38

What are disadvantages of fixing exchange rates?

Answer 38

Reduces the country’s ability to use monetary policy to affect the economy which could be useful during a recession.
There is also huge opportunity cost in using large amounts of foreign exchange reserves on a daily basis to maintain the fixed rate.

Question 39

What are disadvantages of a freely floating exchange rate?

Answer 39

Create instability and uncertainties to international trade.

Question 40

What are advantages of a freely floating exchange rate?

Answer 40

More responsive to changes in the economy.