3.2 Exchange rates

Question 1

exchange rate

Answer 1

Is the value of one currency expressed in terms of another.

Question 2

Appreciation

Answer 2

An increase in demand for the
currency leads to an increase in the price
(value of the currency):

Question 3

Depreciation

Answer 3

A decrease in supply of the
currency leads to a decrease in the price
(value of the currency):

Question 4

what factors influence supply and demand for a currency?

Answer 4

1. Foreign demand for exports: when foreign demand for exports increases, demand for
   the currency will increase because foreign nations will need to buy the exports in
   the domestic currency.
2. Domestic demand for imports: when domestic demand for exports increases, the
   supply of the domestic currency increases because domestic consumers will need
   to buy the exports in the foreign currency. They will need to exchange the
   domestic currency for the foreign currencies.
3. Domestic interest rates relative to foreign interest rates: when the domestic interest
   rate increases relative to the foreign interest rates, foreign investors will bring their
   money into the domestic country. They can only deposit money of the domestic
   currency on the domestic country’s banks, so demand for domestic currency (in
   order to exchange their foreign currencies) will increase.
4. Foreign direct investments/portfolio investments : when foreign investors invest more in
   domestic firms the demand for domestic currency will increase, because these
   investments must be made in the domestic currency.
5. Speculation: investors may spread rumors about the future development of exchange
   rates and speculate on future value. Basically anything can happen to the value of
   the currency, depending on the content of the rumors.
6. Relative inflation.

Question 5

What happens if the domestic currency appreciates?

Answer 5

• Domestic products will be more expensive to buy for foreign nations so exports
will decrease.

• This will result in decreased employment, because people producing goods for
exports will be needed less, and less economic growth.

• Foreign products will be cheaper to buy for the domestic nations so imports will
increase.

• This will result in less inflation due to decrease in price of imports.

• Because exports decrease and imports increase the current account balance (X−M)
decreases.

Question 6

What is a fixed exchange rate systems?

Answer 6

is an exchange rate regime in which the value
of the currency is pegged to the value of
another currency.

Question 7

Revaluation

Answer 7

This rise in value of the currency caused

by government is called a revaluation

Question 8

How does the government influence demand for supply of a currency? (under a managed exchange rate system)

Answer 8

1. Using reserves of money (the central bank has in them in the vaults) to buy or sell
   foreign currencies:

• Selling foreign currencies in exchange for domestic currency decreases the
supply of and increases the demand for domestic currency.

• The opposite is true for buying foreign currency in exchange for domestic
currency.

2. Changing interest rates:

• If a government were to increase the domestic interest rate this would draw
(the money of) foreign investors to the country and they would have to
exchange their foreign currency for domestic currency. This increases
demand for domestic currency and decreases supply of domestic currency.

• The opposite is true for a decrease in interest rate.

Question 9

Devaluation

Answer 9

a decrease in value caused by the

government is called a devaluation

Question 10

Managed exchange rates

Answer 10

Under a managed exchange rate regime the exchange rate is freely floating but there is
periodic government intervention to influence the value of the exchange rate. For
example there is a bandwidth within which the value of the currency can freely float but
if the value of the currency goes outside this bandwidth, the government will intervene.