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IB Economics HL > 3.2 Exchange rates > Flashcards

3.2 Exchange rates Flashcards

1
Q

What does the demand for a foreign currency generate?

A

A supply of the domestic currency being offered in return

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2
Q

What does the demand for a domestic currency generate?

A

A supply of the foreign currency being offered in return for it

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3
Q

For a two currency exchange, how are the demands and supply of each respective currency linked?

A

Demand for currency X ⇔ Supply of currency Y

Demand for currency Y ⇔ Supply of currency X

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4
Q

Define: exchange rate

A

The rate at which one currency can be exchanged for another;

The number of units of one currency that correspond to another currency;

The ‘price’ of a currency, expressed in terms of another currency.

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5
Q

What is a freely floating exchange rate?

A

An exchange rate determined entirely by market forces (of supply and demand). There is no government intervention in the foreign exchange market to influence the value of the exchange rate.

(also known as a floating or flexible exchange rate)

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6
Q

How can a floating exchange rate be shown diagrammatically?

A

If concerning two different currencies:

The price of currency X in terms of currency Y on the y-axis, quantity of currency X on the x-axis.

Supply of and demand for currency X shown.

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7
Q

If the exchange rate is above the equilibrium position, what can be said about the market forces?

A

There is excess supply of currency X

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8
Q

If the exchange rate is below the equilibrium position, what can be said about the market forces?

A

There is excess demand for currency X

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9
Q

What is trading currency ofter referred to as?

A

A zero-sum game

As the price of one rises, another one falls

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10
Q

If currency X strengthens against currency Y, what happens to the exchange rate?

(X : Y)

A

1 unit of currency X is equivalent to more units of currency Y.

The price of currency X increases in terms of currency Y.

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11
Q

If currency X weakens against currency Y, what happens to the exchange rate?

(X : Y)

A

1 unit of currency X is equivalent to fewer units of currency Y.

The price of currency X decreases in terms of currency Y.

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12
Q

If currency Y weakens against currency X, what happens to the exchange rate?

(X : Y)

A

(equivalent to X strengthening against Y)

1 unit of currency X is equivalent to more units of currency Y.

The price of currency X increases in terms of currency Y.

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13
Q

If currency Y strengthens against currency X, what happens to the exchange rate?

(X : Y)

A

(equivalent to X weakening against Y)

1 unit of currency X is equivalent to fewer units of currency Y.

The price of currency X decreases in terms of currency Y.

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14
Q

Where are currencies traded?

A

The foreign exchange market (FOREX)

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15
Q

Who are the participants in the foreign exchange market?

A
  • Individuals
  • Firms
  • Banks and other financial institutions
  • Governments
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16
Q

What is the most traded currency in the world?

Why?

A

The US dollar

  • Unofficial reserves in central banks
  • Used by other countries as the national currency
  • Other currencies are “pegged” to USD
  • Used as a standard currency for many commodities (e.g. oil)
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17
Q

What is an appreciation of a currency?

A

An increase in the value of a currency in a floating exchange rate system.

(The exchange rate of one currency strengthens)

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18
Q

What is a depreciation of a currency?

A

A decrease in the value of a currency in a floating exchange rate system.

(The exchange rate of one currency weakens)

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19
Q

How would an increase in demand for currency X affect the exchange rate?

A

Currency X appreciates

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20
Q

How would an increase in supply of currency X affect the exchange rate?

A

Currency X depreciates

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21
Q

State 8 causes of changes in exchange rates

A
  • Foreign demand for a country’s exports
  • Domestic demand for imports
  • Relative interest rate changes
  • Relative rates of inflation
  • Investment from abroad
  • Changes in incomes
  • Speculation
  • Use of foreign currency reserves
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22
Q

Why does the demand for goods and services from a country after they have depreciated increase?

A

Their goods and services are relatively cheaper

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23
Q

Why does the demand for goods and services from a country after they have appreciated decrease?

A

Their goods and services are relatively more expensive

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24
Q

The demand for a country’s exports increases.

What will happen to the currency? Why?

A

Their currency will appreciate, as there is a greater demand for their currency in order to buy their exports.

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25
Q

The demand for a country’s exports decreases.

What will happen to the currency? Why?

A

Their currency will depreciate, as there is a smaller demand for their currency in order to buy their exports.

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26
Q

The number of imports to a country decreases.

What happens to the currency? Why?

A

Its currency appreciates due to a decrease in its supply to buy imports

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27
Q

The number of imports to a country increases.

What happens to the currency? Why?

A

Its currency depreciates due to an increase in its supply to buy imports

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28
Q

A country’s interest rates increases.

What happens to the currency? Why?

A

Its currency appreciates due to an increase in demand from foreign investors.

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29
Q

A country’s interest rates decrease.

What happens to the currency? Why?

A

Its currency depreciates due to a decrease in demand from foreign investors.

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30
Q

A country’s inflation rates increases (relative).

What happens to the currency? Why?

A

The currency depreciates as their exports are relatively more expensive, therefore a decrease in demand for the currency.

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31
Q

A country’s inflation rates decreases (relative).

What happens to the currency? Why?

A

The currency appreciates as their exports are relatively cheaper, therefore an increase in demand for the currency.

32
Q

Foreign investment from abroad increases.

What happens to the currency? Why?

A

The currency appreciates as to invest they must exchange their funds, which increases the demand for the currency.

33
Q

Foreign investment from abroad decreases.

What happens to the currency? Why?

A

The currency depreciates as to invest they would’ve exchanged their funds, but as they are not, demand for the currency decreases.

34
Q

A country’s level of income increases (relative).

What happens to the currency? Why?

A

The currency would appreciate as increases in income would cause increases in imports, which increases the supply of the currency

35
Q

A country’s level of income decreases (relative).

What happens to the currency? Why?

A

The currency would depreciate as decreases in income would cause decreases in imports, which decreases the supply of the currency

36
Q

How does speculation affect exchange rates?

A

Investors speculating that a currency will appreciate will act in a way that will cause the appreciation (i.e. will want to invest in a currency, which causes the demand that actually appreciates it).

The same for depreciation.

37
Q

A central bank sells foreign currency reserves.

What happens to the domestic currency? Why?

A

The currency appreciates as the selling of foreign currencies in exchange for the domestic currency increases the demand for the currency.

38
Q

A central bank buys foreign currency reserves.

What happens to the domestic currency? Why?

A

The currency depreciates as the buying of foreign currencies in exchange for the domestic currency increases the supply of the currency.

39
Q

When showing the effect on a graph of one currency compared to another currency how many shifts are there usually? Why?

A

Normally two shifts, in opposite directions.

This is because the reason for a decrease in demand for one currency also increases the supply of the currency, relative to another currency.

E.g. a decrease in demand for exports = decreases demand. Whilst an increase in demand for imports = increases supply.

40
Q

When showing the effect on a graph of one currency (without comparison to another), how many shifts are there usually? Why?

A

Usually just one shift.

You cannot assume that a change in one variable will always cause a change in another variable.

41
Q

What macro objectives can you link the exchange rate to?

(5)

A
  • Inflation rates
    • Cost-push
    • Demand-pull
  • Effects on employment
  • Effects on economic growth
  • Effects on the current account balance
  • Effects on foreign debt
42
Q

What are fixed exchange rates?

A

Exchange rates are fixed by the central bank of a country and are not permitted to change in response to supply and demand.

Government intervention corrects the exchange rate.

43
Q

What tools does the government/currency board have to maintain a fixed exchange rate?

(5)

A
  • Foreign currency reserves
  • Interest rates (relative)
  • Borrowing foreign denominated debt
  • Limits on imports
  • Exchange/capital control
44
Q

What is devaluation?

A

The fixed exchange rate is decreased.

45
Q

What is revaluation?

A

The fixed exchange rate is increased.

46
Q

What impact might depreciation have on cost-push inflation?

A

Depreciation makes imports relatively more expensive.

Producers relying on imports would see an increase in their costs.

SRAS shifts left, price level increases.

(cost-push inflation occurs)

47
Q

What impact might appreciation have on cost-push inflation?

A

Appreciation makes imports relatively cheaper.

Producers relying on imports would see a decrease in their costs.

SRAS shifts right, price level decreases.

(cost-push inflation pressures decrease)

48
Q

What impact might depreciation have on demand-pull inflation?

A

Depreciation makes exports relatively cheaper and imports more expensive.

Quantity of exports increase, quantity of imports decrease.

(X - M) increases, AD shifts right, price level increases.

(demand-pull inflation occurs)

49
Q

What impact might appreciation have on demand-pull inflation?

A

Appreciation makes imports relatively cheaper and exports more expensive.

Quantity of exports decreases, quantity of imports increases.

(X - M) decreases.

(demand-pull inflation pressures decrease)

50
Q

What impact might depreciation have on employment?

A

Depreciation increases net exports.

So AD shifts right, real GDP increases.

(employment, if previously below full potential, increases)

51
Q

What impact might appreciation have on employment?

A

Depreciation decreases net exports.

So AD shifts left, real GDP decreases.

Recessionary gap

(employment decreases)

52
Q

What impact might depreciation have on economic growth?

A

Depreciation increases net exports.

So AD shifts right, real GDP increases.

(economic growth increases)

If there is an increased investment into the export sector, could increase LRAS.

53
Q

What impact might appreciation have on economic growth?

A

Appreciation decreases net exports.

So AD shifts left, real GDP decreases.

(economic growth decreases)

54
Q

What impact might depreciation have on the current account balance?

A

Depreciation would likely cause imports to decrease and exports increase.

If the country has a current account deficit beforehand, the deficit should decrease.

If the country has a current account surplus beforehand, the surplus should increase.

55
Q

What impact might appreciation have on the current account balance?

A

Appreciation would likely cause imports to increase and exports decrease.

If the country has a current account deficit beforehand, the deficit should increase.

If the country has a current account surplus beforehand, the surplus should decrease.

56
Q

What impact might depreciation have on foreign debt?

A

Depreciation causes the value of the domestic currency to decrease, which would cause the foreign debt to increase.

57
Q

What impact might appreciation have on foreign debt?

A

Appreciation causes the value of the domestic currency to increase, which would cause the foreign debt to decrease.

58
Q

For a fixed exchange rate system, what must the central bank do to resolve an excess supply of the currency?

A

Increase demand and/or decrease supply

59
Q

For a fixed exchange rate system, what must the central bank do to resolve an excess demand of the currency?

A

Increase supply and/or decrease demand

60
Q

How might a government use foreign currency reserves to resolve an excess supply of fixed-rate currency?

A

Sell foreign currency reserves and buy domestic currency → increase demand for domestic currency

61
Q

How might a government use foreign currency reserves to resolve an excess demand for fixed-rate currency?

A

Sell domestic currency and buy foreign currency → increase supply for domestic currency

62
Q

How might a government use interest rates (relative to other currencies) to resolve an excess supply of fixed-rate currency?

A

Increase IR relative to other countries→ increase demand for & decrease supply of domestic currency

63
Q

How might a government use interest rates (relative to other currencies) to resolve an excess demand for fixed-rate currency?

A

Decrease IR relative to other countries → decrease demand for & increase supply of domestic currency

64
Q

How might a government use borrowing foreign denominated debt to resolve an excess supply of fixed-rate currency?

A

Increase foreign denominated debt → sell borrowed foreign currency and buy domestic currency → increase demand for domestic currency

65
Q

How might a government use borrowing foreign denominated debt to resolve an excess demand for fixed-rate currency?

A

N/A

66
Q

How might a government use limits on imports to resolve an excess supply of fixed-rate currency?

A

Increase trade barriers or contractionary monetary/fiscal policy → decrease demand for imported G&S → decrease demand for foreign currency → decrease supply of domestic currency

67
Q

How might a government use limits on imports to resolve an excess demand for fixed-rate currency?

A

Reduce trade barriers or expansionary monetary/fiscal policy → increase demand for imported G&S → increase demand for foreign currency → increase supply of domestic currency

68
Q

How might a government use exchange/capital controls to resolve an excess supply of fixed-rate currency?

A

Limit amount of foreign currency that consumers/firms are able to exchange → decrease demand for foreign currency → decrease supply of domestic currency

69
Q

How might a government use exchange/capital controls to resolve an excess demand for fixed-rate currency?

A

Remove exchange rate/capital controls → increase demand for foreign currency → increase supply of domestic currency

70
Q

What is the macroeconomic impact of devaluation?

A

+ Trade balance → improve a trade deficit

+ Growth → export-driven sector

+ Employment → increase in employment n exporting sector

  • Cost-push inflation → increase in the price of imports
  • Demand-pull inflation → increase in AD due to increase in X
  • Trade balance → worsen a trade surplus
71
Q

What is the macroeconomic impact of revaluation?

A

+ Trade balance → improve a trade surplus

+ Decrease in the price of imports

+ FDI increases (maybe)

  • Less investment and consumption → AD shifts left
  • Disinflation → recession and unemployment
  • Net exports decrease
72
Q

What is a managed exchange rate?

A

An exchange rate that for the most part is free to float to market levels over long periods of time, however, central banks periodically intervene in order to stabilise them over the short term.

73
Q

What is an overvalued currency?

A

A currency that has an exchange rate that is too high, relative to its market equilibrium.

74
Q

What is an undervalued currency?

A

A currency that has an exchange rate that is too low, relative to its market equilibrium.

75
Q

Why might a currency be overvalued?

A

Developing nations may overvalue their currency in order to benefit from cheap imports to speed up industrialisation in the short term.

76
Q

Why might a currency be undervalued?

A

Nations seeking to increase their export power might undervalue their currency in order for their exports to be cheaper to foreign buyers. This can create an unfair competitive advantage and are referred to as “dirty floats”.

77
Q

How can you go from exchange rate:

X : Y

1 : 1.30

to

X : Y

? : 1

A

Divide both sides by 1.30

IB Economics HL (15 decks)

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