3.4 Exchange Rates

Question 1

Exchange rates

Answer 1

the value of one currency expressed in terms of another currency

Question 2

Forex

Answer 2

foreign exchange market where currencies are traded

Question 3

exchange rate index

Answer 3

expresses one currency against a collection of other currencies

Question 4

fixed/pegged exchange rates

Answer 4

where the central bank intervenes in the market to ensure that an exchange rate is exactly fixed to a pre-determined value of a currency
revaluation (increase in value)
devaluation (decrease in value)

Question 5

floating/flexible exchange rate

Answer 5

where the forces of demand and supply determine the price of a currency
Appreciation (increase in value)
depreciation (decrease in value)

Question 6

managed floating exchange rate

Answer 6

where the currency is able to float within a narrow band of the other currency
app
dep
govt intervenes periodically

Question 7

Advantages of high exchange rates

Answer 7

downward pressure inflation
more imports can be bought
forces domestic producers to improve their efficiency

Question 8

disadvantages of high exchange rates

Answer 8

damage to export industries
damage to domestic industries who cannot compete with cheaper foreign goods
unemployment problems if it continues in the longer term

Question 9

advantages of low exchange rates

Answer 9

greater employments in export industries
greater employments in domestic industries
improves employment

Question 10

disadvantages of low exchange rates

Answer 10

inflation
competitors may complain

Question 11

measure to intervene - Why?

Answer 11

lower exchange rate to increase employment
raise exchange rate to fight inflation
maintain fixed exchange rate
avoid fluctuations in a floating exchange rate
achieve relative exchange rate stability to improve business confidence
improve current account deficit

Question 12

measures to intervene - How?

Answer 12

use reserves of foreign currency to buy/sell own currency
change interest rates

Question 13

advantages of floating exchange rates

Answer 13

automatic adjustment using forces of demand and supply to return to a stable level
no large foreign exchange reserves required
free to set monetary policy and interest rates for domestic issues

Question 14

disadvantages of floating exchange rates

Answer 14

uncertainty in business planning, investment, speculation
no discipline required for interest rates
affected by more than just supply and demand - gov’t intervention, world events
may worsen inflation

Question 15

advantages of fixed exchange rates

Answer 15

certainty and stability - business planning, investment
provides discipline - money supply, interest rates
solves inflationary problems
reduces speculation in the forex market

Question 16

disadvantages of fixed exchange rates

Answer 16

no automatic adjustment
requires large foreign exchange reserves
monetary policy may be inappropriate
imported inflation
setting the level is too complex
if it is too low (e.g. china) there is international disagreement
problems with overvaluation and undervaluation

Question 17

factors that affect the flexible exchange rate

Answer 17

demand for goods and services
relatively high/low inflation rates
relatively high/low interest rates
rising/falling real incomes
speculation
foreign reserves buying or selling

Question 18

factors causing increase in demand for us dollar

Answer 18

increase in us exports of goods/services
increase in foreign investment in us
increase in us interest rates
decrease in us inflation rates
speculative buying of us dollar
us central bank buys dollars (= decrease in foreign reserves)

Question 19

factors that decrease demand for the us dollar

Answer 19

decrease in us exports
decrease in foreign investment in the us
decrease in us interest rates
increase in us inflation rate

Question 20

factors that increase supply of the us dollar

Answer 20

increase in us imports
increase in us foreign investment abroad
increase in foreign interest rates
decrease in foreign inflation rate
speculative selling of the us dollar
us central bank sells us dollar (= increase in foreign reserves)

Question 21

factors that decrease the supply of the us dollar

Answer 21

decrease in us imports
decrease in us foreign investment abroad
decrease in foreign interest rates
increase in foreign inflation rate

Question 22

factors causing a depreciation

Answer 22

decrease X
economic boom
increase in real income
high inflation
low interest rates
govt selling domestic currency

Question 23

factors causing an appreciation

Answer 23

increase X
recession
decrease in real income
low inflation
high interest rates
govt buying domestic currency

Question 24

automatic adjustment

Answer 24

flexible exchange rate will automatically adjust to solve a trade deficit