4. The International Economy - Exchange Rates

Question 1

What is the exchange rate?

Answer 1

The price of one currency in another currency. For example £1 = $1.60

Question 2

What market determines the exchange rate?

Answer 2

The forex market;On the Y axes you have the price of pounds in dollars on the x-axis you have quantity.The point where supply and demand intersect provides the price for a certain quantity of pounds in dollars this is the exchange rate.

Question 3

What affects can a change in supply or demand have on the exchange rate?

Answer 3

And increase in the supply of pounds will decrease the exchange rate the same way and a decrease in demand for pounds will. Decreasing the supply of pounds or increasing the demand pounds will increase the exchange rate.

Question 4

What does is it mean to say a has currency got stronger?

Answer 4

It means that that currency is now worth more in another currency so £1 could now be worth $1.80 as opposed to $1.60 previously.

Question 5

What are the demand-side causes for an appreciation in the exchange rate?

Answer 5

Increase in relative interest-rate - hot moneySpeculators anticipate a rise in the £Increase in FDI - have to pay workers and machineries etc. in £sIncrease in incomes abroad - may want more imports - have to buy in £sIncrease in UK competitiveness - inc. demand

Question 6

What are the supply-side causes the depreciation of the exchange rate?

Answer 6

Decrease in interest ratesSpeculators anticipate decrease in the £FDI leaves UKIncrease in domestic incomes(Opposite to Appreciation on the demand- side)

Question 7

What is appreciation?

Answer 7

When the value of a currency rises in relation to another. When £ increases in worth in $s

Question 8

What is depreciation?

Answer 8

When the value of a currency falls in value in relation to another. When £ decreases in worth in $s.

Question 9

What Macro impacts are there for an appreciation?

Answer 9

SPICEDImports cheaper - Demand for them up - Expenditure on them upExports direr - Demand for them down - Revenue from them down

Question 10

Why will a strong ER diagram show AD falling?

Answer 10

Imports are increasing and export revenues are decreasing so (X-M) is becoming more negative - AD falls

Question 11

What Macro impacts are there for a depreciation?

Answer 11

WIDECWeak £ - Imports dire - Exports cheap Demand for imports down - expenditure on imports downDemand for exports up - export revenues up

Question 12

Why will a weaker ER diagram show AD rising?

Answer 12

mports are falling and exports are increasing meaning the value of (X-M) is positive so AD will increase.

Question 13

What are likely effects of a strong currency on the economy?

Answer 13

AD downDemand pull inflation downOutput/Growth downUnemployment upBoP worsens

Question 14

What are likely effects of a weak currency on the economy?

Answer 14

AD UpDemand pull inflation upOutput/Growth upUnemployment downBoP strengthens

Question 15

How may a weak exchange rate also effect cost-push inflation?

Answer 15

Imports are now more expensive meaning that any firms that use imports as part of the factors of production will experience increased costs and pass these on to consumers leading to cost push inflation.

Question 16

How may a strong exchange rate also effect cost-push inflation?

Answer 16

Imports are now cheaper meaning that any firms that use imports as part of the factors of production will experience decreased costs and so reduce cost-push inflation.

Question 17

What are the evaluation points for the impact of an exchange rate on an economy?

Answer 17

This depends on the PED of imports and exports - SPICED - imports cheap but if very price inelastic no real change to demand Depends on the size of the appreciation or depreciation - large change, larger impactsAre there restrictions on trade? If tariffs are on reduces impacts of cheaper exportsIncomes abroad will effect demand for exports

Question 18

What are the three main types of exchange rate system?

Answer 18

1. A free-floating currency - Where the external value of a currency depends wholly on market forces of supply and demand.
2. A managed-floating currency - When the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives.
3. A fixed exchange rate system (semi and fully fixed) - A currency peg either as part of a currency board system or membership of the ERM II for countries intending to join the Euro.

Question 19

What are the features of a free-floating currency?

Answer 19

The value of a currency is determined purely by demand and supply of the currency
Trade flows and capital flows affect the exchange rate under a floating system
There is no target for the exchange rate and no intervention in the market by the central bank
Sterling has floated since the UK suspended membership of the ERM in September 1992
The Bank of England has not intervened to influence the pound’s value since it became independent in 1997

Question 20

What are the features of a managed-floating currency?

Answer 20

Value of the currency is determined by market demand for and supply of the currency
Some currency market intervention might be considered as part of demand management (e.g. a desire for a lower currency to boost exports)
Governments normally engage in managed floating if not part of a fixed exchange rate system.
Managed floating was a policy pursued in the UK from 1973-1990

Question 21

What are the features of a semi-fixed currency?

Answer 21

Exchange rate is given a specific target.
The currency can move between permitted bands of fluctuation on a day-to-day basis
Interest rates are set at a level necessary to keep the exchange rate within target range – or direct intervention in the FOREX market

Question 22

What are the features of a fully fixed currency?

Answer 22

The exchange rate is pegged and there are no fluctuations from the central rate
A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable
Several countries operate with fixed exchange rates or currency pegs - The Ivory Coast Franc is pegged to the Euro, with the French Treasury guaranteeing convertibility.

Question 23

How may the government intervene to influence the exchange rate in an economy?

Answer 23

1. Interest Rates - raising or lowering them will influence the flow of hot money which requires people to buy a given country
2. Direct buying in the FOREX market - buying up or selling currency in the FOREX market to influence the ER
3. In the long-run they could develop SSPs to improve productivity - improve competitiveness making ppl buy there products in their currency (increased AD)

Question 24

What other factors may influence the exchange rate? (1)

Answer 24

1. Inflation - If inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive, and there will be an increase in demand for Pound Sterling to buy UK goods. Also, foreign goods will be less competitive and so UK citizens will buy fewer imports.
2. Speculation - If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise.
3. Change in competitiveness - If British goods become more attractive and competitive this will also cause the value of the exchange rate to rise.

Question 25

What other factors may influence the exchange rate? (2)

Answer 25

4. Balance of Payments - A deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial/capital account, then this is OK. But a country which struggles to attract enough capital inflows to finance a current account deficit will see a depreciation in the currency.
5. Government Debt - Under some circumstances, the value of government debt can influence the exchange rate. If markets fear a government may default on its debt, then investors will sell their bonds causing a fall in the value of the exchange rate.

Question 26

What are the advantages of a fixed exchange rate system?

Answer 26

1. Certainty of currency value gives confidence for inward investment
2. Reduced costs of currency hedging for businesses
3. Businesses can’t rely on the exchange rate to keep them competitive - drives efficiency
4. Imposes responsibility of government policies
5. A credible fixed exchange rate leads to less speculation

Question 27

What are the advantages of a floating exchange rate system?

Answer 27

1. Reduced need for large currency reserves - to buy up currency as part of gov. intervent.
2. Freedom to use interest rates to meet domestic policy objectives
3. Helps to prevent imported inflation
4. Less risk of speculative attack
5. Partial automatic correction for a current account deficit

Question 28

What is a currency (or monetary) union?

Answer 28

A currency union is an agreement among members of that union (countries or other jurisdictions) to share a common currency, and a single monetary and foreign exchange policy.

Question 29

What is an example of a currency union?

Answer 29

The Eurozone - all the countries using the euro (no the UK)

Question 30

What are the advantages of a currency union?

Answer 30

1. Transparency - Producers and tourists can more easily compare the prices of international goods, services and resources.
2. Lower transaction costs - Transaction costs are reduced because there are no commission payments to financial intermediaries.
3. Certainty and Investment - The Euro creates certainty because firms can predict the cost of imported raw materials and can set the price of their exports, which means they can plan, and are more likely to invest.
4. Trade Creation - Trade between members of a single currency area is likely to increase because of the benefits of sharing a currency.
5. Job Creation - Increased trade is likely to generate jobs in those industries that experience increased exports.
6. Discipline against inflation - Members cannot take the easy option (devaluation) to get out of economic difficulty.

Question 31

What are the disadvantages of a currency union?

Answer 31

1. Loss of economic sovereignty - Once a country become a member of the euro area, National Central Banks, including the Bank of England, lose their ability to use interest rate policy to achieve independent macro-economic objectives.
2. Difficulty of conversion - Many European countries, including the UK, may never be able to converge fully with the euro area. In the UK in particular, convergence is difficult because of the uniqueness of its housing market and financial services sector, and because of the closeness of the UK’s trade cycle to that of the USA.
3. One cap doesn’t fit all - Having only one interest rate is not sensible when dealing with a diverse range of economies and economic circumstances.
4. Dealing with asymmetric shocks - Asymmetric shocks are external shocks that have an unequal impact on an economy or, in this case, the EU area. The growing imbalance between the more affluent northern euro members, including Germany, and the increasingly indebted southern ones, including Greece, Italy and Portugal, has also raised the issue of the inadequaces of having a single monetary policy.