4.1 Exchange Rates

Question 1

What is an exchange rate?

Answer 1

The value of one currency in terms of another

Question 2

What is an effective exchange rate?

Answer 2

The weighted overall exchange rate of a currency when measured against multiple other countries

Question 3

What are foreign currency reserves?

Answer 3

A collection of foreign assets/currencies held by the government or central bank in a country

Question 4

What are foreign currency reserves used for?

Answer 4

• International trade (provide the necessary funds to fulfill imports)
• Fund a financial crisis (provide a cushion that helps a country withstand external shocks)

Question 5

What are the 3 exchange rate regimes?

Answer 5

• Fixed exchange rate
• Floating exchange rate
• Managed floating exchange rate

Question 6

What is a fixed exchange rate?

Answer 6

When the government or central bank ties their country’s exchange rate to another country’s currency

Question 7

What is a benefit and drawback of a fixed exchange rate?

Answer 7

• Creates certainty (which reduces speculation + encourages investment)
• Difficult to maintain (many variables, foreign reserves are required)

Question 8

What is a floating exchange rate?

Answer 8

When the value of a currency is determined purely by market demand and supply of the currency (no government intervention)

Question 9

What is a benefit and a drawback of a floating exchange rate?

Answer 9

• Low exchange rates may increase economic growth (as exports increase)
• Inflationary pressures (currency depreciation increases cost of raw materials=cost-push inflation)

Question 10

What is a benefit and a drawback of a managed floating exchange rate?

Answer 10

- Reduce risk of a deflationary recession: lower currency increases exports and increases domestic price
- Exchange Rate Uncertainty: interventions create uncertainty for businesses/investors

Question 10

What is a managed floating exchange rate?

Answer 10

When the value of a currency is determined by supply and demand within the parameter set by government (regular government intervention)

Question 11

Why is a lack of foreign currency reserves negative?

Answer 11

• There are no funds to service debts
• Government is unable to import goods

Question 12

What is the difference between appreciation and depreciation?

Answer 12

• Appreciation: when there is an increase in the value of a currency (caused by increased demand)
• Depreciation: when there is a decrease in the value of a currency (caused by decreased demand)

Question 13

What 4 factors influence the supply/demand of currency?

Answer 13

- Interest rates: higher rates make financial investments more attractive, so demand for the currency increases

- Rate of inflation: higher inflation leads to fall in demand for exports as they become more expensive (so fall in demand for the currency)

- Speculation: if speculators expect currency to appreciate they buy it, increasing demand

- Income levels: as incomes rise people demand more imports, so supply rises

Question 14

Where can the exchange rate be found on the diagram?

Answer 14

Where the supply and demand of a currency intersect

Question 15

What 2 factors influence a currency’s value?

Answer 15

- Interest rate differentials (high rates lead to an inflow, causing an appreciation)
- Trade balances (strong trade/CA surplus leads to appreciation)

Question 16

What is the difference between revaluation and devaluation?

Answer 16

- Revaluation: when the value of a currency increases relative to the pegged country
- Devaluation: when the value of a currency decreases relative to the pegged country

Question 17

What 3 factors influence the choice of exchange rate regime?

Answer 17

• Level of development (e.g fixed ER provides stability for developing countries)
• Export dependency (export prices more volatile under floating regime)
• Amount of foreign reserves (reserves are finite)

Question 18

What influence does a depreciation have on imports and exports?

Answer 18

A depreciation increases the cost of imports, so they experience a fall in demand. However, the cost of exports decreases so there is an increase in demand

Question 19

What does the J-curve effect suggest?

Answer 19

The sum of the PEDs of imports and exports must be more than 1, if devaluation is to have a positive impact on the CA

Question 20

Describe what the Marshall-Lerner condition suggests

Answer 20

• A depreciation in the exchange rate causes a deterioration of the CA in the short-term (demand is inelastic)
• People do not immediately realize British exports are cheaper and imports expensive
• In the long-term, demand becomes more elastic and CA improves

Question 21

What are the advantages and disadvantages of floating exchange rate?

Answer 21

• Reduces the need for currency reserves
• Does not require monetary policy (easy to maintain)
• Uncertainty for firms (reduction in investment)
• Inflationary pressures (fall in exchange rate)

Question 22

What are the advantages and disadvantages of a fixed exchange rate?

Answer 22

• Creates certainty (encourages investment)
• Competitive pressure on firms (forced to lower costs/increase productivity)
• Less control over interest rates (cannot act independently/conduct monetary policy)
• Large amount of currency reserves required

Question 23

What are 2 methods a government can use to influence the value of their currency?

Answer 23

• Interest rates (increased rates will strengthen the pound, demand increases)
• Foreign currency reserves (buying FCR will increase supply of pound, weakening it)

Question 24

What is competitive devaluation/depreciation?

Answer 24

When a country deliberately intervenes in foreign exchange markets to drive down the value of their currency

Question 25

What is the impact of a change in exchange rate on economic growth?

Answer 25

• A weaker exchange rate will increase exports (become cheaper) and decrease imports
• Increases in AD, leading to employment and economic growth.

Question 26

What is the impact of a change in exchange rate on FDI?

Answer 26

• A fall in the currency may increase FDI because it becomes cheaper to invest
• However, if it continues to fall then may indicate economic difficulties, discouraging investment.