4.1 Exchange Rates Flashcards
What is an exchange rate?
The value of one currency in terms of another
What is an effective exchange rate?
The weighted overall exchange rate of a currency when measured against multiple other countries
What are foreign currency reserves?
A collection of foreign assets/currencies held by the government or central bank in a country
What are foreign currency reserves used for?
- International trade (provide the necessary funds to fulfill imports)
- Fund a financial crisis (provide a cushion that helps a country withstand external shocks)
What are the 3 exchange rate regimes?
- Fixed exchange rate
- Floating exchange rate
- Managed floating exchange rate
What is a fixed exchange rate?
When the government or central bank ties their country’s exchange rate to another country’s currency
What is a benefit and drawback of a fixed exchange rate?
- Creates certainty (which reduces speculation + encourages investment)
- Difficult to maintain (many variables, foreign reserves are required)
What is a floating exchange rate?
When the value of a currency is determined purely by market demand and supply of the currency (no government intervention)
What is a benefit and a drawback of a floating exchange rate?
- Low exchange rates may increase economic growth (as exports increase)
- Inflationary pressures (currency depreciation increases cost of raw materials=cost-push inflation)
What is a benefit and a drawback of a managed floating exchange rate?
- Reduce risk of a deflationary recession: lower currency increases exports and increases domestic price
- Exchange Rate Uncertainty: interventions create uncertainty for businesses/investors
What is a managed floating exchange rate?
When the value of a currency is determined by supply and demand within the parameter set by government (regular government intervention)
Why is a lack of foreign currency reserves negative?
- There are no funds to service debts
- Government is unable to import goods
What is the difference between appreciation and depreciation?
- 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)
What 4 factors influence the supply/demand of currency?
- 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
Where can the exchange rate be found on the diagram?
Where the supply and demand of a currency intersect
What 2 factors influence a currency’s value?
- Interest rate differentials (high rates lead to an inflow, causing an appreciation)
- Trade balances (strong trade/CA surplus leads to appreciation)
What is the difference between revaluation and devaluation?
- 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
What 3 factors influence the choice of exchange rate regime?
- 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)
What influence does a depreciation have on imports and exports?
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
What does the J-curve effect suggest?
A country’s trade balance initially worsens after a currency depreciation/devaluation, before eventually improving
Describe the Marshall-Lerner condition
- A depreciation in the exchange rate causes a deterioration of the CA in the short-term (demand is inelastic)
- People do not immediately realise British exports are cheaper and imports expensive
- In the long-term, demand becomes more elastic and CA improves
What does the Marshall-Lerner condition suggest?
a currency depreciation will improve a country’s trade balance only if the combined price elasticity of demand for exports and imports is greater than one (elastic)
Draw:
Marshall-Lerner condition
Y-axis = surplus and deficit
Straight line in the middle = time
Deficit straight line, then curve worsens before it rises above time
What are 2 advantages and disadvantages of floating exchange rate?
- 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)
