4.1 - Exchange rates Flashcards
international economics
What is an exchange rate?
the price of one currency in terms of another
What are the 3 exchange rate systems?
- floating exchange rate
- fixed exchange rate
- managed exchange rate
who controls the exchange rate system that is used in determining the value of a nation’s currency?
The Central bank
What is a floating exchange rate?
A system where the rate at which one currency is exchanged for another is determined by
market demand and supply of the currency,
(with no target set by the government and
no official intervention in the currency markets)
What are some arguments for a floating exchange rate?
- central bank does not need to try and maintain a particular exchange rate
> so they will not need to use reserves to buy pounds in the market to keep it at target.
> Interest rates are also reserved for domestic monetary policy control rather than maintaining exchange rate - It will partly auto-correct a trade deficit
> as a large trade deficit will cause a fall in the value of the currency (eg: pound - uk uses floating exchange rate)
> since supply of the currency is high and demand is low, this depreciation makes exports cheaper and imports more expensive
> which will reduce the trade deficit (assuming marshall lerner condition)
What is a fixed exchange rate?
a system where a government sets their currency against another and that
exchange rate does not change
What is a managed exchange rate
- System where the value of the currency is determined by demand and supply but the Central Bank will try to prevent large changes in the exchange rate on a day to day basis.
- This is done by buying and selling currency and by changing
interest rates.
What is the appreciation of a currency?
- An increase in the value of the currency relative to another under floating exchange rates
- demand for that currency rises relative to its supply
What is the depreciation of a currency?
- a fall in the value of the currency relative to another under floating exchange rates.
- increase in supply of the currency relative to its demand
What factors influence a floating exchange rate system?
- Relative interest rates
- Relative inflation rates
- Net investment
- The current account
- Speculation
- Quantitative easing
What is revaluation of a currency?
when the currency is increased against the value of another under a fixed system
What is the devaluation of a currency?
A decrease in the
value of one currency against another under a fixed system
Explain how relative interest rates influence floating exchange rates (£) …
- influence the flow of hot money between countries. > If the UK increases its interest rate, then demand for £’s by foreign investors increases & the £ appreciates.
> If the UK decreases its interest rate, then the supply of £’s increases as investors sell their £’s in favour of other currencies & the £ depreciates
Explain how Relative inflation rates influence floating exchange rates (£) …
- inflation in the UK rises relative to other countries, - so, its exports become more expensive
- so there is less demand for UK products by foreigners,
- which means there is less demand for £s & so the £ depreciates
Explain how net investment influences floating exchange rates (£) …
- foreign direct investment (FDI) into the UK creates a demand for the £ which leads to the £ appreciating.
- FDI by UK firms abroad creates an increase in the supply of £’s which leads to the £ depreciating
Explain how the current account influences floating exchange rates (£) …
- UK exports have to be paid for in £’s, so an increase in exports means an increase in the demand for £s
- so an increasing trade surplus will result in an appreciation of the £
- UK imports have to be paid for in local currencies, which requires £’s to be supplied to the forex market, which means there is an increase in the supply of £s
- so an increasing trade deficit will result in a depreciation of the £
Explain how speculation influences floating exchange rates (£) …
- majority of currency trades are speculative.
- Speculation occurs when traders buy a currency in the expectation that it will be worth more in the short to medium term, at which point they will sell it to realise a profit
- if speculators fear a fall in the pound, the pound will depreciate as they will sell their pounds
and buy another currency (increasing the supply).
Explain how quantitative easing influences a floating exchange rate system …
- Involves increasing the money supply & much of the new supply is used to buy back gilts.
- Many of these gilts are owned by foreigners who then exchange the £s received for their own currency.
- The increase in the supply of £’s depreciates the £
How might a government intervene in the currency market?
(occurs in a managed exchange rate system)
1) Changing interest rates:
- if the Central Bank wants to appreciate the country’s currency,
- it would raise interest rates thereby making it more attractive for foreigners to move money into the country’s banks (hot money).
> increasing the demand for the currency - Decreasing interest rates has the opposite effect & causes a depreciation
2) Foreign currency transaction
- The Central Bank can change the demand or supply for their currency using their reserves.
- If they want to appreciate the currency then they buy it on the forex market using foreign currencies
> This increases the market demand of the domestic currency leading to an appreciation of that currency - If they want to depreciate the currency then they sell their own currency & buy foreign currencies
> This leads to an increased market supply of the domestic currency and a depreciation of that currency
What are the consequences of competitive devaluation and depreciation of a currency?
- It is anticompetitive & upsets international competitors
- Large countries usually have more financial resources to manipulate markets & so gain unfair advantages over smaller countries
- Other countries may respond by also lowering the value of their currencies resulting in very little change to market share
- The devaluation/depreciation raises the cost of imports used in production & with little change to the value of exports - profits decrease
Why might a government intentionally devalue/depreciate their domestic currency?
- When a currency is intentionally devalued/depreciated by a government, it makes the country’s exports cheaper
- If demand for their exports is price elastic, then the country is likely to experience higher export volumes & higher export revenues
What may be impacted by changes in exchange rates?
- the current account of the balance of payments
- economic growth
- unemployment / employment
- rate of inflation
- foreign direct investment (FDI) flows
How might economic growth be impacted by changes in exchange rates?
- Net exports are a component of aggregate demand (AD)
> A depreciation that results in an increase in net exports will lead to economic growth
How might inflation be impacted by changes in exchange rates?
- Cost push inflation is likely to occur as the price of imported raw materials increases with currency depreciation
- Net exports are a component of aggregate demand (AD)
- A depreciation that results in an increase in net exports will lead to an increase in aggregate demand
> This may lead to an increase in demand pull inflation - An appreciation of the currency will have the opposite effect
How might unemployment levels be impacted by a change in exchange rates?
- If depreciation leads to an increase in exports,
- unemployment is likely to fall as
- more workers are required to produce the additional products demanded
- An appreciation of the currency will have the opposite effect
How might foreign direct investment be impacted by changed in exchange rates?
- Depreciation of a currency makes it cheaper for foreign firms to invest in the country and can increase the FDI
> The money they have available to invest is worth more when the currency has depreciated - An appreciation has the opposite effect
How might living standards be impacted by changes in exchange rates?
- The impact of a depreciation on living standards can be muted
- As imports are more expensive, households face higher prices & less choice, which detracts from living standards
- Rising exports can decrease unemployment & increase wages/income which means an improved standard of living for some households
- The impact of an appreciation on living standards will be the opposite
What is the marshall-lerner condition?
States that when a currency depreciates, the current account balance will only improve if the sum of PEDs for exports and imports is greater than 1.
What does the J curve show?
In the short-run, a depreciation of currency will initially lead to a worsening of the current account balance, before it begins to improve. This is due to price inelastic demand in the short-term and price elastic demand in the long-term.
Use the Marshall - lerner condition to explain the impacts of a depreciation of the £ on the current account …
- Depreciation of the £ causes exports to be cheaper for foreigners to buy & imports to the UK to be more expensive
- should be an increase in exports and a decrease in imports
- however the extent to which this improves the current account balance (in this case fixing a current account deficit) depends on the Marshall-Lerner condition
- This follows the revenue rule which states that in order to increase revenue, firms should lower prices for products that are price elastic in demand
- If the combined elasticity of exports/imports is less than 1 (inelastic), a depreciation (fall in price) will actually worsen the current account balance
- because consumers will still demand imports, but have to pay a higher price
- and a decrease in export price will not lead to an increase in the quantity demanded
- means that there are more outflows from higher import prices and less inflows of money from lower export prices into the country, worsening the current account deficit.
Explain why there is time lag between the depreciation of the £ and any subsequent improvement in the current account balance
- explained by the J-Curve effect
> In the short-run, a depreciation of currency will initially lead to a worsening of the current account balance, before it begins to improve. This is due to price inelastic demand in the short-term and price elastic demand in the long-term. - This is because It takes time for firms & consumers to respond to changes in price
> foreign consumers will not immediately recognise that a countries exports are cheaper and it will take a while to find a source for them
> whilst domestic consumers will not see that imports are more expensive and may be
unable to switch straight away (need time to find substitute goods)
> so demand tends to be inelastic in the short run.
> Therefore, the amount sold of each will stay the same but the price of exports will fall, so the export revenue will fall, and the price of imports will rise, so the outflow of money on imports will rise
> worsening a current account deficit - However, in the long term, the current account deficit will fall as demand
becomes more elastic.
> it also becomes evident that price changes will last for a longer period of time, so firms & consumers switch
