4.15.1 - Exchange Rate Systems

Question 1

What is the exchange rate?

Answer 1

The external price of the currency, usually measured against another currency.

Question 2

What are the main types of exchange rates?

Answer 2

Freely floating exchange rates
Dirty floating exchange rates
Adjustable peg exchange rates
Rigidly fixed exchange rates

Question 3

What is a freely floating exchange rate?

Answer 3

Where the exchange rate of the currency is determined solely by the demand for, or supply of, the currency.

Question 4

Why does a depreciating exchange rate of the pound mean that UK exports are more competitive?

Answer 4

As the value of your currency falls, foreign companies can purchase more goods from the converted value of your goods are cheaper.

Question 5

What are the advantages of floating exchange rates?

Answer 5

• Automatically achieving BoP equilibrium
• Improving resource allocation
• Freedom to achieve domestic policy objectives
• Making it easier to control inflation
• Ability to pursue an independent monetary policy

Question 6

Why is automatically achieving BoP equilibrium an advantage of floating exchange rates?

Answer 6

Provided the adjustment mechanism operates smoothly, a currency should never be over- or under-valued for long.

Question 7

Why is improving resource allocation an advantage of floating exchange rates?

Answer 7

If the world’s resources are to be efficiently allocated between competing uses, exchange rates must be correctly valued.

Market prices must reflect shifts in supply and demand so a freely floating exchange rate can easily adjust and respond to these changes.

Question 8

Why is freedom to achieve domestic policy objectives an advantage of floating exchange rates?

Answer 8

In this manner, the market takes over to control the current account of BoP and the government can concentrate on domestic economic policy.

Question 9

Why is making it easier to control inflation an advantage of floating exchange rates?

Answer 9

This exchange rate prevents the economy from ‘importing inflation’ from the rest of the world. If inflation is occuring elsewhere, the floating exchange rate would appreciate, lowering the prices of imports to prevent imported inflation.

Question 10

Why is ability to pursure an independent monetary policy an advantage of floating exchange rates?

Answer 10

With a floating exchange rate, monetary policy can be used solely to achieve domestic policy objectives. This ensures that monetary policy is not changed due to events in the outside world and is solely decided based on the needs of the domestic economy.

Question 11

What are the disadvantages of floating exchange rates?

Answer 11

• Adverse effects of speculation and capital flows
• International trading uncertainty
• Floating exchange rates may cause cost-push and/or demand-pull inflation

Question 12

Why are adverse effects of speculation and capital flows a disadvantage of floating exchange rates?

Answer 12

In the short-run, currencies are extremely vulnerable to ‘hot money’ movements into or out of currencies.

Question 13

Why is international trading uncertainty a disadvantage of floating exchange rates?

Answer 13

The volatility and instability of floating exchange rates can slow the growth of international trade. This uncertainty may deter firms from engaging in international trade.

Question 14

Why is cost-push and demand-pull inflation a disadvantage of floating exchange rates?

Answer 14

Cost-push Inflation
* If a country has high inflation, trading competitiveness and the current account of the BoP worsen, causing the exchange rate to fall to restore competitiveness.
* This may trigger a vicious downward spiral of faster inflation and exchange rate depreciation.
* The falling exhange rate increases import prices, raising the rate of domestic cost-push inflation.

Demand-pull inflation
* If many countries with floating exchange rates simultaneously increase AD, excess demand will occur on a worldwide scale. (1970s oil)
* The excess demand, and the inability of supply to meet the excess, led to an increase in the price level.
* There is greater pressure being placed on existing FoP, so the price level increases.
* Firms and countries pass on these costs to consumers, leading to demand-pull inflation.

Question 15

What are fixed exchange rates?

Answer 15

An exchange rate fixed at a certain level by the country’s central bank and maintained by the central bank’s intervention in the foreign exchange market.

Question 16

How do fixed exchange rates work?

Answer 16

The central bank announces a central peg, with limits set just above and below the central peg. Market forces determine the currency’s ‘day-to-day’ exchange rate.

If the market forces look like they are going to break this rate, then the central bank intervenes.

Question 17

What are the advantages of fixed exchange rates?

Answer 17

• Fixed exchange rates attempt to achieve certainty and stability in foreign exchange markets.
• Fixed exchange rates impose an anti-inflationary discipline on a country’s domestic economic management.

Question 18

What are the disadvantages of fixed exchange rates?

Answer 18

• Fixed exchange rates may increase uncertainty if devaluation or revaluation is expected.
• If the fixed exchange rate is overvalued, it may impose severe deflationary costs of lost output and unemployment.
• If the fixed exchange rate is undervalued, inflation may be imported from the rest of the world.
• An independent monetary policy cannot be undertaken.

Question 19

How can governments intervene to influence the exchange rate?

Answer 19

• The central bank can purchase or sell their own currency on the foreign exchange market when the exchange rate is going to fall below the floor or above the ceiling respectively, to offset excess demand or supply.
• The Bank Rate can be raised or lowered when the exchange rate is going to fall below the floor or above the ceiling respectively.

Question 20

What are the two types of managed exchange rates?

Answer 20

• Adjustable peg
• Managed floating

Question 21

How do adjustable peg exchange rates work?

Answer 21

If the currency is constantly being supported to stay above or below the central peg, it condemns the country to lost output and unemployment and inflation being imported respectively. If this happens, the central peg will be adjusted to re-evaluate the price of the currency.

Question 22

How does managed floating exchange rates work?

Answer 22

The currency is officially freely floating, but the central bank intervenes behind the scenes to iron out temporary fluctuations in the pound’s exchange rate.

Question 23

What is a currency union?

Answer 23

An agreement between a group of countries to share a common currency, and usually to have a single monetary and foreign exchange policy.

Question 24

Why did certain EU members think a monetary union was necessary?

Answer 24

• Exchanging national currencies in trade between EU member states increased transaction costs.
• There were undervalued and overvalued exchange rates within the trading bloc, increasing the competitiveness of those with a falling exchange rate and reducing the competitiveness of those with a rising exchange rate.

Question 25

What is an optimal currency area?

Answer 25

In order for adoption of a common currency to be worthwhile, the countries must satisfy most, or all, of these factors:
* Major economic interconnectedness
* The freedom of labour and capital to move
* A unified fiscal policy across all countries

Question 26

Why is the EU not an optimal currency area?

Answer 26

They do not have a unified fiscal policy across all member states.

Question 27

Why is the lack of a unified fiscal policy such an issue?

Answer 27

Transfers of wealth from the richer to poorer parts of the EU are impossible, so countries cannot achieve competitive advantage as they are unable to devalue their currency.

The lack of transfers of wealth also means that countries cannot invest in themselves to improve infrastructure.

Question 28

Why is the EU not truly a single market?

Answer 28

Labour mobility is limited and capital flows from Europe’s core to the periphary have mostly slowed since ‘08.