4.1.8 - exchange rate systems

Question 1

What are exchange rates?

Answer 1

Exchange rates are the price of one currency in terms of another.

Question 2

What is a floating exchange rate system?

Answer 2

Demand and supply determine the rate at which one currency can be exchanged for another

Question 3

What is a fixed exchange rate system?

Answer 3

The country’s exchange rate is fixed in relation to a currency, eg. US dollar. It can only be changed by the central bank in agreement with other countries usually mediated through the IMF.

Question 4

What is a managed exchange rate system?

Answer 4

The monetary authorities control the exchange rate through buying and selling of the country’s currency on the foreign exchange market and through changes in interest rates.

Question 5

What are the advantages of a floating exchange rate system?

Answer 5

-Independent monetary policy = interest rates and QE decision can be used to influence domestic economy, not constrained by exchange rate considerations
-Shock Absorption = allows countries to absorb external economic shocks more effectively to help rebalance the economy
-Reduced speculative attacks = exchange rates are determined by market forces so speculative attacks on a currency are less likely
-Automatic correction of trade imbalance = if a country is running a large trade deficit, currency depreciation over time make exports more price competitive and imports more expensive, reducing the deficit
-Currency reserves = central bank does not need to hold large foreign currency reserves because there is no specific currency target, financial capital can flow freely across countries seeking the best returns

Question 6

What are the disadvantages of a floating exchange rate system?

Answer 6

-Exchange rate volatility = causes uncertainty for businesses reducing trade and investment
-Currency risk = volatility introduces currency risk for businesses and investors
-Inflation Pass-through = exchange rate fluctuations can lead to changes in import prices, impacting domestic inflation
-Loss of exchange rate as a policy tool = countries gain monetary policy autonomy but they lose the ability to manage the exchange rate as a deliberate policy tool.

Question 7

What are the advantages of a fixed exchange rate system?

Answer 7

-Price stability = a fixed system provides price stability helping control inflation, provides a predictable environment for businesses and consumers
-Reduced exchange rate risk = fixed exchange rates eliminate the currency risk associated with fluctuating exchange rates
-Discipline on monetary policy = constrains a country’s central bank from pursuing an independent monetary policy. This can prevent excessive money supply growth and associated inflationary pressures
-Foreign investment = a stable exchange rate can attract foreign investment because there is less risk associated with currency fluctuations

Question 8

What are the disadvantages of a fixed exchange rate system?

Answer 8

-Lack of flexibility = a fully fixed system can’t respond to external economic shocks. Interest rate may be needed to keep exchange fixed rather than affect domestic economic indicators
-Balance of payments issues = persistent imbalances can lead to pressures on the currency peg
-Speculative attacks = fixed exchange rate systems can be vulnerable to speculative attacks if investors believe that the currency is overvalued or if there are concerns about the country’s ability to maintain the peg
-Dependence on reserves = to maintain a fixed exchange rate, a country needs to have sufficient foreign exchange reserves

Question 9

What is the difference between revaluation and appreciation of a currency?

Answer 9

Revaluation is an increase in the value of the pound in terms of other currencies, in a fixed exchange rate system. This is determined by the country’s central bank.
Appreciation is an increase in the value of the pound in terms of other currencies, in a floating exchange rate system

Question 10

What is the difference between devaluation and depreciation of a currency?

Answer 10

Devaluation is a decrease in the value of the pound in terms of other currencies, in a fixed exchange rate system. This is determined deliberately by the central bank.
Depreciation is a decrease in the value of the pound in terms of other currencies, in a floating exchange rate system.

Question 11

What are the factors affecting the floating exchange rate of a currency?

Answer 11

-relative interest rates
-current account of BOP
-inflation rates
-FDI/net investment into the country
-speculation
-quantitative easing

Question 12

How will the current account impact the exchange rate?

Answer 12

Current account surplus (exports > imports) = the pound will appreciate due to higher demand, fall in value of the foreign currency as this is supplied to buy pounds
Current account deficit (imports > exports) = more supply of the foreign currency needed, reduced value of pound and increased demand and value for the foreign currency

Question 13

How will relative interest rates affect the exchange rate?

Answer 13

A rise in interest rates may result in an increased value of this currency as investors need to buy the currency to cash their reserves into bank accounts to take advantage of higher interest rates. However investors may not place cash in the bank if they see the country as volatile.
A fall in interest rates may reduce the value of the currency.

Question 14

How will inflation affect the exchange rate?

Answer 14

If a country has higher inflation than foreign countries, it may be more difficult to sell goods abroad, especially if price elastic. Demand for the currency and value will fall. Domestic consumers may buy imports as they are cheaper increasing supply of currency onto the market.
Lower inflation = more price competitive exports, appreciation of the currency

Question 15

How does FDI/net investment affect the exchange rate?

Answer 15

If firms wish to invest in a country it may impact the price of the currency. FDI increases demand for the currency because it needs to be purchased to buy capital, etc. The bigger the investment and smaller the country, the bigger impact this will have.

Question 16

How does speculation impact the exchange rate?

Answer 16

If investors believe the value of a currency will rise or fall, they will buy or sell the currency accordingly.

Question 17

How does QE impact the exchange rate?

Answer 17

QE has the effect of increasing the supply of a currency, reducing the price as there is more of it available.

Question 18

How can the government influence the exchange rate?

Answer 18

-changing interest rates = to increase the value of the currency, they can increase interest rates so that foreigners place cash reserves in banks
-intervention on the foreign exchange rate (buying/selling currency) = to increase the value of the currency, the central bank would buy its own currency

Question 19

Why may a country try to lower the value of their currency (competitive devaluation/depreciation) ?

Answer 19

They can gain comparative advantage. However, if several countries also do this, advantages would disappear quickly and there may even be a decline in world trade if countries pursued this policy.

Question 20

How does a change in exchange rate impact the current account of the balance of payments?

Answer 20

Depreciation/devaluation = increased price competitiveness of a country’s goods/services by causing a fall in the price of the currency, leading to a current account surplus. There will only be an improved current account if the sum of the PEDs of exports and imports is greater than 1 (Marshall-Lerner condition)
Appreciation/revaluation = decreased price competitiveness of a country’s exports, cheaper imports, can lead to a current account deficit.

Question 21

What is the Marshall-Lerner condition?

Answer 21

For there to be an improvement in the current account after the depreciation/devaluation of a currency, sum of PEDs for imports and exports must be greater than 1. For there to be an affect on the quantity demanded of a good from a price change, PED must be price elastic.

Question 22

What is the J curve effect?

Answer 22

There may be a time lag before the full effects of a depreciation work through the economy, causing a difference between short run and long run effects of the depreciation. The sum of the PEDs would be between zero and one in the short run, but greater than one in the long run, causing the J curve effect. Initially, current accounts may deteriorate because demand for imports is price inelastic (contracts have been agreed), demand for exports may be inelastic as it takes time for consumers to adapt to price changes. In the long run, demand for X and M is likely to become price elastic.

Question 23

How does a change in exchange rates impact economic growth and employment?

Answer 23

Increased price competitiveness of exports due to a depreciation/devaluation should decrease unemployment rates as demand increases for the country’s goods and services, economic growth may increase (higher output levels).
An appreciation makes exports more expensive, reducing demand increasing unemployment and reducing economic growth (lower output).

Question 24

How does a change in exchange rates impact rate of inflation?

Answer 24

A depreciation causes an increase in the price of imported raw materials and manufactured goods. This may have inflationary consequences as firm’s cost of production would increase, causing cost push inflation. Also, a rise in net exports causes AD to increase, leading to demand pull inflation.
An appreciation could reduce inflationary pressure as imported FOPs are cheaper and cost of production will fall. Negative net trade means that AD will decrease, reducing inflation levels.

Question 25

How does a change in exchange rates impact FDI flows?

Answer 25

A depreciation may increase FDI as it is cheaper for foreign firms to invest in the country.
An appreciation would decrease FDI as investment is more expensive.