4.1.8 Exchange rates

Question 1

What is an exchange rate?

Answer 1

• The rate at which one currency trades against another on the foreign exchange market

Question 2

What is a floating exchange rate?

Answer 2

• When the exchange rate is determined solely by the forces of demand and supply

Question 3

What are fixed exchange rates?

Answer 3

• A system where the government ties its exchange rate to the price of another currency

Question 4

What are managed exchange rates?

Answer 4

• When the exchange rate is primarily determined by demand and supply
  
  • —- but the government may intervene on occasion to influence the exchange rate

Question 5

What is meant by an appreciation of an exchange rate?

Answer 5

• An increase in the value of one currency in relation to another currency.

Question 6

What is meant by a depreciation of an exchange rate?

Answer 6

• A fall in the value of a currency in terms of its exchange rate versus other currencies

Question 7

What are some factors which might determine the demand for a currency?

Answer 7

• interest rates
• confidence
• economic growth

Question 8

What are some factors which might determine supply of a currency?

Answer 8

• Inflation rates

- Monetary policies

Question 9

What are some ways in which a country might attempt to manage its exchange rate?

Answer 9

• Sell foreign exchange assets, purchase own currency.
• Raise interest rates (attract hot money flows)
• Reduce inflation

Question 10

How might a country benefit from a depreciation of its currency?

Answer 10

• boost exports
• shrink trade deficits
• reduce the cost of interest payments

Question 11

How might exchange rate changes impact on the current account of the balance of payments?

Answer 11

• A change in a country’s balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies.
• a depreciation in the value of a currency is likely to improve the current account (reduce deficit)

Question 12

What is the Marshall-Lerner condition?

Answer 12

• A devaluation or depreciation of the exchange rate will only improve a current account
  (or balance of trade) deficit if the sum of the price elasticities of demand for exports and imports
  —
  i.e. net exports is greater than 1

Question 13

What is the J-Curve?

Answer 13

• The J Curve effect a depreciation in the exchange rate can cause a deterioration of the current account in the short-term (because demand is inelastic).
• In the long-term, demand becomes more price elastic and the current account begins to improve.

Question 14

How might changes in the exchange rate impact on a country’s competitiveness?

Answer 14

• If a country experiences an appreciation then its exports will be more expensive to foreigners.
• Devaluation will give a temporary boost to competitiveness

Question 15

How might changes in the exchange rate impact on FDI?

Answer 15

• An increase in FDI will increase the demand for the currency of the receiving country, and raise its exchange rate.