4.1.8 Exchange Rates Flashcards
What is an exchange rate
is the rate at which one country’s currency can be exchanged for other currencies in the foreign
exchange (FX) market
What is an Effective exchange rate
This is a weighted index of sterling’s value against a basket of currencies the weights are based
on the importance of trade between the UK and each country
What are the three main types of exchange rate systems
A free-floating currency
A managed-floating currency
A fixed exchange rate system
What is a free-floating currency
where the external value of a currency depends wholly on market forces of supply
and demand – there is no central bank intervention
What is a managed-floating currency
when the central bank may choose to intervene in the foreign exchange markets
to affect the value of a currency to meet specific macroeconomic objectives
What is a fixed exchange rate system
a hard currency peg either as part of a currency board system or
membership of the ERM Mark II for those EU countries eventually intending to join the Euro.
What is the difference between depreciation and devaluation of a currency
Depreciation is a fall in the value of a currency in a floating exchange rate system
Devaluation is a fall in the value of a currency in a fixed exchange rate system
What is the difference between appreciation and revaluation of a currency
- Appreciation is a rise in the value of a currency in a floating exchange rate system
- Revaluation is a rise in the value of a currency in a fixed exchange rate system
What are 3 key features of a free-floating exchange rate
- The external value of the currency is set by market forces
- There is no intervention by the central bank
- There is no target for the exchange rate
What is it meant by in a free-floating market, the external value of the currency is set by market forces
The strength of currency supply and demand drives the external value of a currency in the markets
The currency can either appreciate (rise) or depreciate (fall)
What are the 5 factors which can cause changes in the currency in a floating system
- trade balances
- Foreign direct investment
- Portfolio investment
- Interest rate differentials
- Speculation
Explain how Trade balances can cause a change in currency in a floating system
countries that have strong trade and current account surpluses tend (other factors remaining
the same) to see their currencies appreciate as money flows into the circular flow from exports of goods and services and from investment income
demand for exports tends to affect the demand for currency curve - because if people overseas want to buy UK exports they will need to buy £s in order to pay for them
whereas demand for imports tends to affect the supply of currency - because we need to
supply £s to the foreign exchange market to buy foreign currencies to pay for imports
Why could Foreign direct investment cause changes in a floating currency
an economy that attracts high net inflows of capital investment (i.e. long-term capital flows) from overseas will see an increase in currency demand and a rising exchange rate
Why could Portfolio investment causes changes in a floating exchange rate
strong inflows of portfolio investment into equities and bonds from overseas can cause
a currency to appreciate
Why would interest rate differentials cause changes in the currency in a floating system
countries with relatively high-interest rates can expect to see ‘hot money’ (i.e. short-
term capital) flowing coming in and causing an appreciation of the exchange rate.
Why could speculation cause changes in the currency in a floating system
this is responsible for much of the day-to-day volatility
Explain how a rise in policy interest rates by the central bank, could lead to a currency appreciating in value in a floating system
- Rise in interest rates
- Currency is more attractive for investors
- Attracts inflows of short-term hot money
- Causes outward shift in currency demand
- Currency appreciates in value in a floating system
How on an S&D graph how an increase in demand of a currency causes the currency to appreciate
y - Value of currency
x - Quantity of currency traded
Demand curve shifts outwards
Shift from P1 to P2 showing appreciation in value
Explain how a recession in a trading partner could lead to a currency depreciating
- Recession in trading partner
- Causes a fall in export sales
- Worsening of trade balance
- Inward shift of currency demand
- Currency will depreciate
Show on an S&D graph how an inward shift in demand for a currency can lead to a currency depreciating
y - value of currency
x - quantity of currency traded
Demand shifts inwards
Movement from P1 to P2 showing currency depreciating
What are the 3 usual factors of a managed exchange rate
- Currency is usually set by market forces
- A central bank may intervene occasionally to influence the price
- In a managed floating system, the currency becomes a key target or monetary policy
What a policy tool for managing floating exchange rates
- Changes in monetary policy interest rates
- Quantitative easing
- Direct buying/selling in the currency market (intervention)
- Taxation of overseas currency deposits and capital control
Hence, explain how a central bank can influence the value of a currency using interest rate (monetary policy)
- Central bank could influence the external value by changing the interest rates
- Therefore a depreciation through a fall in interest rates
- Causes a reduction in the returns on overseas money being held in country’s banking system - real return may become negative
- This may hence cause an outflow of ‘hot money’ from commercial banks to other countries
- Will cause an outward shift in the supply curve for the currency as investors look for currencies with higher expected returns
- Assume all other factors are constant could cause a depreciation
What are competitive devaluations
When may a country do this
occur when a country deliberately intervenes to drive down the value of their
currency to provide a competitive lift to demand, output and jobs in their export industries
They may try this when faced with a deflationary recession or perhaps to attract extra foreign investment, for nations with persistent trade deficits and rising unemployment
What are the key problems with Competitive devaluations
- can be seen by other countries as a form of trade protectionism that invites some form of retaliatory action such as an import tariff
- makes it harder for other countries to export negatively affecting their growth rate
which in turn can damage the volume of trade that takes place between nations - go against the principles of trade based on comparative advantage
What are the 3 key features of a fixed exchange rate
- The Government/central bank fixes the currency value
- Pegged exchange rate becomes official rate
- Adjustable Peg
What does it mean when a country has Pegged exchange rate
External value is pegged to one or more currencies (known as the anchor currency)
The central bank must hold sufficient foreign exchange reserves in order to intervene in currency market to maintain the fixed peg
With a Fixed exchange rate, how would the central bank increase the value of the domestic currency
They may need to buy domestic currency using foreign currency
What are the 4 ways exchange rates, impact business activity
- Price of exports in international markets
- Cost of goods bought from overseas
- Revenues and profits earned overseas
- Converting cash receipts from customers overseas
Who are the winners from a lower exchange rate
- Businesses earning substantial profits in overseas currencies
- Businesses exporting into international markets
Who are the losers from a low-interest rate
- Business importing good/serivces
- Overseas businesses trying to compete in the domestic market
What does SPICED stand for
Strong Pound Imports Cheaper Export Dearer
A currency depreciation usually has a similar effect on the macro-economy as
a cut in interest rates
A currency depreciation may help to provide a partial auto-correction of a
large trade deficit
How can inflation be impacted by a currency depreciation
Why can this be problematic?
Higher import prices feed into increased consumer prices
help a country to avoid deflation and it also lowers real interest rates
threatens real living standards especially for groups with weak bargaining power for wages
How does the currency depreciating impact on economic growth
How is this problemetic
A weaker currency is usually a stimulus to GDP growth due to higher net exports
But this depends on the price elasticity of demand for exports
Also, many exports are made from imported components which will have become more expensive as a result of the depreciation (capital goods)
How does the currency depreciating impact on unemployment
A more competitive currency will help to increase domestic production and perhaps create a
positive export multiplier effect which will further stimulate aggregate demand and jobs.
How does a currency depreciating impact on the balance of trade
Trade deficit may grow in initial period after depreciation
This is because the price elasticities of demand for exports & imports are likely to be inelastic in the short term
The impact on export sales also depends in part on the strength of GDP growth in key export
markets
How does a depreciating currency affect business investment
Should help to improve profitability
because a fall in the value of the Pound increases the overseas earnings of UK companies in foreign currency which will now be worth more in Pounds
How does a depreciating currency affect wider investment
Depreciation is similar to a cut in interest rates therefore an expansion of monetary policy
Therefore reduced price levels for businesses
but there are risks too – including higher costs of importing components, raw materials and prices of important capital technologies.
How does a depreciating currency affect FDI
Depreciation of a currency makes a country’s FDI assets appear more valuable when converted into the domestic currency
Likewise, FDI liabilities (i.e. investment in UK) appear less valuable to overseas investors. This can
ultimately therefore reduce inwards FDI.
Using a chain of reasoning, explain how a currency depreciation can affect international competitiveness
- A depreciation could result in exporters reducing the price of goods/services sold overseas
- This makes UK exports relatively cheaper in overseas markets - export prices fall leading to improved competitiveness
- UK price of imported products will increase
- A rise in import prices will make domestic producers in the UK appear relatively more competitive in price terms
A depreciation of the exchange rate provides a stimulus for aggregate demand
But this depends on…
- Time lags for consumers/businesses to respond
- Scale of change in the exchange rate
- How long the change lasts for
- Price elasticity for imports/exports (J-curve)
- Multiplier or accelerator affects
- When in the economic cycle the change occurs
- Type of economy
- Degree of openness the economy has
What are the advantages of a floating exchange rate
- reduces the need for central bank to hold large currency reserves
- Freedom to set monetary policy interest rates to meet domestic objectives
- May help imported inflation
- Insulation for an economy after an external shock
- Partial automatic correction of a current account deficit
- Less risk of a currency becomes significantly over/undervalued
What are the problems with a floating exchange rate
- No guarantee that floating exchange rates will be stable
- Volatility in a floating currency might be detrimental to attracting inward investment
- A lower (more competitive) exchange rate doesn’t necessarily correct a BoP deficit
- consider J curve theory and the importance of non-price competitiveness
A currency appreciation makes exports more expensive and likely lead to a …… shift of AD
inward
A currency appreciation makes imports cheaper and likely to cause an ……. shift in AS
Outward
What are the advantages of a Fixed exchange rate
- Certainty of currency value gives confidence for inward investment from overseas businesses
- Reduced costs of “currency hedging” for businesses such as airlines
- Currency stability helps to control inflation
- A stable currency can lead to lower borrowing costs
- Imposes responsibility on government macro policies
- Less speculation in the currency market if the fixed exchange rate is regarded by traders as credible
What are the problems with a fixed exchange rate
- Reduced freedom to use interest rates for other macro objectives
- Many developing countries do not have sufficient foreign currency reserves
- Difficult for countries to use a competitive devaluation of their fixed exchange rate – this creates political tensions and might lead to a protectionist response
- Devaluation of a fixed exchange rate can lead to a surge in cost-push inflation – this is damaging for competitiveness and has regressive effects on poorer families
What type of country would a fixed exchange rate be favourable for
for developing countries wanting to control inflation
What type of country would favour a managed floating rate
Export-dependent economies may favour a managed floating rate e.g. to offset fluctuating world prices
