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