4.1.8 Exchange Rates Flashcards
What is meant by a fixed exchange rate system?
When the value of a currency in terms of another currency is fixed against the target currency.
Why might a country want to fix its exchange rates?
If it is joining a monetary union and will change its currency. Also to stabilise their currency if it has been volatile.
What is meant by devaluation and revaluation?
Devaluation - When a country deliberately reduces the exchange rate in a fixed or managed exchange system.
Revaluation - When a country deliberately increases the exchange rate in a managed or a fixed economy.
What is meant by a floating exchange rate system?
A floating exchange rate is one where the exchange rate is determined purely purely by the supply and demand of that currency on the international market.
Identify and explain 4 factors that would increase the demand for £
- Increase in Exports - as more domestic currency would be demanded by overseas consumers.
- An increase in interest rates - as more domestic currency would be demanded by overseas depositors looking for a bank with a high interest rates.
- Speculation that the currency will appreciate - investors will purchase the currency whilst the exchange rate is low, expecting it to rise in value.
- An increase in foreign tourists in the UK
Identify and explain 4 factors that would increase the supply of £
- An increase in imports - as UK residents need to sell sterling in order to purchase the imports.
- A decrease in interest rates - anyone with money in UK banks will want to withdraw their money and sell it in order to transfer it to another country.
- Speculation that the currency will depreciate - investors will sell the currency at a high price before the currency falls in value.
- An increase in UK tourism abroad - UK residents will sell the £ in order to purchase foreign currency to pay for things on their holiday.
What can cause an exchange rate to appreciate?
Anything that causes an increase in the demand for a currency or a fall in the supply.
What is the difference between a devaluation/revaluation and a depreciation/appreciation?
A depreciation is when a currency falls/rises in value in a floating exchange rate system, or because of a fall/rise in the demand/rise in the supply of the currency on the free market. In contrast, a devaluation/revaluation is where the same thing happens but because of deliberate intervention by the government.
What is meant by purchasing power parity theory of exchange rates ?
This theory suggests that the value of a currency adjusts so that the same product costs the same in every market in which it is sold. E.g. if a Big Mac costs £3.99 in the Uk, and $3.99 in the USA, then the exchange rate is £1 = $1. In other words the nominal exchange rate adjusts so that relative prices between countries are equal.
What is meant by hot money?
This refers to the stocks of money that are moved around the world in search of the best relative exchange rate or return.
What are the advantages and disadvantages of a fixed exchange rate?
+ A fixed exchange rate creates stability and predictability
+ Encourages firms to invest
+ Incentive to keep inflation low
+ Avoids depreciation
- Conflicts with other macro-objectives
- Less flexibility
- current account imbalance
What are the disadvantages and advantages of a floating exchange rate?
+ Automatic stabiliser - ER should automatically change to bring about Balance of Payments equilibrium
+ Absorbs external shocks more easily - Brexit, ER depreciated to help the economy adjust to the shock that the UK was going to leave the EU
- Uncertainty: the very fact that currencies change in value from day to day introduces a large element of uncertainty into trade
- Speculation: movements of hot money, causing more ER fluctuations
What is a managed exchange rate?
This ER is mostly determined by the market forces, but the government intervenes to influence the ER for macroeconomic reasons.
What is FDI?
Foreign Direct Investment is when an overseas company invests in fixed capital in another country. For example, they may set up a factory in another country.
How does the ER influence FDI?
A weaker ER may make a country more attractive as a target for attracting FDI. It means that the investors’ money can go further and purchase more capital than if the currency is strong. There are many other factors though that are as important in determining FDI.
