4.1.8 Exchange Rates Flashcards
What is an exchange rate?
The price of one currency relative to another
What are the 3 types of exchange rate?
- floating
- fixed
- managed
What is a floating exchange rate?
When the value of the exchange rate is determined by demand and supply
What are the 3 factors that affect the value of a floating exchange rate?
- interest rates
- relative inflation rate
- speculation
How does an interest rate affect the value of a floating exchange rate?
If UK interest rates rise, then the demand for the £ as it is more attractive for foreign consumers and businesses to deposit money in the UK. Therefore demand for sterling will rise from D£1 to D£2, causing an appreciation in the exchange rate.
How does inflation affect the value of a floating exchange rate?
If UK inflation is relatively lower than elsewhere, then UK exports will become more competitive and there will be an increase in the demand for sterling to buy British goods. F
How does speculation affect the value of a floating exchange rate?
If speculators believe that sterling will appreciate in the future, they will demand more of sterling now to make a profit. Increase in demand will cause an appreciation of the exchange rate. For example, if markets see news of a likley interest rate rise, they will move money into British banks.
What is a fixed exchange rate?
A fixed exchange rate has the value determined by the government
How does the government change a fixed exchange rate?
The supply of the currency can be manipulated by the central bank, which can buy or sell currency to change the rate to what they want.
What is a managed exchange rate?
A managed exchange rate system combines the characteristics of a fixed and floating exchange rate
How does the government control a managed exchange rate?
The currency fluctuates due to the free market, but only within a range determined by the central bank. The bank buys and sells its currency to manipulate the supply to influence the e/r.
Give an advantage of a managed exchange rate?
Creates a degree of certainty over the maximum price a good might cost
What is a appreciation?
When the value of a currency increases.
What is a devaluation?
When the value of the exchange rate is officially lowered in a fixed exchange rate system.
What is a depreciation?
When the value of one currency falls relative to another currency.
What two ways can the government intervene in currency markets?
- currency transactions
- interest rates
How can a government use currency transactions to influence an exchange rate?
The government may want a weaker currency to make exports cheaper and imports more expensive. AD e.c.t… . The central bank can release more money into the market which increases the supply of the £ from S£ to S£1.
How can a government use interest rates to influence the exchange rate?
The central bank may want a weaker currency. A cut in interest rates will mean foreign consumers and firms will not want their money in British banks, withdrawing it causing the supply of sterling to fall from S£ to S£1
Evaluation points of using currency transactions to alter the exchange rate?
-time lag
What is the Marshall Lerner Condition?
A depreciation in the exchange rate will improve the condition of the balance of payments so long as the combined PED of the goods and services is greater than -1.
According to Marshall Lerner, what happens to the imports if the exchange rate depreciates and the goods and services are inelastic?
The value of Imports will rise
According to Marshall Lerner, when exports are PED inelasitc and the currency depreciated, what happens?
The price of exports falls (WPIDEC), total revenue of exports will also fall. Export revenue will then decrease
According to Marshall Lerner, when imports are PED inelasitc and the currency depreciated, what happens?
The price of imports rise (WPIDEC), expenditure on imports increases with a weaker exchange rate if imports are inelastic
