4.1.8 Exchange rates Flashcards
is UK known to have a large current account deficit?
yes we tend to import more than export so trade balance is -.
for floating exchange rate what does this mean for UK?
it simply means there will be more supply of the pound than demand
how would the diagram look like and give depth of analysis?
-label the x-axis as quantity of pound
-label the y-axis as pound changing into another currency e.g £ to $
-draw a normal demand curve pointing downwards
-then draw a normal shift of supply to the right
where draw the new equilibrium point showing how there’s an increase in supply and decrease in prices
-essentially what happens during the curve is as UK is planning to import more the supply of the pound will increase but as prices are decreasing we are seeing that the value of the pound depreciates, this means WIDEC will happen before as imports start becoming expensive and exports will become cheaper- this is extremely beneficial to solve current account in UK.
major bullet points of this diagram?
- there will be more injection in the UK economy
- downward pressure on exchange rate
- supply of currency rises
- weak exchange rates so widec comes in to correct this deficit
evaluation of floating exchange rate
there will be speculation e.g let’s assume that USA speculates that the demand for pound will drop which will lead to a greater depreciation in the pound
definition of fixed exchange rate?
to support a fixed exchange rate, the government require to hold large amounts of currency reserves.
assume that the government has imposed a fixed exchange rate of £1: $1.50 but let’s say that the economy is operating at £1:$1.60, what will happen?
the value of the pound is over-valued
-what will happen is that the gov can buy up the foreign currency by selling the pound which means supply will shift to the right from s1 to s2 meaning that prices will decrease going back to the equilibrium rate.
let’s assume that the fixed exchange rate is £1:$1.70, but that the economy is operating at £1: $1.60 what does that mean for the government?
the government will step in and try to increase the demand for pound through using the currency reserves to buy up the pound causing the demand curve to shift to the right where prices will rise meeting back to the equilibrium price.
what is the difference between floating and fixed exchange rate?
fixed-government intervention
floating-no gov intervention
for floating exchange rate what is the advantage of currency reserves?
the need for currency reserves will decrease, for instance when it comes to fer the banks will need to have large currency reserves prepared and it is expensive
what is another advantage of floating exchange rate-monetary?
there will be relaxation for domestic monetary policy to deal with domestic issues
what is another advantage of floating exchange rate-current account deficit?
it can correct the current deficit
what is another advantage of a floating exchange rate?-macro effect
it can promote high growth because exports become more price competitive so exchange rates are cheaper
what is the problem with floating exchange rate?
for instance we assume that the floating exchange rate will improve the current account deficit but in reality there might be issues like speculation
what are the advantages of fixed exchange rates?- uncertainty for exchange rates
the uncertainty for exchange rates will go down this will encourage foreign investment and trading will me much easier
