4.1.8 Exchange rates

Question 1

Two main types of exchange rate system

Answer 1

• A fixed exchange rate
• A floating exchange rate

Question 2

What is a fixed exchange rate?

Answer 2

Where the government (or central bank) sets the exchange rate. This often involves maintaining the exchange rate at a target rate.

Question 3

What is a floating exchange rate?

Answer 3

An exchange rate which is free to move with changing supply of, and demand for, a currency.

Question 4

What is a hybrid exchange rate system?

Answer 4

A mixture of fixed and floating.

The types of hybrid exchange rate systems are:

• Managed floating
• Semi-fixed
• Pegged

Question 5

[Hybrid exchange rates]

What are managed floating exchange rates?

Answer 5

The exchange rate is mainly left to market forces (i.e. to float freely), but the government will occasionally intervene to influence the exchange rate. For example, to reduce the impact of economic shock on the value of its currency.

Question 6

[Hybrid exchange rates]

What are semi-fixed exchange rates?

Answer 6

The value of the currency is ‘pegged’ to another currency or group of currencies. This peg can be moved periodically, or as the government sees fit.

Question 7

[Hybrid exchange rates]

What are pegged exchange rates?

Answer 7

The exchange rate is only allowed to fluctuate within a set band of exchange rates.

Question 8

Target exchange rates

Answer 8

Fixed exchange rate systems, and certain hybrid exchange rate systems, have a target rate.

A government or central bank will maintain the exchange rate at the target rate by controlling interest rates and by buying and selling the currency (using foreign currency reserves) to keep supply of, and demand for, the currency stable.

Question 9

Nominal exchange rate

Answer 9

An unadjusted or ‘direct’ comparison of the value of currencies.

Question 10

Nominal exchange rate

Answer 10

An unadjusted or ‘direct’ comparison of the value of currencies.

Question 11

Real exchange rate

Answer 11

This is a nominal rate which is adjusted to take price levels into account.

Question 12

Bilateral exchange rates

Answer 12

The comparison of just two currencies.

• E.g. a nominal bilateral exchange rate could directly compare the US dollar and the pound so it might show that £1 : $1.50 (£1 is worth $1.50).

Question 12

Bilateral exchange rates

Answer 12

The comparison of just two currencies.

• E.g. a nominal bilateral exchange rate could directly compare the US dollar and the pound so it might show that £1 : $1.50 (£1 is worth $1.50).

Bilateral exchange rates are not effective measure because virtually no countries only trade with one other country.

Question 13

Effective exchange rates

Answer 13

A country’s currency is compared to a basket of currencies (usually its trading partners). It’s a weighted average - i.e. the proportion of the currency’s trade with each partner determines the size of its weighting. The aim is to give a kind of ‘summary’ of the overall value of a currency compared to several others.

Question 14

What are the two ways of converting exchange rates?

Answer 14

Spot rate – the exchange rate on the day of transaction

Forward rate – a guaranteed rate for some point in the future. This is used extensively for large business transactions.

Question 15

Devaluation of exchange rate

Answer 15

When the exchange rate is lowered formally by the government.

They can achieve this by selling the currency.

Question 16

Revaluation of exchange rate

Answer 16

When the exchange rate is raised formally by the government.

They can achieve this by buyer selling the currency.

Question 17

Depreciation of exchange rate

Answer 17

When the exchange rate falls.

This might occur naturally due to market forces, although government action (e.g. lowering interest rates) might affect it indirectly.

Question 18

Appreciation of exchange rate

Answer 18

When the exchange rate rises.

This might occur naturally due to market forces, although government action (e.g. lowering interest rates) might affect it indirectly.

Question 19

Competitive devaluation

Answer 19

This is when government deliberately devalue their own currencies to improve international competitiveness.

• This can occur in fixed or hybrid exchange rate systems.

Question 20

Competitive depreciation

Answer 20

This is where government intervention might indirectly reduce the value of the currency, improving the country’s international competitiveness.

• This can occur in floating or hybrid exchange rate systems.

Question 21

Advantages and disadvantages of floating and fixed exchange rates

Answer 21

Question 22

What factors cause a fluctuation in the supply/demand of currencies

Answer 22

• Speculation – where people buy and sell currency because of changes they expect are going to happen in the future.
• The official buying and selling of the currency by the government or central bank.
• Relative inflation rates – if a country’s inflation rate is higher than its competitors, then the value of its currency is likely to fall. Prices in the country will become less competitive, leading to reduced exports and increased imports, so demand for the currency decreases and supply increases.
• Relative interest rates – high interest rates increase demand for a currency because there is an inflow of ‘hot money’.
  o Hot money refers to the flow of funds from one country to another in order to earn short-term profit on interest rate differences. These are called “hot money” because they can move very quickly in and out of markets, potentially leading to market instability.
• Confidence in the state of the economy – there’ll be greater demand for a currency if people feel confident in, for example, a country’s growth and stability (this will include a country’s economic and political stability – investors are unlikely to have confidence in unstable governments).
• The balance of the current account of the balance of payments has a small effect on the exchange rate – for example, a current account deficit will mean there’s a high supply of the currency due to the purchase of imports.

Question 23

If the value of a currency falls, what will happen to the economy…

Answer 23

• Exports will become cheaper, so domestic goods will become more competitive.
• This means that demand for exports will increase.
• Imports will become more expensive, so demand for imports will fall.
• If exports increase and imports decrease, there’ll be economic growth caused by an increase in aggregate demand.
• Unemployment may also be reduced through the creation of more jobs from economic growth.
• Inflation may rise if demand for imports is price inelastic.
• Increased import prices can also cause cost-push inflation.

A current account deficit should therefore be reduced, but a surplus should increase.

Question 24

A rise in the value of a currency will make exports more expensive and imports cheaper, which means there is….

Answer 24

• An increase in the size of a current account deficit, or a reduction in a current account surplus.
• A fall in aggregate demand, which is likely to lead to a fall in output.
• Unemployment may rise.
• The impact on inflation will depend on the PED for imports and for domestic goods.

Question 25

A rise in the value of a currency will make exports more expensive and imports cheaper, which means there is….

Answer 25

• An increase in the size of a current account deficit, or a reduction in a current account surplus.
• A fall in aggregate demand, which is likely to lead to a fall in output.
• Unemployment may rise.
• The impact on inflation will depend on the PED for imports and for domestic goods.

Question 26

The Marshall-Lerner Condition

Answer 26

The Marshall-Lerner Condition states that a depreciation/devaluation of the exchange rate will lead to a net improvement in the trade balance provided that the sum of the price elasticity of demand for exports and the price elasticity for imports > 1.

Question 27

Purchasing Power Parities

Answer 27

An adjustment of an exchange rate to reflect the real purchasing power of two currencies.

This is used when comparing the prices of goods between countries. The nominal exchange rate does not measure the cost of living.

Question 28

The J-Curve

Answer 28

The J-curve shows possible time lags between a falling currency and an improved trade balance. Initially, a country’s external trade deficit (X-M) might increase (widen) following a currency depreciation.

Question 29

What does the J-Curve show?

Answer 29

• The Marshall-Lerner condition might hold in the long run, so there’ll be an improvement in the current account deficit if the value of a currency falls.
• However, in the short run a current account deficit is likely to worsen, as demand for imports and exports will be inelastic – e.g. because it takes time for people to switch to a cheaper substitute.
• In the short run, the overall value of exports falls and the overall value of imports rises, so the current account deficit worsens.
• This is shown on the J-curve.