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Theme 4 > 4.1.8 Exchange Rates > Flashcards

4.1.8 Exchange Rates Flashcards

1
Q

Exchange rate

A

The price of one currency relative to another

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2
Q

Appreciation

A

An increase in the value of a current in relation to other currencies

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3
Q

Depreciation

A

An decrease in the value of a current in relation to other currencies

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4
Q

Factors that influence exchange rate

A
  • interest rates
  • econ growth/recession
  • relative inflation rate
  • competitiveness
  • confidence/expectations
  • balance of payments
  • govt debt
  • govt intervention
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5
Q

Factors that influence exchange rate (interest rates)

A
  • increase in UK interest rate (compared to elsewhere) = more attractive to despoil money in the UK = better ate of return on UK saving accounts = ‘hot money flow’ in to take advantage of higher interest rates = increased demand for sterling = appreciation in value
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6
Q

Factors that influence exchange rate (confidence) example

A

In 2010 and 2011, the value of the Japanese Yen rose since markets were worried about all the other major economies - US and EU.
Therefore, despite low-interest rates and low growth in Japan, the Yen kept appreciating.
- in the mid 1980s, the Pound fell to a low against the Dollar, caused by rising interest rates in the US

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7
Q

Factors that influence exchange rate (economic growth/recession)

A
  • recession = fall in interest rates compared to other countries = less attractive place to invest = ‘hot money flows’ are likely to leave the UK and move to countries with higher interest rates = if ppl move money out of the UK = sell pounds and buy other currencies = depreciation in exchange rate
  • a currency is likely to fall bc country become a less attractive place to invest
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8
Q

Factors that influence exchange rate (economic growth/recession) example

A

The Great Recession in 2008, the UK experienced a sig depreciation. The pound sterling fell over 25% from 2007 (before recession) to 2009

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9
Q

Factors that influence exchange rate (economic growth/recession) evaluation

A
  • in a recession inflation is likely to fall = more competitive = increased demand for currency
  • depends on what is happening to other countries = during the Great Recession, US interest rates fell to 0% however most major economies also had low-net rest rates and high govt debt so investors felt the US was relatively safe
  • if US has ended a recession on its own then value would depreciate
  • depends on the confidence of investors
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10
Q

Factors that influence exchange rate (relative inflation rate)

A
  • if inflation in UK is relatively low, UK exports will be more competitive = increase in demand for Pound sterling to buy UK goods
  • Foreign foods = less competitive therefore domestic consumers buy fewer imports
  • therefore lower inflation rates = appreciation in the value of their currency
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11
Q

Factors that influence exchange rate (relative inflation rate) example

A

The long-term appreciation in the German D-Mark in the post-war period due to lower inflation rate

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12
Q

Factors that influence exchange rate (competitiveness)

A
  • attractive and competitive goods = increased value of exchange rate
  • e.g if UK has long-term productivity = goods will become more international competitive = in long run cause pound appreciate
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13
Q

Factors that influence exchange rate (confidence)

A
  • if ppl believe the sterling will rise in the future = more demand for sterling (to make profit) = increased value of pound)
  • e.g a fall in the value of pound post -Brexit was partly related to the concerns that the UK would no longer attract as many capital flows outside the Single Currency
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14
Q

Factors that influence exchange rate (balance of payments)

A
  • deficit on current account = the value of imports > value of exports
  • if ountry struggles to attract enough capital inflows to infancy the deficit = depreciation in current
  • UK exports = demand for sterling/imports into the UK = supply of pound on the foreign exchange market so increased trade surplus = increased value
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15
Q

Factors that influence exchange rate (balance of payments) example

A

UK current account deficit reached 7% of GDP at the end of 2015 contributing to the decline in the value of the pound

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16
Q

Factors that influence exchange rate (balance of payments) evaluation

A

This deficit doesn’t matter if it is finance day a surplus on the financial/capital

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17
Q

Factors that influence exchange rate (govt debt)

A
  • if markets fear a govt may default on its debt = investors will sell their bonds = fall in value of exchange rate
  • e.g Iceland debt problems in 2008, caused a rapid fall int the value of Icelandic currency
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18
Q

Factors that influence exchange rate (govt intervention)

A
  • e.g China sought to keep its currency undervalued to make Chinese export moe competitive. They can do this by buying US dollar assets which increases the value of the US dollar to Chinese yuan therefore making export prices low
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19
Q

Factors that influence exchange rate (govt intervention) evaluation

A
  • some countries don’t agree with this
  • can cause increased tariffs and political tensions
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20
Q

Fixed exchange rate

A

The country’s exchange rate is fixed in relation to ,say the US
- can only be changed by the Central Bank in agreement with other countries usually mediated through the IMF
- e.g USD to yuan

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21
Q

Fixed and overvalued graph

A
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22
Q

What is a managed exchange rate?

A

The monetary authorities control the exchange rate through the buying and selling of the country’s currency on the foreign exchange market & through changes in interest rates

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23
Q

USD to RMB graph

A
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24
Q

Example of the exploitation of currency

A
  • in Venezuela, Madura exploited the currency system setting official exchange at 10 bolivars: US dollar but only his funds & allies have access to this rate.
  • In reality, the currency has become worthless. Most Venezuelans get their dollars on black market.
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25
Q

Floating exchange rate

A

Where the value of the currency is determined purely by market demand and supply of the currency, with no target set by the government and no official intervention in the currency markets.

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26
Q

Floating exchange rate example

A

The British pound - there is no intervention by central banks or government in the currency value.

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27
Q

Floating exchange rate advantages

A
  • no need for frequent central bank intervention
  • Monetary policy can be used for domestic macro objective
  • can help to partially correct a current account deficit
  • can be a useful macro absorber when there is an external economic shock
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28
Q

Floating exchange rate advantages (no need to central bank intervention)

A

There is no need for frequent central bank intervention. Central bank does not need to hold large foreign exchange reserves since it doesn’t have a currency target, capital can flow freely across borders

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29
Q

Floating exchange rate advantages (monetary policy for macro objectives)

A

Monetary policy (i.e base interest rates and QE) can be used for domestic macro objective such as stimulating employment and controlling inflation

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30
Q

Floating exchange rate advantages (correct current account deficit)

A

It can help to partially correct a current account deficit (
- E.g if a country is running a large trade/current account deficit = decrease exchange rate since there’s a excess supply of currency leaving the circular flow = cheap imports and expensive exports

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31
Q

Floating exchange rate advantages (macro absorber of econ shock)

A
  • can be a useful macro absorber when there is an external economic shock
  • E.g Brexit vote 2016, 15% depreciation of sterling- acts the same way as reduced interest rates
  • E.g Poland, in Global Financial Crisis 2009, had a floating exchange rate and their currency fell by 15% and had a competitive boost to their economy preventing recession. Compared to countries such a Greece and Italy who were locked under a single currency
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32
Q

Floating exchange rate disadvantages (higher volatility)

A

Higher volatility compared to other = could inhibit trade and long-run inward investment

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33
Q

Floating exchange rate disadvantages (can’t use currency to achieve a competitive depreciation)

A

Removes the option to use the currency to achieve a competitive depreciation to improve competitiveness

34
Q

Floating exchange rate disadvantages (can invite more speculation)

A

It can invite more currency speculation from traders. A currency might move a long way form a value suitable for the domestic economy.

35
Q

Fixed exchange rate system (includes currency ‘Pegs’)

A

A regime applied by a government or central bank that ties the country’s official exchange rate to another country’s currency or the price of gold.
- currency can change but the peg would have to be altered

36
Q

Fixed exchange rate system (includes currency ‘Pegs’) example

A

The Danish krone (DKK) is pegged to the euro at a central rate of 746.038 kroner per 100 euro, with a ‘fluctuation band’ of +/- 2.25%

37
Q

Fixed exchange rate system advantages

A
  • greater certainty
  • can keep costs and price under control
38
Q

Fixed exchange rate system advantages (greater certainty)

A
  • Greater certainty - makes investment into the country more appealing as investment is less risky.
  • E.g if an investor is thinking about buying Bulgarian govt debt or buying property there, they know their currency is fixed to the Euro therefore the value won’t suddenly diminish).
  • This can also increase tourism due to certainty they know what their holiday will cost
39
Q

Fixed exchange rate system advantages (can keep costs and price under control)

A

It can help keep costs and price under control if fixed against a low-inflation economy = reduces risk of high inflation. Businesses benefit from improving productivity (from unit labour cost reductions).

40
Q

Fixed exchange rate system disadvantages

A
  • Many poorer countries don’t have sufficient foreign currency to maintain a fixed exchange rate
  • part of monetary policy
  • lead to permanent imbalance
  • risk of deflation
41
Q

Fixed exchange rate system disadvantages (part of monetary policy)

A

Fixed exchange rate = part of monetary policy = reduced freedom to use interest rates and tools of monetary policy for other macro-objectives.
- (E.g stimulating GDP growth or reducing unemployment)

42
Q

Fixed exchange rate system disadvantages (permanent imbalance)

A

It can lead to permanent imbalance in the current account depending on the value of the currency peg (if too high = imports greater than exports vice versa)

43
Q

Fixed exchange rate system disadvantages (deflation)

A

Maintaining a high fixed exchange rate during a time of recession = risk of deflation

44
Q

Fixed exchange rate system evaluation

A
  • depends on type of fixed exchange rate- full-fixed or semi-fixed
  • Stil possible to revalue or devalue the fixed currency rate
  • can increase inflation risks
45
Q

Fixed exchange rate system evaluation (revalue or devalue the fixed currency rate)

A

It is still possible to revalue or devalue the fixed currency rate (although a competitive devaluation can invite realiation e.f through import tariff)

46
Q

Fixed exchange rate system evaluation (imported inflation risks)

A

Pegging to the US dollar = changes in world commodity price to feed straight to the domestic economy = increase imported inflation risks

47
Q

Managed float exchange rate example

A
  • Countries with managed floating exchange rate: China, South Korea, Brazil
  • e.g: China’s central bank sets a reference rate against which the Renminbi yuan is allowed to rise or fall. China sees this as key to economic stability but Washington views it as manipulation
  • e.g: the Indian rupee fluctuates on the market, but the central bank intervenes when it falls outside a set range
48
Q

Managed float exchange rate advantages

A
  • can reduce volatility
  • bring a depreciation or appreciation
  • can improve balance of trade
  • reduce risk of deflationary recession
  • long run growth
49
Q

Managed float exchange rate advantages (reduce volatility)

A

It can reduce the volatility of market exchange rates. Big fluctuations in the external value of currency = increase investor risk = decreased business confidence

50
Q

Managed float exchange rate advantages (depreciation or appreciation)

A

Central bank can bring about a depreciation or appreciation according to the needs of the country

51
Q

Managed float exchange rate advantages (improve balance of trade)

A
  • Central bank can bring about a depreciation to improve the balance of trade = exports more competitive
  • e.g China wanted to keepts if currency undervalued to make Chinese exports more competitive. They bought US dollar assets increasing the value of the US dollar to the Yuan)
52
Q

Managed float exchange rate advantages (reduce deflationary recession)

A
  • Depreciation = Reduces the risk of a deflationary recession.
  • Lower currency = increased export demand = increased domestic price level due to expensive imports
53
Q

Managed float exchange rate advantages (long run growth)

A

Appreciation = decreased imported goods = long run growth

54
Q

Managed float exchange rate disadvantages

A
  • requires large-scale foreign exchange
  • central banks might have no market power
  • might conflict against other macro objectives
55
Q

Managed float exchange rate disadvantages (requires large-scale foreign exchange)

A

It requires a large-scale foreign exchange reserve (many smaller and poorer countries don’t have this)

56
Q

Managed float exchange rate disadvantages (central banks might have no market power)

A

Central banks intervening on their own may have little or no market power against the weight of buying and selling global currency markets
- (E.g 6 trillion dollars of currencies bought and sold every day)

57
Q

Managed float exchange rate disadvantages (might conflict against other macro objectives)

A

Changing interest rates to influence a currency might conflict against other macroeconomic objectives. (E.g higher interest rates for ‘hot money inflow’ and depreciation = reduced consumer demand, mortgages expensive, reduce business investment = reduced economic growth

58
Q

Monetary unions

A

An economic union + countries adopt a common currency and central bank which controls the monetary policy of member countries.

59
Q

Monetary unions (consider the Euro) example

A

The single European currency (Euro) came into circulation in Jan 2002. Of the 28 EU countries (not including UK- brexit), 9 are not part of the single currency including Denmark, Hungary, the Czech Republic and Poland.

60
Q

Monetary unions advantages

A
  • more stability
  • can enhance welfare gains
  • can solidly membership
  • can stimulate inward investment
  • increase price transparency
  • reduce costly conversion
61
Q

Monetary unions advantages (more stability)

A

The Euro is more stable than smaller currencies. Reduced currency risk = cheaper for smaller countries to borrow

62
Q

Monetary unions advantages (can enhance welfare gains)

A

Euro enhances the welfare gains from being in the single market (e.g encourages more cross border trade)

63
Q

Monetary unions advantages (can solidly membership)

A

With regards to the Euro, joining can solidify their membership with the EU. (E.g the Baltic states wanted to join as a political signal of moving away from the Russian orbit)

64
Q

Monetary unions advantages (can stimulate inward investment)

A

It can stimulate inward investment in industries such as tourism, financial services and car making. (E.g As of January 2023, Croatia will stop using Kuna and will use Euro. Croatia is heavily reliant on tourism and therefore their sector could gain from joining the European Monetary Union)

65
Q

Monetary unions advantages (increase price transparency)

A

Joining a Monetary Union increased price transparency = helps consumers to find products at better prices

66
Q

Monetary unions advantages (reduce costly conversion)

A

It reduces the costly conversion of money = improved labour mobility within the single market

67
Q

Monetary unions disadvantages

A
  • can no longer rely on competitive depreciation
  • difficult to set interest rates
  • can bring risks
  • bring financial costs of future bail-outs
68
Q

Monetary unions disadvantages (can no longer rely on competitive depreciation)

A
  • Sharing a common currency = a country can no longer rely on a competitive depreciation of their currency as part of monetary policy
  • (E.g if they want to become more competitive or kick start their economy after a recession, they won’t be able to depreciate their currency but might have to rely on higher productivity, lower wages etc - Greece 2017 high level of debt compared to GDP, they might benefited of being outside the Eurozone
69
Q

Monetary unions disadvantages (difficult to set interest rates)

A
  • It is difficult to set interest rates that fit the monetary union as a whole.
  • Different countries have different cycles so a common interest rate = divergence rather than convergence in living standards.
  • (E.g German economy (GDP) is more than 15 times the size of Greece’s 2017)
70
Q

Monetary unions disadvantages (can bring risks)

A

It can bring risks if there’s a recession in a main trading partner.
- (E.g slowdown in the German economy 2019 with inflation at 1.7% = effects Slovakia, Austria, Holland etc)

71
Q

Monetary unions disadvantages (bring financial costs of future bail-outs)

A

It might expose a government to the financial costs of future bail-outs of struggling countries.

72
Q

Exchange rate conclusion

A
  • Many countries favour managed floating currencies - to give them the option of influencing the currency for policy reason
  • Other favour a semi-fixed exchange rate or a fixed rate against a larger currency such as the US dollar or Euro
  • For counties exposed to external shocks, floating currencies might be most effective
  • Countries inside a fixed exchange rate system/single currency system have less flexibility and may require a period of internal devaluation to restore competitiveness. (E.g Greece see monetary union)
73
Q

J curve graph

A

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

74
Q

Give one macro effect of a depreciation of the pound

A

An improved current account balance of payments
- an increase in the price of imports will lead to a contraction in volume import sales/UK exports cheaper

75
Q

Evaluation of how a depreciation of the pound can lead to an improved current account

A
  • this assumes the demand for exports and imports are relatively elastic (an improvement in current account will only happen if Marshall-Lerner condition is met)
  • J curve
76
Q

UK’s trade

A
  • The UK is quite price and income inelastic = the size of the depreciation would need to be big for it to have any real effect on UK firms. - Therefore, in the short run, a small depreciation might not have a big impact.
  • In the short run, demand for exports may be inelastic so there is no improvement in the current account.
  • For example, the UK has had a current account trade deficit for the past 30 years whilst the pound has almost halved in relation to the dollar over the least 4o years.
  • It is evident to that the depreciation has not helped to reduced the UK’s current account deficit since the deficit is too big. However, over time, demand might become most elastic.
77
Q

Give on micro effect of the depreciation of the pound

A
  • a fall in profits for domestic businesses
78
Q

Who does UK trade with most?

A

The UK trades mostly with the EU and the US.
- Whilst being a top trade in financial services, the UK is experiencing negative primary income flows. For example, many football companies are owned by foreigners. This causes money to flow out of the UK

79
Q

Evaluation of how the depreciation of the pound will lead to a fall in profits

A
  • depends on import dependency (lots of raw materials imported = large impact)
  • in the long run, UK might see a change in patterns of demand with consumers deciding to switch demand from imported to domestic
  • firms might move to different industry (e.g from manufacturing to music)
80
Q

What will effect the impacts of a depreciation?

A

the impact of a depreciation depends on the duration and timing of the currency fall.
- If the UK economy is in a recession during the depreciation = low consumer confidence = no overall increases in aggregate demand
- e.g if the UK experiences a balance of payments crisis = an outflow of capital as investors will be more nervous over the speed of the depreciation.

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