4.1.8: Exchange Rates

Question 1

What is exchange rate?

Answer 1

The weight of one currency relative to another.

Question 2

What are the 3 exchange rates?

Answer 2

-Nominal.
-Real.
-Effective.

Question 3

What is nominal exchange rate?

Answer 3

The rate at which one country’s currency exchanges for a basket of multiple foreign currencies.

Question 4

What is real exchange rate?

Answer 4

The nominal exchange rate adjusted for the inflation rates in both countries.

Question 5

What is effective exchange rate?

Answer 5

A weighted index of a currency’s value against a basket of currencies.

Question 6

What are the 3 exchange rate systems?

Answer 6

-Free-Floating.
-Managed-Floating.
-Fixed.

Question 7

What is free-floating currency?

Answer 7

Where the external value of a currency depends wholly on market forces of demand & supply.

Question 8

What is an example of a free-floating currency?

Answer 8

UK Pound Sterling.

Question 9

What is managed-floating currency?

Answer 9

Where the external value of a currency depends on demand & supply, but the Central Bank will intervene to control the currency’s volatility.

Question 10

What is an example of a managed-floating currency?

Answer 10

Indian Rupee: fluctuates on the market, but the central bank intervenes when it falls outside a set range.

Question 11

What is fixed exchange rate?

Answer 11

The fixing of the value of a currency to another currency or gold (set by the central bank).

Question 12

What is an example of a fixed exchange rate?

Answer 12

Gold Standard.

Question 13

What is appreciation?

Answer 13

Increase in the value of a currency (under floating exchange rates).

Question 14

What is depreciation?

Answer 14

Decrease in the value of a currency (under floating exchange rates).

Question 15

What is revaluation?

Answer 15

Increase in the value of a currency (under fixed exchange rates).

Question 16

What is devaluation?

Answer 16

Decrease in the value of a currency (under fixed exchange rates).

Question 17

What factors affect a currency’s value?

Answer 17

-Relative Inflation Rates.
-Relative Interest Rates.
-State Of The Economy.
-Political Stability.
-Speculation.

Question 18

How does relative inflation rates affect a currency’s value?

Answer 18

If the country’s inflation rate is higher than its competitors, the value of the currency will fall.

Question 19

How does relative interest rates affect a currency’s value?

Answer 19

High interest rates makes investing funds in the country attractive, as the rate of return on investment is higher.
This increases demand for the currency, causing an appreciation.

Question 20

How does the state of the economy affect a currency’s value?

Answer 20

A strongly performing economy will increase the confidence of investors & speculators.

Question 21

How does political stability affect a currency’s value?

Answer 21

Instability may cause a loss of confidence and put downward pressure on the currency value.

Question 22

How does speculation affect a currency’s value?

Answer 22

If speculators think a currency will appreciate, demand will increase, as the rate of return on investment is higher.
This can cause an increase in the value of the currency.

Question 23

How can the government intervene in currency markets?

Answer 23

-Buy foreign currency in exchange for the pound.
-Decrease interest rates.

Question 24

How can the government use foreign currency transactions in currency markets?

Answer 24

To weaken a currency, the supply can be increased by buying foreign currency (or gold) with the currency.

Question 25

How can the government use interest rates in currency markets?

Answer 25

Increasing interest rates makes currency more attractive for investors.
This attracts inflow of ‘hot money’.
Demand for currency increases, appreciates (in a floating system).

Question 26

What is competitive devaluation/depreciation?

Answer 26

When a country deliberately drives down the value of the currency in the foreign exchange market.

Question 27

What are the consequences of competitive devaluation/depreciation?

Answer 27

-Can cause inflation due to higher import prices, reducing competitiveness, leading to a fall in the balance of payments.
-Other countries may follow suit.

Question 27

Why would the government use competitive devaluation/depreciation?

Answer 27

A weaker currency encourages exports and discourages imports, improving the balance of payments.

Question 28

What are the impacts of changes in exchange rates?

Answer 28

-Current account of the balance of payments (Marshall-Lerner condition, J curve effect).
-Economic growth & unemployment rate.
-Inflation.
-FDI flows.

Question 29

What is the Marshall-Lerner condition?

Answer 29

The sum of the price elasticities of imports & exports must be more than 1 (i.e. elastic) if a currency devaluation is to have a positive impact on the trade balance.

Question 30

What is the J-Curve effect (with diagram)?

Answer 30

How the current account will worsen before it improves.
-People will not immediately recognise that British exports are cheaper (and UK consumers will not see that imports are more expensive).
-Demand tends to be inelastic in the short run.
-However, in the long term, the current account deficit will fall as demand becomes more elastic.

Question 31

How is economic growth & unemployment an impact of changes in exchange rates?

Answer 31

A weaker exchange rate is likely to increase (cheaper) exports and decrease (expensive) imports - increase in AD.
This will increase employment and economic growth.

Question 32

How is inflation rate an impact of changes in exchange rates?

Answer 32

Falls in the exchange rate will increase inflation as imports become more expensive, causing a rise in prices and a fall in SRAS. Also, the net exports section of AD will increase and so inflation will rise further.

Question 33

How is FDI an impact of changes in exchange rates?

Answer 33

A fall in the currency may increase FDI as it becomes cheaper to invest.
However, if the currency is continuing to fall then this is an indication that an economy has serious economic difficulties which will discourage investment.