4.1.8 exchange rates Flashcards
Exchange rate systems:
floating
definition - free floating system where value of currency is determined wholly by market forces of supply and demand
pros
- central bank doesn’t need large reserves of currency to keep exchange rate fixed
- can also partly autocorrect current account deficit as dearer exports will cause a fall in the currency as supply is high and demand is low
cons
- speculation of exchange rate could lead to people dumping their supply on pounds on the market, could cause currency crisis
- volatile
- no constraints on domestic policy
Exchange rate systems:
fixed
definition - when a government sets their currency against another and that exchange rate does not change
pros
- ensures stable currency by avoiding fluctuations in value
- reduces trade costs as firms have to spend less on currency hedging (process of agreeing on forward exchange rates)
- may reduce inflation and help keep it low and stable
cons
- if exchange rate is fixed too high could lead to uncompetitive exports
- requires large foreign currency reserves
- changing these fixed rates could have negative effects on other policies
- less flexibility, difficult to respond to temporary shocks
- development of parallel unofficial exchange rate
Exchange rate systems:
managed
definition - value of currency is determined by supply and demand but central bank will try to prevent large changes in the exchange rate
- an adjustable peg system is where currencies are fixed against another but the level at which they are fixed can be changed.
- crawling peg systems are a form of this but have a mechanism which allows the value to change.
- managed float or dirty float is where the government intervenes to improve macroeconomic stability.
pros
- can help to protect from large currency shocks
cons
- requires foreign and domestic currency reserves
Distinction between revaluation and appreciation of a currency
An appreciation of the currency is an increase in the value of the currency using floating exchange rates
A revaluation of the currency is when the currency is increased against the value of another under a fixed system
Distinction between devaluation and depreciation of a currency
depreciation is a fall in the value of the currency under floating exchange rates
devaluation of the currency is a decrease in the value of one currency against another under a fixed system.
Factors influencing floating exchange rates
- currency supply and demand
- speculation
- economic fundamentals
- position of current account
government intervention in currency markets through foreign currency transactions and the use of interest rates
- using interest rates to manipulate exchange rate
- use gold and foreign currency reserves
Competitive devaluation/depreciation and its consequences
definition - where a country deliberately intervenes in foreign exchange markets to drive down the value of their currency to provide a competitive boost to their exporting industries
- One problem is that other countries may follow and reduce their currency as well. This is unlikely if there is a current account deficit but if the country who devalues has a surplus, other countries are likely to retaliate
Impact of changes in exchange rates:
the current account of the balance of payments (reference to Marshall-Lerner condition and J curve effect)
marshall lerner condition
- states that the current account deficit will only improve is the PED of imports and exports > 1
- demand for imports and exports need to be elastic enough so that a change in the value of the exchange rate will result in a change in quantity of exports demanded
J Curve
- diagram shows that in the short run the current account will worsen and then improve in the long run
- this is because in the short run firms and countries may be tied in trade contracts or people have not immediately recognised British exports
- demand tends to be inelastic in the short run so deficit will worsen, in long run demand tends to be more elastic so deficit will improve
Impact of changes in exchange rates:
economic growth and employment/ unemployment
A weaker exchange rate is likely to increase exports, since they become cheaper, and decrease imports so lead to an increase in AD. This will increase employment and economic growth
Impact of changes in exchange rates:
rate of inflation
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
Impact of changes in exchange rates:
foreign direct investment (FDI) flows
A fall in the currency may increase FDI because 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
