4.1.8 Exchange rates Flashcards
Two main types of exchange rate system
- A fixed exchange rate
- A floating exchange rate
What is a fixed exchange rate?
Where the government (or central bank) sets the exchange rate. This often involves maintaining the exchange rate at a target rate.
What is a floating exchange rate?
An exchange rate which is free to move with changing supply of, and demand for, a currency.
What is a hybrid exchange rate system?
A mixture of fixed and floating.
The types of hybrid exchange rate systems are:
- Managed floating
- Semi-fixed
- Pegged
[Hybrid exchange rates]
What are managed floating exchange rates?
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.
[Hybrid exchange rates]
What are semi-fixed exchange rates?
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.
[Hybrid exchange rates]
What are pegged exchange rates?
The exchange rate is only allowed to fluctuate within a set band of exchange rates.
Target exchange rates
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.
Nominal exchange rate
An unadjusted or ‘direct’ comparison of the value of currencies.
Nominal exchange rate
An unadjusted or ‘direct’ comparison of the value of currencies.
Real exchange rate
This is a nominal rate which is adjusted to take price levels into account.
Bilateral exchange rates
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.
Effective exchange rates
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.
What are the two ways of converting exchange rates?
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.
Devaluation of exchange rate
When the exchange rate is lowered formally by the government.
They can achieve this by selling the currency.