4.1.8 Exchange rates Flashcards
Exchange rate
One currency in terms of another
Free floating system
Is 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.
-> Both trade flows and capital flows
affect the exchange rate under a floating system.
Managed floating system
Is where the value of the currency is determined by demand and supply but the Central Bank will try to prevent large changes in the exchange rate on a day to day basis.
-> This is done by buying and selling currency and by changing
interest rates.
Fixed system
Is when a government sets their currency against another and that exchange rate does not change.
-> The country can decide to devalue its currency
overnight to improve international competitiveness of its industry.
Appreciation/Depreciation
An increase in the value of the currency under a floating exchange rate - vice-versa (depreciation).
Revaluation/Devaluation
Is when the currency is increased against the value of
another under a fixed system - vice-versa (devaluation).
Factors influencing floating exchange rates:
Interest Rates: Higher interest rates attract foreign capital, increasing demand for the currency.
Economic Data: Economic indicators like GDP growth, inflation, and employment affect currency demand.
Speculation: Traders’ perceptions of future exchange rate movements can drive short-term fluctuations.
Political Stability: Political events can impact investor confidence and currency values.
Trade Balance: Trade surpluses or deficits can affect a currency’s value.
Government Intervention in Currency Markets
Governments can influence exchange rates through:
Foreign Currency Transactions: Buying or selling their own currency in the foreign exchange market.
Interest Rates: Adjusting domestic interest rates to attract or deter foreign capital inflows.
Competitive Devaluation/Depreciation and Its Consequences
Competitive devaluation/depreciation occurs when a country intentionally lowers their exchange rates to gain a competitive advantage in international trade.
Consequences include:
-Trade tensions
-Protectionism
Impact of changes in exchange rates: The Current Account of the Balance of Payments
Marshall-Lerner Condition:
- A depreciation of the domestic currency will improve the trade balance if the sum of price elasticities of demand for exports and imports is greater than 1.
J Curve Effect
- In the short term, a depreciation may initially worsen the trade balance before improving it, as it takes time for demand elasticities to adjust.
Impact of changes in exchange rates: Economic growth and employment/unemployment
A weaker currency can boost exports, stimulating economic growth and potentially reducing unemployment.
Impact of changes in exchange rates: Rate of inflation
A depreciating currency can lead to higher import prices, contributing to inflationary pressures.
Impact of changes in exchange rates: Foreign direct investment (FDI) flows
A weaker currency may make a country’s assets more appealing to foreign investors.
