4.1.8 Exchange Rates

Question 1

What happens to exports when the pound (GBP) inflation decreased short run vs long run?

Answer 1

In the short run, the GBP inflating less than the USD leads to the usa having more money compared to uk, so they can buy exports cheaper.
So short run, exports rise

In long run, exchange rates adjust, leading to USD can only buy less GBP, leading to less exports
So, long run, the opposite happens vs short run as exports decrease

This means expenditure reducing policies may not work long run

Question 2

What’s an expenditure switching policy?

Answer 2

Gov policies such as devaluation and protectionism designed to switch production currently being sold domestically to exports

E.g devaluating the GBP leads to exports becoming cheaper for foreigners, increasing exports

Question 3

What’s an expenditure reducing policy?

Answer 3

Policies to reduce AD in the economy, leading to less imports being brought and more exports as domestic markets are dry so firms produce more exports

A fall in inflation makes the exports chaperon the short run, so increasing them
- but when exchange rates change, the opposite happens

Question 4

What’s a bilateral exchange rate?

Answer 4

Rate of exchange of one single currency to another

Question 5

What’s a multilateral exchange rate?

Answer 5

Calculating exchange rates in terms of a group of currencies that the country trades with

Only relevant the exchange rate changes to the countries that they trade with
- calculated by giving weightings determined by the value of trade undertaken with a countries main trading partners

Question 6

How do we calculate multilateral exchange rates?

Answer 6

There are several different calculations which calculate multilateral exchange rates:
- Effective exchange rate
- Trade weighted exchange rate
- Exchange rate index

Question 7

What is a spot exchange rate?

Answer 7

The exchange rate at a current point in time
By paying immediately, you avoid the risk of fluctuating exchange rates

Question 8

What is a forward exchange rate?

Answer 8

Exchange rates where 2 parties agree to exchange currencies at a future date
Risk of fluctuating exchange rates

Question 9

What is inward investment?

Answer 9

Foreign capital flows into THE country. This includes foreign companies or individuals investing in assets or businesses within the country.

Question 10

What is outward investment?

Answer 10

Domestic capital flows out of a country. This involves THE country’s domestic companies or individuals investing in foreign assets or businesses.

Question 11

What is speculation?

Answer 11

Act of making high-risk financial investments with the hope of earning a profit based on future price movements
Trading

Question 12

What are Foreign Exchange (Forex/FX) Markets?

Answer 12

The global marketplace where currencies are brought and sold
Govs can buy/sell currencies to influence their prices but we’ll assume they don’t

They fluctuate because of speculation and change because of the supply and demand equilibriums for the currency
- e.g if the Uk buy something from Germany, the euro has been demanded, increasing the Euros demand and the pound has been supplied. Overall lowering value of pound and increasing value of Euro

Question 13

What are the 3 main reasons FX is brought and sold?

Answer 13

International trade in goods/ services needs to be financed
- exports create demand for a currency and imports create supply
- Buying something from USA (UK import and US export) will create supply of £ and create demand for $

Long term capital movements
- Investing in Uk’s shares/ bonds means you have to convert currency to £, increasing it’s demand increasing value of £

Enormous amount of speculation
- predicting and reacting to price movements through market analysis

Question 14

What 5 factors shift demand and supply for a currency?

Answer 14

1. Rise in Exports
   - foreign firms buy more of them, increasing demand for the currency
2. Rise in Imports
   - Uk buying US exports lead to the £ being supplied more, decreasing the £’s value
3. Rise in interest rates
   - US investors start to invest into London’s saving accounts, increasing demand for £
4. Inflow of investment funds
   - rises demand for currency
   - e.g FDI and long term investments
5. Belief currency will change value
   - speculation being the biggest short term determinant
   - however long term depends on economic factors such as exports, imports, long term capital movements

Question 15

What are nominal exchange rates?

Answer 15

The rate at which a currency is brought and sold on the FX markets for another currency
The ‘normal’ exchange rates which don’t aim to reflect to prices of living or anything

Likely to be different to real exchange rates due to day to day speculation

Question 16

What are real exchange rates (RER)?

Answer 16

Ratio between the cost of a typical bundle of goods in one country compared to another
Done by measuring purchasing power parities (PPP)

Question 17

What’s the purchasing power parity (PPP) theory of exchange rates?

Answer 17

States in the long run that nominal exchange rates will adjust over time to reflect changes in real exchange rates

So nominals will change when inflation changes PPPs as well

Question 18

What’s an exchange rate system?

Answer 18

Any system that determines the conditions of how one currency will be exchanged for another

A country only uses one exchange rate system and can trade with anyone with different exchange rate systems

Question 19

What are the 3 different primary types of exchange rate systems?

Answer 19

Floating/ Free exchange rate system
Fixed exchange rate system
Managed exchange rate system

Question 20

What is a Floating/ Free exchange rate system?

Answer 20

Exchange rates are solely determined upon free market forces of supply and demand
No gov controls in any sort

Question 21

What is a Fixed exchange rate system?

Answer 21

Where a country has a fixed value against another currency or commodity
May use a currency board system
or other systems which may also be classified as managed exchanged rate systems

Question 22

What is a currency board system?

Answer 22

Where a currency is directly pegged to a foreign currency like USD

Question 23

What is a Managed exchange rate system?

Answer 23

Where supply and demand is one determinant, but the gov can also determine them

Different forms:
- adjustable peg system
- Bretton Woods system
- crawling peg system
- managed duty float

Question 24

What is an adjustable peg system?

Answer 24

Currencies are fixed or pegged in the short term, but can be changed in the long term

Question 25

What is a Bretton Woods system?

Answer 25

Type of adjustable peg system

Exchange rate allowed to fluctuate within a very narrow band
- if threatened to go off band, the central bank intervenes

Question 26

What is a crawling peg system?

Answer 26

Type of adjustable peg system

Country fixes currency or within a band, but theres a mechanism which allows the band to rise and fall regularly over time

Question 27

What’s a Managed/ duty float?

Answer 27

Occurs when exchange rates are freely floating, but central banks and Govs occasionally intervene to change value of currency

May reduce volatility of currency
- smooths out sudden rises disturbing foreign trade
Most important type used today
- e.g USD, EUR, GBP, JPY

Question 28

What 5 ways can the gov influence exchange rate systems under a managed float?

Answer 28

1. Buying and selling currency
   - can only buy own currency as central bank holds gold and foreign currency reserves to finance it
2. Changing interest rates
3. Currency controls
   - limits how much a foreign currency can be brought
   - may lead to black markets opening
4. Borrowing from international institutions
   - Like the IMF who are like a last resort
5. Devaluation and revaluation

Question 29

What are the International Monetary Find (IMF)?

Answer 29

An international institution which finance countries when needed
Last resort as borrowing is seen as economic failure

Question 30

What is devaluation and revaluation?

Answer 30

Revaluation
- rising value of currency due to gov’s doing
Devaluation
- decreasing value of currency due to gov’s doing

Different to appreciation and depreciation as these changes in value are from the natural market of supply and demand

Question 31

What are the advantages and disadvantages of the different exchange rate systems?

Answer 31

Volatility
- No volatility for fixed
- Is for floating
Robustness
- floating are as currency is self correcting
- fixed isn’t as gov may lead to failure of currency
Economic cost of adjustment
- if supply and demand for currency are in disequilibrium
- floating is predictable of the consequences
- fixed isn’t
Financial discipline
- Gov may spend too much in a fixed system causing a big problem
- no problem in floating

Question 32

What is the main economic impact of changes in exchange rates?

Answer 32

Exchange rates increase
- higher imports, lower exports
- worsening current account

Vica verse for decrease

Hence, devaluating the currency leads to a better current account

Question 33

What’s the Marshal-Lerner condition?

Answer 33

Devaluating a currency only improves the current account when PED(X) + PED(M) > 1

This means both can still be inelastic and still increase budget
- as exports still rise in value being elastic, still actually weighs out increase of imports

Question 34

Why does a change in the current account through devaluation depend on PEDs?

Answer 34

The higher PED of exports, the more export will increase in price in devaluation
The higher PED of imports, the more imports will drop in price in devaluation

Meaning current account improves more greatly with higher PEDs

Question 35

When exchanges rates change, what price changes?

Answer 35

It’s up to the exporter and importer
It depends on their strategy

They could both leave prices constant, which still devalues the pound if exchange rates drop for example

Question 36

What is the J-curve effect?

Answer 36

Following a devaluation, the current account is likely to worsen before it improves

In the short run, PED for exports imports and are inelastic
- as it takes time for countries to react, exports are even more elastic and don’t even change straight away
So, imports increase in value in the short run due to inelastic demand, causing the J-curve to go down initially

Question 37

What are the 3 major problems if Govs use devaluation to improve current account?

Answer 37

The J-Curve effect
Cost push inflation
- devaluation causes prices of imports to increase, increasing prices for firms, leading to cost-push inflation. Becomes a real problem when it leads to a cost-push inflationary spiral
- Hence, devaluation is only successful alongside other policies to help competition and performance
Competitive devaluation
- A currency devaluating may lead to other currencies copying to keep their rates and current account healthy

Question 38

What does higher exchange rates do to inflation?

Answer 38

Lowers inflation for 2 reasons:
- Fall in import prices
- Lowers AD as AD=C+I+G+(X-M)

Question 39

What does higher exchange rates do to economic growth?

Answer 39

Overall decreases economic growth

Negatives:
- increased imports leads to less brought from domestic firms, so less investment decreasing growth
- Reduced FDI
- Decreased jobs

Positives:
- Lower business costs may support growth
- increased competitiveness

Negatives > Positives

Question 40

What does higher exchange rates do to employment?

Answer 40

Increases employment from less domestic output and lower AD

Question 41

How does exchange rates effect FDI?

Answer 41

If exchange rates fall, it’s cheaper to buy for foreigners into the Uk, increasing FDI

However, if carried on to fall, it indicates economy has difficulties, discouraging FDI