4.1.8- Exchange Rates

Question 1

What is an exchange rate?

Answer 1

The purchasing power of a currency in terms of what it can buy of other currencies

Question 2

What is the spot exchange rate?

Answer 2

Actual exchange rate at current prices

Question 3

What is the forward exchange rate?

Answer 3

Providing a currency at some point in the future for an agreed rate

Question 4

What is devaluation?

Answer 4

Deliberate attempt by a government to depreciate the value of a currency

Question 5

What is revaluation?

Answer 5

Deliberate attempt by a gov to appreciate the value of a currency

Question 6

What is depreciation?

Answer 6

When a currency becomes weaker relative to other currencies

Question 7

What is appreciation?

Answer 7

When a currency becomes stronger relative to other currencies

Question 8

What is a fixed exchange rate system?

Answer 8

When the exchange rate is decided by the governments

Question 9

What fixed exchange rate system was used in the past?

Answer 9

The gold standard was used pre WW2, where each major trading country made its currency convertible into gold at a fixed rate

Question 10

What are the benefits of a fixed exchange rate system?

Answer 10

-avoids currency fluctuations
-no need for currency hedging
-may prevent inflation
-less risk from FDI and selling bonds

Question 11

What is currency hedging?

Answer 11

Process of agreeing on forward exchange rates

Question 12

How does a fixed exchange rate prevent inflation?

Answer 12

No sudden reduction in the value of the currency leading to a rise in imports

Question 13

What are the evaluation points for a fixed exchange rate system?

Answer 13

-conflicts with other objectives
-easy to set at the wrong rate
-less flexibility and harder to respond to external shocks

Question 14

What is a managed/pegged/dirty float exchange rate?

Answer 14

Value of currency is maintained against a broad currency band

Question 15

What happens if the currency goes above the upper limit in a managed exchange rate system?

Answer 15

The central bank sells domestic currency and buys foreign

Question 16

What are some examples of countries that use a managed exchange rate system?

Answer 16

Brazilian Real, Swiss Franc, Japanese Yen

Question 17

When was the UK in the Exchange Rate Mechanism?

Answer 17

1990-92

Question 18

Why was the UK driven out of the ERM?

Answer 18

Due to currency speculation from George Soros

Question 19

What is a free floating exchange rate system?

Answer 19

The value of the currency is determined entirely by market supply and demand

Question 20

What are the benefits of a floating exchange rate system?

Answer 20

-automatically reacts to the CAc position
-automatically adjusts when there is an economic shock
-no need for larger foreign exchange reserves to be held by the central bank
-monetary policy can be used for other GMEOs

Question 21

How does a floating exchange rate system automatically react to the CAc position?

Answer 21

If CAcD, imports are high, so increased supply of pounds, so £ depreciates, so exports are cheaper, so gets rid of CAcD

Question 22

What is the evaluation of the floating exchange rate system getting rid of CAcD?

Answer 22

Not proven to work in real life, only if ceteris paribus

Question 23

What is the UK CAcD?

Answer 23

£20 billion

Question 24

What is an example of the floating exchange rate helping when there are negative external shocks?

Answer 24

When the UK left the EU, £ fell by 15% against the euro

Question 25

What are the factors that affect floating exchange rates?

Answer 25

-trade
-interest rates
-FDI
-gov’t bonds
-speculation

Question 26

What is the most important determinant affecting floating exchange rates?

Answer 26

Speculation

Question 27

What are the evaluation points of floating exchange rates?

Answer 27

-no option for gov’s to devalue the currency
-currency is volatile in the short term
-can’t use exchange rates to manage AD

Question 28

What is Purchasing Power Parity?

Answer 28

Price of a basket of goods in 1 country compared to another

Question 29

What are the steps of the PPP theory?

Answer 29

1. PPP and exchange rate is £1:$2
2. UK productivity falls leading to higher prices so higher inflation
3. Average export prices will be higher so more demand for imports
4. Increased supply of pounds and decreased demand so exchange rate falls
5. Keeps falling until PPP is restored
6. No longer price incentive to trade G+S

Question 30

What is the PPP called in terms of exchange rates?

Answer 30

Long run stable exchange rate

Question 31

How can the government intervene in currency markets?

Answer 31

-change interest rates
-use gold and foreign currency reserves

Question 32

What is arbitrage?

Answer 32

When goods are bought where prices are cheaper and sold where prices are higher

Question 33

What are the impacts of changes in exchange rates on the current account?

Answer 33

-devaluation has a positive impact if the sum of elasticities is more than 1 (Marshall-Lerner condition)
-J curve shows that CAc worsens before it improves

Question 34

What are the impacts of changes in exchange rates on growth and employment?

Answer 34

Weaker exchange rate increases exports so increases AD, which leads to increased growth and employment

Question 35

What are the impacts of changes in exchange rates on inflation?

Answer 35

Fall in the exchange rate makes imports expensive so inflation

Question 36

What are the impacts of changes in exchange rates on FDI?

Answer 36

A fall in the currency increases FDI as it becomes cheaper to invest