4.1.8: Exchange Rates

Question 1

What is the exchange rate?

Answer 1

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

Question 2

What is a free floating system?

Answer 2

• Where the value of the currency is determined by demand and supply of the currency
• eg the UK

Question 3

What is a managed floating exchange rate system?

Answer 3

• 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 daily basis

Question 4

What is a fixed exchange rate system?

Answer 4

• When a government sets their currency against another and the exchange rate doesn’t change

Question 5

What is the difference between appreciation and depreciation in the currency?

Answer 5

• Appreciation: An increase in the value of currency using floating exchange rates
• Depreciation: A fall in the value of the currency under floating exchange rates

Question 6

What is the difference between revaluation and devaluation of currency?

Answer 6

• Revaluation: When the currency is increased against the value of another under a fixed system
• Devaluation: A decrease in the value of one currency against another under a fixed system

Question 7

What are some factors which affect floating exchange rates?

Answer 7

• Changes in demand and supply
• Demand: the amount of British goods that foreigners want to buy, the number of foreigners wanting to invest in the UK, the amount of speculation on the pound
• Supply: the amount of foreign goods people in the UK want to buy, the number of British firms that want to invest abroad, the amount of people who place their money in foreign banks, the amount of speculation on the pound

Question 8

What are the two main ways government intervention can affect the exchange rates/ the value of the currency?

Answer 8

• Interest Rates: An increase in interest rates will strengthen the pound, a fall in interest rates will decrease demand for the pound and weaken the currency
• Gold & Foreign Currency Reserves: Increasing the supply by buying foreign currency or gold with pounds will weaken the value of the pound

Question 9

What is another way the government can intervene to influence

Answer 9

• Competitive Devaluation/ Depreciation: where a country deliberately intervenes in foreign exchange markets to drive down in the value of their currency to provide a competitive boost to their exporting industries.

Question 10

How does competitive devaluation/ depreciation affect exchange rates?

Answer 10

• A weaker currency will encourage exports and discourage imports causing the balance of payments to improve (assuming the Marshall- Lerner condition)
• EV: this could cause inflation and may reduce competitiveness, leading the a fall in the BoP.
• EV2: Other countries may follow, reducing their currency as well.

Question 11

How do changes in the exchange rate affect economic growth and unemployment?

Answer 11

• Economic Growth and Unemployment: A weaker exchange rate increase employment and economic growth, as a weaker exchange rate is likely to increase exports, since they become cheaper and decrease imports, leading to an increase in AD.

Question 12

How do changes in exchange rates affect the rate of inflation?

Answer 12

• A fall in exchange rates can cause an inflation as imports become more expensive, causing a rise in prices and a fall in SRAS, also causing the net exports in AD to increase

Question 13

How do changes in exchange rates affect FDI?

Answer 13

• A fall in the currency can cause an increase FDI as it becomes to invest.
• EV: If the currency continues to fall then this is an indication that an economies has serious economic difficulties which will discourage investment in the long run.