4.1.8: Exchange Rates Flashcards
What is exchange rate?
The weight of one currency relative to another.
What are the 3 exchange rates?
-Nominal.
-Real.
-Effective.
What is nominal exchange rate?
The rate at which one country’s currency exchanges for a basket of multiple foreign currencies.
What is real exchange rate?
The nominal exchange rate adjusted for the inflation rates in both countries.
What is effective exchange rate?
A weighted index of a currency’s value against a basket of currencies.
What are the 3 exchange rate systems?
-Free-Floating.
-Managed-Floating.
-Fixed.
What is free-floating currency?
Where the external value of a currency depends wholly on market forces of demand & supply.
What is an example of a free-floating currency?
UK Pound Sterling.
What is managed-floating currency?
Where the external value of a currency depends on demand & supply, but the Central Bank will intervene to control the currency’s volatility.
What is an example of a managed-floating currency?
Indian Rupee: fluctuates on the market, but the central bank intervenes when it falls outside a set range.
What is fixed exchange rate?
The fixing of the value of a currency to another currency or gold (set by the central bank).
What is an example of a fixed exchange rate?
Gold Standard.
What is appreciation?
Increase in the value of a currency (under floating exchange rates).
What is depreciation?
Decrease in the value of a currency (under floating exchange rates).
What is revaluation?
Increase in the value of a currency (under fixed exchange rates).
What is devaluation?
Decrease in the value of a currency (under fixed exchange rates).
What factors affect a currency’s value?
-Relative Inflation Rates.
-Relative Interest Rates.
-State Of The Economy.
-Political Stability.
-Speculation.
How does relative inflation rates affect a currency’s value?
If the country’s inflation rate is higher than its competitors, the value of the currency will fall.
How does relative interest rates affect a currency’s value?
High interest rates makes investing funds in the country attractive, as the rate of return on investment is higher.
This increases demand for the currency, causing an appreciation.
How does the state of the economy affect a currency’s value?
A strongly performing economy will increase the confidence of investors & speculators.
How does political stability affect a currency’s value?
Instability may cause a loss of confidence and put downward pressure on the currency value.
How does speculation affect a currency’s value?
If speculators think a currency will appreciate, demand will increase, as the rate of return on investment is higher.
This can cause an increase in the value of the currency.
How can the government intervene in currency markets?
-Buy foreign currency in exchange for the pound.
-Decrease interest rates.
How can the government use foreign currency transactions in currency markets?
To weaken a currency, the supply can be increased by buying foreign currency (or gold) with the currency.
How can the government use interest rates in currency markets?
Increasing interest rates makes currency more attractive for investors.
This attracts inflow of ‘hot money’.
Demand for currency increases, appreciates (in a floating system).
What is competitive devaluation/depreciation?
When a country deliberately drives down the value of the currency in the foreign exchange market.
Why would the government use competitive devaluation/depreciation?
A weaker currency encourages exports and discourages imports, improving the balance of payments.
What are the impacts of changes in exchange rates?
-Current account of the balance of payments (Marshall-Lerner condition, J curve effect).
-Economic growth & unemployment rate.
-Inflation.
-FDI flows.
What is the Marshall-Lerner condition?
The sum of the price elasticities of imports & exports must be more than 1 (i.e. elastic) if a currency devaluation is to have a positive impact on the trade balance.
What is the J-Curve effect (with diagram)?
How the current account will worsen before it improves.
-People will not immediately recognise that British exports are cheaper (and UK consumers will not see that imports are more expensive).
-Demand tends to be inelastic in the short run.
-However, in the long term, the current account deficit will fall as demand becomes more elastic.
How is economic growth & unemployment an impact of changes in exchange rates?
A weaker exchange rate is likely to increase (cheaper) exports and decrease (expensive) imports - increase in AD.
This will increase employment and economic growth.
How is inflation rate an impact of changes in exchange rates?
Falls in the exchange rate will increase inflation as imports become more expensive, causing a rise in prices and a fall in SRAS. Also, the net exports section of AD will increase and so inflation will rise further.
How is FDI an impact of changes in exchange rates?
A fall in the currency may increase FDI as it becomes cheaper to invest.
However, if the currency is continuing to fall then this is an indication that an economy has serious economic difficulties which will discourage investment.
What are the consequences of competitive devaluation/depreciation?
-Can cause inflation due to higher import prices, reducing competitiveness, leading to a fall in the balance of payments.
-Other countries may follow suit.
