4.1.8. Exchange Rates Flashcards
What is an exchange rate?
The price of one currency in terms of another e.g. £1=$1.30. (Purchasing power of a currency in terms of what it can buy of other currencies)
Who controls the exchange rate of a country?
The Central Bank is in charge of determining the value of a nation’s currency
What is an appreciation?
Appreciation of a currency is an increase in the value of the currency using floating exchange rates
What is a depreciation?
Fall in the value of the currency under floating exchange rates
What is a revaluation?
When the currency is increased against the value of another under a fixed system
What is a devaluation?
It’s a decrease in the value of one currency against another under a fixed system
What are the three exchange rate systems?
- Floating exchange rate
- Fixed exchange rate
- Managed exchange rate
What is a floating exchange rate?
A system in which demand and supply determines the rate at which one currency exchanges for another
How does the floating exchange rate system work?
If there is excess demand for the currency then prices rise (currency is worth more). This is called and appreciation.
If there is excess supply of the currency then prices fall (the currency is worth less). This is called a depreciation
What is a fixed exchange rate?
A system in which the country’s Central Bank intervenes in the currency market to fix the exchange rate in relation to another currency
How does the fixed exchange rate system work?
The Central Bank negotiated with the IMF to fix their currency to another one.
A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency.
A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currency
What is a managed exchange rate?
A system in which the free market determines the value of a currency but also where central banks will intervene from time to time so as to keep the currency value within a desired range
How does the managed exchange rate system work?
Combination of the fixed and floating mechanisms. Central Bank determines the prefered currency value and then currency is free to fluctuate within a certain range of this value.
If it goes above this range then the CB will intervene by selling its own currency to increase supply. This decreases the value and brings it back within the range.
If it goes below this value then the CB will intervene by buying its own currency. Increased demand increases the value of the currency and brings it back within the range.
Interest Rates can also be used to intervene. Raising IR helps appreciate ROI become more attractive to foreigners. Decreasing IR depreciates currencies ROI and currency becomes less attractive to foreigners
What factors influence floating exchange rates?
- Relative interest rates
- Relative inflation rates
- Net investment
- The current account
- Speculation
- Quantitative easing
How does relative interest rates influence floating exchange rates?
Influence the flow of hot money (Money that moves quickly between countries to chase best interest rates or returns) between countries.
If UK increases IR the demand for £ by foreign investors increases and it appreciates.
If UK decreases IR the demand for £ by foreign investors decreases and it depreciates
How does relative inflation rates influence floating exchange rates?
As inflation rises in UK relative to other countries its exports become more expensive so there is less demand for UK products by foreigners which means less demand for £ and so £ depreciates
How does net investment influence floating exchange rates?
FDI into the UK creates a demand for the £ which leads to it appreciating. On the other hand, FDI by UK firms abroad creates a supply of £ and so it depreciates.
How does The current account influence floating exchange rates?
UK exports have to be paid for in £’s. UK imports have to be paid for in local currencies. Increase in trade surplus will result in appreciation of £ and increasing debt will result in a depreciation of the £
What is speculation?
When people buy or sell currencies because they think the price will change and they want to make a profit from that change
How does speculation influence floating exchange rates?
Vast majority of currency trade are speculative. If speculators think currency will go up they start buying that currency which increases the demand and currency value rises. If speculators think currency will go down they start selling it which increases the supply and the value falls
What is Quantitative easing?
CB prints money and uses it to buy gov bonds or other financial assets. Goal is to get more money into the economy to encourage borrowing, spending and investment especially when the IR are low
How does Quantitative easing influence floating exchange rates?
Many of these gov bonds etcc… are owned by foreigners who then exchange the £ received for their own currency. Increase in supply of £ depreciates £.
What are forex transactions?
They are exchanges of one currency for another and happen in the foreign exchange market (FOREX). It’s where people, businesses and banks buy and sell currencies
What are some examples of Forex transactions?
- Travel: Exchange pounds for euros when going on holiday to Spain
- Business: UK company buys goods from US and pays in dollars, so exchanges pounds for dollars
- Investing/Speculation: Traders by euros and sell dollars hoping to make a profit if the euro goes up
- Central Banks: Might buy/sell currencies to stabilize their exchange rate
