4.1.8 Exchange rates

Question 1

3 types of exchange rate systems?

Answer 1

1) Fixed – fixing the value of your currency against another currency (Yuan fixed to US Dollar until 2005)
2) Managed exchange rate – the government or central bank will intervene to keep the currency within a certain range
3) Floating exchange rate – exchange rates are determined by free market forces

Question 2

Difference between revaluation and appreciation?

Answer 2

Revaluing - is increasing the value of a fixed exchange rate. The currency appreciates and then is fixed at the appreciated amount

Appreciation – when the value of a currency increases due to free market forces

Question 3

Difference between devaluation and depreciation?

Answer 3

Devaluing - decreasing the value of a fixed exchange rate

Depreciation - when the value of a currency decreases due to free market forces

Question 4

4 factors influencing floating exchange rates?

Answer 4

1) Imports and exports – More imports - supply of currency increases – exchange rate depreciates. More exports demand increases – exchange rate appreciates
2) Speculation – speculation that there will be future appreciation can cause immediate appreciation (demand increases)
3) Relative interest rates – higher interest – more hot money flows – more demand for your currency – currency appreciates. If interest is low – investors buy foreign currencies - supply of currency will increase – currency depreciates
4) FDI – more FDI inflows - more demand for currency e.g. TATA purchasing Jaguar – more demand – currency appreciates

Question 5

How do you calculate the real exchange rate?

Answer 5

(nominal ER x domestic price level) / foreign price level

Question 6

What are the 2 ways government can intervene to manipulate exchange rates?

Answer 6

1) Changing interest rates (hot money)
2) Foreign currency transactions (e.g. buying your own currency appreciates it)

Question 7

What is competitive devaluation, and what are its consequences?

Answer 7

Deliberately manipulating currency to improve domestic economy and achieve growth (competitive exports)

Consequences:

• Currency war - other countries’ exports will reduce as exports in the country that devalued their currency will increase. E.g. Thailand - China (1994) after China devalued its currency. Thailand retaliated and depreciated their currency too
• Depreciation - more expensive imports - domestic producers in China and Thailand that import raw materials will have higher costs - inflation

Question 8

How does printing money affect inflation?

Answer 8

Printing money – increased money supply – households have more cash – increased consumption - AD shifts – demand pull inflation

Question 9

What are the 4 impacts of changes in exchange rates?

Answer 9

1) J-curve effect and current account
2) Growth & Employment – Depreciation - more demand for exports – more export revenue, less imports – less money leaking out of economy - more money in circular flow of income. AD (X-M) increases – GDP increases – derived demand for labour - employment increases. Appreciation will lead to cheaper imports – SRAS shifts right, GDP and employment increases
3) Inflation – appreciation - fall in import prices – firms that importing will have lower costs, SRAS shifts right - price level falls. Appreciation - fall in exports – (X-M) decreases so AD falls – this reduces inflation as price level will fall. All depends on PED
4) FDI – depreciation may lead to an increase in FDI – because it costs foreign investors less to buy firms in the country with depreciated currency. However, if currency continues falling investors may not invest as investment worth less and less overtime - if they wanted to sell their stake, it would be worth less

Question 10

What is the impact of a change in the exchange rate on the current account (J curve and Marshall-Lerner condition)

Answer 10

J-curve effect – depreciation - imports become more expensive but imports won’t fall straight away because they are inelastic - import contracts may have been agreed or there are no domestic suppliers available – imports will remain the same in and current account will worsen in SR – in LR imports can be more elastic so current account will improve.Takes time before other countries react to the change in currency and the cheaper export prices as well, so exports may not increase in the short run

In LR, the M-L condition is satisfied. For a depreciation in a currency to cause a CA improvement, the Marshall-Lerner condition is:

PED_X + PED_{<strong>M</strong>} > 1