4.1.8 Exchange rates ppts

Question 1

What is currency demand?

Answer 1

Demand for a currency is an inflow of money into an economy. Demand for a specific currency in the FEX market is derived from demand for a country’s exports of goods and services, and from speculators looking to profit from changes in currency values and from currency volatility.

Question 2

How is demand for currency generated?

Answer 2

1. Income from exports of G+S
2. Overseas portfolio flows into property, shares and bonds
3. Hot money flowing into a country’s banking system.
4. Inflows from FDI
5. Speculative buying of a currency by market traders.

Question 3

What is currency supply?

Answer 3

Supply of a currency is an outflow of money into an economy. The supply of a currency is determined by level of domestic demand for/ expenditure on imported G+S from aboard. It is also influenced by speculative outflows of a country’s currencies on the FEX markets.

Question 4

How is currency supplied?

Answer 4

1. Domestic spending on imported G+S
2. Outflow of portfolio flows in property, shares and bonds.
3. Hot money flowing out of a country’s banking system
4. Outflows of FDI
5. Speculative selling of a currency by market traders.

Question 5

What is equilibrium exchange rate?

Answer 5

Its the rate which equates demand and supply for a particular currency against another currency. This price clears the market. Changes in the equilibrium exchange rate happen when there are changes in the currency demand and supply.

Question 6

What will happen to a country’s currency if the central bank cut monetary policy interest rates?

Answer 6

Depreciation in the value as there will be an outflow of hot money.

Question 7

What will happen to a country’s currency if there is a rise in spending on imports?

Answer 7

Depreciation- there is an increased currency supply.

Question 8

What will happen to a country’s currency if there is an increase in the net inflows of remittances?

Answer 8

There will be an appreciation of the currency value as the current account improves.

Question 9

What will happen to a country’s currency if there is a rise in outward portfolio investment?

Answer 9

The currency will depreciate in value as there is increased currency supply.

Question 10

What will happen to a country’s currency if the government introduce a tax on interest paid to foreign savings held in a nations’ commercial banks?

Answer 10

The currency will depreciate as there is an outflow of foreign savings from domestic banks.

Question 11

What will happen to a country’s currency if speculators expect a currency appreciation?

Answer 11

The value of the currency will appreciate as there will be increased demand for the currency from the speculators and investors.

Question 12

What will happen to a country’s currency if the economy experiences high relative inflation rates?

Answer 12

The currency will depreciate as there may be a fall in exports as the price of imports will be cheaper and exports will be more expensive.

Question 13

What factors will affect a floating exchange rate?

Answer 13

• Trade balances- countries with current account surpluses see their currencies appreciate.
• FDI- an economy that attracts high net inflows of capital investment from overseas will sea in increase in currency demand and a rising exchange rate.
  -Portfolio investment; strong inflows of portfolio investments into equities and bonds can cause an exchange rate to appreciate as investors buy a country’s currency
• interest rate differentials; countries with relatively high interest rates can expect to see ‘hot money’ flowing across the currency markets and causing an appreciation.
• QE; expansionary QE increases a country’s money supply. Likely that this will cause a depreciation in the ER as some money flows out of a country.

Question 14

Outline the impact of a recession in key export industries.

Answer 14

• Recession in a trading partner
• causes fall in value of exports
• Worsening trade balance
• Inward shift of currency demand
• currency will depreciate.

Question 15

outline the impact of speculative selling of a currency.

Answer 15

• Speculators target a weak currency
• The expect the price to fall
• They sell this currency and buy others
• Outward shift of currency supply
• Currency will depreciate in value.

Question 16

What factors may cause the external value of a currency to depreciate?

Answer 16

• Central banks cut interest rates- hot money outflows
• Overseas investors downgrade expected returns from a country
• Rising trade deficit as spending on imports rises
• Domestic firms increase their overseas investments
• Fall in net income flows such as from remittances.

Question 17

What factors may cause the external value of a currency to appreciate?

Answer 17

• Strong inflows of portfolio investment from overseas.
• Relatively high interest rates leading to hot money inflows
• significant rise in value of export sales (demand for currency)
• Increase in net inflow or remittance income
• Rise in the value of foreign takeovers of domestic businesses.

Question 18

What are 3 reasons why the £ might depreciate against the US $?

Answer 18

• A recession in the USA leading to a decline in the value of UK exports to USA.
• Rising global prices of those commodities priced in the US$s which the UK imports.
• US interest rates rising faster than rates in the UK causing net outflow of hot money.

Question 19

How can direct intervention by the central bank be used to manipulate the exchange rate?

Answer 19

Depreciation; sell home currency, buy foreign currency -> foreign currency reserves increasing.
Appreciation; Buy home currency, sell foreign currency -> foreign currency reserves reduces

Question 20

How can the central bank use IRs to manipulate the ER?

Answer 20

Depreciation; Reduce domestic interest rates to cause hot money outflows.
Appreciation; Raise interest rates to attract increased inflows of hot money.

Question 21

What other ways can the central bank manipulate the ER?

Answer 21

Depreciation; Expand QE to stimulate domestic money supply and lower bond yields.
Appreciation; reduce taxes on income from assets to attract overseas investors to buy a currency.

Question 22

What impact does QE have on the external value of a country’s currency?

Answer 22

Increased QE, increased demands for bonds, increase in bond prices. Since bond prices and yields are inversely related, QE can lead to a fall in bond yields and long term interest rates in general. If IRs fall, outflows of hot money as investors switch finds into other currencies offering a higher return. QE could lead to an outwards shift in the supply of a currency in the FEX markets which could lead to a depreciation of a currency.

Question 23

What are the main features of a free-floating exchange rate?

Answer 23

• Currency value is set purely by market forces
• strength of currency supply and demand drives the external value of a currency in the markets.
• Currency can either appreciate or depreciate
• No intervention by central bank- central bank allows the currency to find its own market level. There is no target for the ER.
• The external value of currency is not an explicit target of monetary policy

Question 24

What are the main features of a managed floating currency system?

Answer 24

• Central banks give freedom for market exchange rates on a day-to-day basis, supply and demand
  factors drive the currency’s value.
• Central banks may intervene occasionally, buying to support a currency e.g. selling FEX reserves and selling to weaken a currency e.g. adding to their FEX reserves.
• Currency becomes a target of domestic monetary policy, higher exchange rate to control inflationary pressures, managed depreciation to improve competitiveness and trade balance.

Question 25

What are the main features if a fixed exchange rate system?

Answer 25

• Central bank fixes the currency value- pegged to one or more currencies.
• The central bank must hold enough FEX reserves to intervene in currency markets when needed to maintain the fixed currency peg.
• Pegged rate becomes the official rate- Trade in currencies when buying and selling products takes place day to day at this official exchange rate.
• There might be unofficial trades in shadow currency markets.
• Adjustable peg; occasional realignments may be needed leading to the devaluation or revaluation.

Question 26

What is a currency board system?

Answer 26

• It is a type of exchange rate regime in which a country’s domestic currency is fully backed by a FEX currency or a specific foreign asset, typically held in a fixed exchange rate relationship.
• The domestic currency is issued only when there are corresponding foreign currency reserves to back it up. The currency in circulation is fully convertible into the foreign reserve currency at the established fixed exchange rate.

Question 27

What are the advantages of a free floating exchange rate?

Answer 27

• Monetary policy autonomy, have greater flexibility in conducting an independent monetary policy
• Shock absorption, they allow countries to absorb external economic shocks more effectively. The ER can help rebalance the economy.
• Reduced speculative attacks as ERs are determined by market forces.
  -Trade balance adjustments, can help correct trade imbalances over time.
• Currency reserves, the central bank doesn’t need to hold large foreign currency reserves because there is no specific currency target.

Question 28

What are the drawbacks of a free floating exchange rate?

Answer 28

• ER volatility; currency can experience rapid and unpredictable fluctuations which can lead to uncertainty for businesses.
• Currency risk; introduces currency risks for businesses and investors.
• Inflation pass-through; ER fluctuations can lead to changes in import prices which can impact domestic inflation. Significant depreciation of the currency can contribute to imported inflation and erode real purchasing power.
• Loss of ER as a policy tool; they cant manage the ER as a deliberate policy tool. This can limit the direct influence of ERs on trade and competitiveness.

Question 29

What are the advantages of a fixed exchange rate system?

Answer 29

• Price stability; fluctuations in the ER are limited. This stability can help control inflation and provide a predictable environment for businesses and consumers.
• Reduced ER risk; fixed ERs can eliminate the currency risk associated with fluctuating ERs. This can be beneficial for companies engaged in LT contracts, investments, and trade.
• Discipline on monetary policy; It constrains a country’s central bank from pursuing an independent monetary policy. This can prevent excessive money supply growth and associated inflationary pressures.
• Foreign investment; A stable ER can attract FDI. Investors may be more inclined to invest in a country with predictable currency values, reducing the risk associated with currency fluctuations.

Question 30

What are the drawbacks of a fixed exchange rate system?

Answer 30

• Lack of flexibility; The country may be forced to adopt monetary policies that aren’t necessarily suited to it’s specific economic circumstances when responding to external economic shocks.
• BoP issues; A country’s BoP must be maintained through other means such as fiscal policy or controls on capital flows. Persistent imbalances can lead to pressures on the currency peg.
• Speculative attacks; Can be vulnerable to speculative attacks if investors believe that the currency is overvalued or if there are concerns about a country’s ability to maintain the peg.
• Dependence on reserves; To maintain a fixed ER, a country needs to have sufficient FEX reserves. If reserves are inadequate, the country might struggle to defend the peg during times of market stress.

Question 31

What are the limits to the ability to manage a currency?

Answer 31

Many countries operate with a managed floating ER.
- The volume of speculative trading of currencies is huge- central banks may find they have little impact when buying and selling to move the currency in a particular direction.
- Central banks might have multiple objectives, such as price stability and employment. These objectives can sometimes conflict with each other, making it challenging to devise a single policy approach.

Question 32

How should you analyse the impact of a currency appreciation or depreciation with the use of a graph?

Answer 32

You need to understand that a currency movement can have ST effects on both AD and SRAS and that the impact also depends on the stage of the economic cycle when it occurs.

Question 33

What are the main macroeconomic effects of currency depreciation?

Answer 33

• Inflation; Higher import prices, higher consumer prices- may help a country to avoid deflation
• Economic growth; a weaker currency is usually a stimulus for GDP growth from higher net exports but much depends on the price elasticity of demand for exports
• UE; A more competitive currency will help to increase domestic production and create a positive export multiplier effect which will further stimulate AD and jobs.
• BoT; Dependent on PED for X+M- possible J cure effect in the SR.
• Investment; should help to improve profitability and capital investments in sectors open to trade
• Wider effects; Depreciation is like a cut to interest rates but there are risks- including higher costs of importing components, raw materials and capital technologies

Question 34

What are the ST impacts of a currency depreciation?

Answer 34

• Prices of imported goods and services; higher import costs.
• Rate of consumer price inflation, cost push and demand pull
• Export volumes/export values
• SR production and jobs in export industries GDP
• Profits from overseas investments/ remittances sent home
• Businesses and consumer confidence impact.

Question 35

What are the medium term impacts of a currency depreciation?

Answer 35

• Vulnerability of domestic firms to overseas takeover bids
• Yields on new issues of gov bonds
• Impact on planned capital investment by domestic businesses
• Cost of importing essential inputs including new tech
• Stock market valuations and property affordability.

Question 36

What is a competitive devaluation?

Answer 36

• A situation in which 2 or more countries compete to devalue their currencies to gain a competitive advantage in international trade.
• This can lead to a currency war, in which countries repeatedly devalue their currencies to gain an edge over their rivals.
• A competitive devaluation can lead to trade wars, as countries retaliate against each other’s devaluations by imposing import tariffs or other trade barriers.
• The international monetary fund (IMF) discourages competitive devaluations, as they can have negative consequences for the global economy. However, it is a tempting option for countries that are facing economic challenges.

Question 37

Explain the J cure effect.

Answer 37

• suggests that immediately after a country’s trade balance might worsen before improving.
• Initial; Country’s currency depreciates, exports become cheaper for foreign buyers, potentially leading to increased demand for its goods aboard. The immidiate effect on the BoT may not be significant due to factors like contracts that have fixed prices in the ST and time lags in adjusting to the new ER.
• ST deterioration; In the ST, the value of imports remains relatively unchanged, and the PED for exports and imports may be low.
• This can lead to a situation where the value of imports continues to exceed the value of exports, causing a temporary deterioration in the trade balance.

Question 38

What is the Marshall-Lerner condition?

Answer 38

• Its an economic concept that assesses whether a country depreciation or devaluation will lead to an improvement in a country’s trade balance.
• It states that a devaluation will lead to an improvement in the trade balance if the sum of the price elasticities of demand for a country’s exports and imports is greater than 1:
• price elasticity of exports + price elasticity of imports > 1

Question 39

What is an exchange rate?

Answer 39

• It is the price of one currency in terms of another- the purchasing power of one currency against another.
• They are traded in the global currency market
• They play a crucial role in international trade, finance and investment, as they determine the relative value of different currencies and the impact the cost of goods and services when traded between countries.

Question 40

What are foreign currency reserves?

Answer 40

• FEX reserves are cash and other reserve assets such as gold held by a central bank that are available to balance payments of the country, influence the foreign ER of it’s currency, and to maintain confidence in financial markets.

Question 41

What are the reasons for large trading volumes of global currency?

Answer 41

• Impact of globalisation
• Speculation; currencies themselves have become tradable assets, often treated similarly to commodities or financial instruments
• Hedging behaviour; many businesses engage in currency trading to hedge against the risk of adverse currency movements.

Question 42

What is a currency depreciation?

Answer 42

• Happens inside a floating exchange rate system and means that one currency buys less of another currency
• can be influenced by various factors including changes in interest rate, inflation differentials, economic growth rates, geopolitical events and market sentiment.
• Values are relative, depreciation of one currency implies the appreciation of another.

Question 43

What is currency appreciation?

Answer 43

• Happens within a floating ER system
• Currency appreciation is an increase in the external value of one currency in relation to another.