4.1.8 part 1 Flashcards
Three types of exchange rate systems
o floating
o fixed
o managed
problems with gov borrowing to sustain a deficit
● Problems arise if foreign investors refuse to lend to a ‘country’- but it is an individual
or institution which takes the loan and not the country. If they refuse to lend to a bank
or the government, this will have much larger impacts than if they refuse to lend to a
firm or individual.
● Today, deficits are less of a concern to countries: the US and UK have no problem
financing their deficits and borrowing has not built up unsustainable debts.
● Current account imbalances become a problem when governments can’t repay their
foreign currency debts.
define exchange rate
The exchange rate is the purchasing power of a currency in terms of what it can buy of
other currencies
define floating exchange rates
Under a system of floating exchange rates, market forces (supply of, and demand for, the currency in the foreign exchange market) determine the value at which one currency exchanges for another.
What is a fixed exchange rates
Under a system of fixed exchange rates, the value at which one currency exchanges for another is fixed by the central bank or government against another currency, a basket of currencies or gold.
What is a managed exchange rate
Under a system of managed exchange rates, market forces determine the value at which one currency exchanges for another but intervention by the central bank or government influences the exchange rate of the currency.
Options to influence the exchange rate include: buying and selling currency, changing the interest rate (monetary policy), and currency controls.
how does inflation affect a floating exchange rate
- inflation: A lower inflation = exports are relatively more competitive = increase
demand for the currency = appreciation
How does speculation affect floating exchange rate
If speculators think a currency will appreciate in the future, demand will increase in
the present, since they believe a profit can be made by selling the currency in the
future. This can cause an increase in the value of the currency.
how does other currencies affect floating er
If markets are concerned about major economies, such as the EU, the currency might
rise. This happened with the Swiss Franc in 2010 when markets were worried about
the EU economy.
How does gov finances affect floating exchange rates
A government with a high level of debt is at risk of defaulting, which could cause the
currency to depreciate. This is since investors start to lose confidence in the economy, so they sell their holdings of bonds
How does balance of payments affect floating exchange rates
When the value of imports exceeds exports, there is a current account deficit. Countries which struggle to finance this, such as through attracting capital inflows, have currencies which depreciate as a result.
How does relative interest rates affect floating exchange rates
high interest rates increase demad for a currency bc there’s an inflow of hot money
Define revaluation
A revaluation is an increase in the official exchange rate of a currency set by the government or central bank. It is a deliberate policy move to strengthen the currency’s value
define appreciation
Appreciation refers to a natural increase in the value of a currency due to market forces, such as increased demand for the currency in the foreign exchange market.
define devaluation
Devaluation: Devaluation is a deliberate policy action by a government or central bank to reduce the official exchange rate of its currency. This makes exports cheaper and imports more expensive.
Define depreciation
Depreciation occurs when a currency’s value decreases in the foreign exchange market due to market forces, such as decreased demand for the currenc
What is hot money
- investments or funds that are rapidly moved between countries in search of the highest short term risk-adjusted return
- so it is highly mobile speculative capital that flows across border to take advantage of interest rate differentials or exchnage rate volatilitu
example of hot money flows
inflow: CB raises MP interest rates, hot money flows into banking system = currency appreciates
outflow: hot money outflow due to capital flight puts severe downwards pressure on currency causing exhcnage rate crisis
What other factors can affect floating exchange rate
- rise in incomes abroad, increase in uk comp (lower ULC, inflation and higher investment), increase in FDI INCREASES DEMAND = APPRECIATION
- firms move away from britain, increase in domestic incomes increase SUPPLY = DEPRECIATION
arguments for floating exchange rate
- reduced need for currency reserves
- freedom with domestic monetary policy
- useful instrumet for macroeconomic adjustment
- partial atuomatic correction of trade deficit
- reduced risk of currency speculation
arguments against floating exchange rate
- Volatility - inhibits trade and long run inward investment (inceases risks for overseas investors)
- self-correction of trade deficits was unlikely, due to so many interacting factors at play
- removes option for competitive devaluation to improve intl compness
arguments for fixed exchange rate
- reduced exchange rate uncertainty; beneficial for overseas investors and investment by exporting firms
- some flexibility permitted
- reductions in the costs of trade (reduced hedging),
- can help keep costs and prices udner control (especially if fixed against a low inflation economy)
- discipline on domestic producers
arguments against fixed exchange rate
- interest rates may have little effect
- reduced freedom to use interest rates tpo control other macro objectives
- large level of foriegn currency needed (many LIC OR MIC dont have enough)
- speculative attacks if exchange rate set too high or too low
- peg too high/low, permanent imbalance in current account
evaluation of fixed exhcnage rates
- fully fixed and semi fixed exchange rate; latter allows some movement of currency day to day
- possible to revalue or devalue fixed cureency rate although competitive devalation = retaliation
- pegging to us dollar will = changes to commodity prices feeding straight though dom economy = imported inflation
- mainting high fixed ER udring recession = deflation v costly
evaluate floating currency
- impact of floating er on trade/growth dep on how open economy is to trade
- speculative activity agisnt fixed er too, especially those perceived as weak and risk of a devaluation
What is competitive devaluation/depreciation
Competitive devaluation/depreciation occurs when multiple countries intentionally lower their exchange rates to gain a competitive advantage in international trade.
consequences of competitive devaluation/depreciation
- this will encourage exports and discourage
imports = balance of payments should improve ( assuming the ML) . - However, the problem is that this can cause inflation and this may reduce competitiveness, leading to a fall in the balance of payments.
- other countries may follow and reduce their currency as well.This is unlikely if there is a current account deficit but if the country who devalues has a surplus, other countries are likely to retaliate
- trade tensions, protectionism, and potential disruptions in the global economy
