6.1 - Floating Exchange Rates Flashcards
What is an Exchange Rate?
Exchange Rate - The price of one currency in terms of another
What is a Fixed Exchange Rate?
Fixed Exchange Rate - When the price of one currency in terms of another is set and maintained by central authorities
What is a Floating Exchange Rate?
Floating Exchange Rate - When the price of one currency in terms of another is determined purely by the forces of demand and supply
Q: What are the factors that can cause an appreciation of a floating exchange rate?
A: Several factors can cause an appreciation of a floating exchange rate:
Q: How does an increase in incomes abroad affect the exchange rate?
A: An increase in incomes abroad (outside the UK) can lead to an appreciation of the pound. As incomes abroad rise, the marginal propensity of foreigners to buy UK goods and services also increases. This results in higher demand for UK exports and, consequently, an increased demand for the pound. The demand curve for the pound shifts to the right from D1 to D2, causing the pound to appreciate in value from P1 to P2.
Q: How does a relative rise in UK interest rates affect the exchange rate?
A: A relative rise in UK interest rates compared to the rest of the world can cause the pound to appreciate. When UK interest rates increase and become relatively higher than in other countries, investors seeking the best interest rates for their money are more likely to save their money in UK banks. This inflow of “hot money” into the UK economy increases the demand for the pound. The demand curve for the pound shifts to the right from D1 to D2, resulting in an appreciation of the pound from P1 to P2.
Q: How does an increase in foreign direct investment (FDI) in Britain affect the exchange rate?
A: An increase in foreign direct investment (FDI) in Britain leads to higher demand for the pound. As more FDI enters Britain, foreign businesses need to buy capital goods, such as machinery, vehicles, factories, and buildings, in pounds to operate in the UK. Additionally, staff members must be paid in pounds, requiring an exchange of foreign currency into pounds. These factors increase the demand for pounds, shifting the demand curve for the pound to the right from D1 to D2, causing the pound to appreciate in value from P1 to P2.
Q: How does speculation in anticipation of a rise in the pound affect the exchange rate?
A: Speculators who anticipate a rise in the pound buy more pounds in the present, increasing the demand for the currency. Speculators are individuals who gamble on changes in exchange rates to make a profit. If speculators expect the pound to rise in value, they purchase more pounds, creating additional demand for the currency. When the pound appreciates as anticipated, they sell it, earning a profit on the trade. This speculative activity shifts the demand curve for the pound to the right from D1 to D2, leading to an appreciation of the pound from P1 to P2.
Q: How does an improvement in international competitiveness affect the exchange rate?
A: If UK exports become more price or non-price competitive, there will be an increase in demand for them. As UK goods must be purchased using pounds, the demand for pounds also rises. This increase in demand for the pound shifts the demand curve for the currency to the right from D1 to D2, causing the pound to appreciate from P1 to P2. Factors that can contribute to improved international competitiveness include enhanced labor productivity, increased investment, and lower relative inflation rates.
Q: How does high investor confidence in the economy affect the exchange rate?
A: High investor confidence in the long-term state of the UK economy, coupled with low economic volatility, leads to increased demand for the pound. When investors perceive the UK as a safe and reliable place to store or invest their money, they seek a good rate of return. This heightened investor confidence results in greater demand for the pound as more UK assets, both financial and non-financial, are acquired. The demand curve for the pound shifts to the right from D1 to D2, causing the pound to appreciate in value from P1 to P2.
Q: How does UK businesses investing abroad affect the exchange rate?
A: When UK businesses decide to invest abroad, they need to sell the pound in order to acquire foreign exchange to invest in the foreign country. This increases the supply of the pound in the foreign exchange market. The supply curve of the pound shifts to the right from S1 to S2, causing the pound to depreciate in value from P1 to P2. The increase in the supply of pounds results from the conversion of the currency into foreign exchange to facilitate investment activities outside the UK.
Q: How does speculation in anticipation of a fall in the pound affect the exchange rate?
A: Speculators who anticipate a fall in the pound sell their pounds in the present to avoid future losses when the currency depreciates. This increased selling of the pound in the foreign exchange market increases its supply. The supply curve of the pound shifts to the right from S1 to S2, leading to a depreciation of the pound from P1 to P2. Speculators engage in this behavior to protect themselves from potential losses associated with a currency’s decline in value. The increased supply of pounds reflects their selling activity as they convert the currency into other currencies.
Q: How does an increase in domestic incomes affect the exchange rate?
A: If incomes in the UK rise due to a domestic boom, the marginal propensity to import also increases. This means that UK consumers have a greater propensity to import goods and services. To purchase imports, they need to sell the pound and acquire foreign currency. The increased demand for foreign currency leads to an increased supply of the pound in the foreign exchange market. The supply curve of the pound shifts to the right from S1 to S2, causing the pound to depreciate in value from P1 to P2. The increase in the supply of pounds reflects the selling activity required to purchase imports in foreign currency.
Q: How does a fall in relative interest rates affect the exchange rate?
A: If relative interest rates in the UK fall compared to other countries, investors may decide to move their money out of UK financial institutions in search of better interest rates elsewhere. This leads to “hot money” outflows from the UK. As investors convert their pounds into other currencies, the supply of pounds in the foreign exchange market increases. The supply curve of the pound shifts to the right from S1 to S2, resulting in a depreciation of the pound from P1 to P2. The increased supply of pounds reflects the selling activity required to move funds out of UK financial institutions in pursuit of higher interest rates available in other countries.
Q: How does low investor confidence in the economy affect the exchange rate?
A: When investors have low confidence in the UK economy, perceiving it as weak, fragile, or volatile, they tend to sell the pound to seek more stable and reliable rate of return elsewhere. This selling activity leads to an increased supply of pounds in the foreign exchange market. The supply curve of the pound shifts to the right from S1 to S2, causing the pound to depreciate in value from P1 to P2. The increased supply of pounds reflects investors’ conversion of the currency into other currencies as they seek investment opportunities in more favorable economic conditions.
