6.3, 6.4 Foreign Exchange Rates & The Current Account

Question 1

Explain floating exchange rates

Answer 1

• Different currencies can be bought and sold
• Determined by demand and supply
• Excess demand –> currency appreciates, excess supply –> currency depreciates

Question 2

Explain fixed exchange rates

Answer 2

• Central Bank intervenes to fix (peg) the exchange rate in relation to another currency
• Want to appreciate –> buy currency on forex markets –> increase demand
• Want to depreciate –> sell currency on forex markets –> increase supply

Question 3

What are the advantages of a floating exchange rate?

Answer 3

• Natural fluctuations help to maintain stable current account
• Appreciation –> costs of imports decrease
• Depreciation –> exports increase (economic growth)
• Government doesn’t need to monitor fixed exchange rate

Question 4

What are the disadvantages of a floating exchange rate?

Answer 4

• Fluctuations can create uncertainty
• Depreciation –> costs of imports increase (cost-push inflation)
• Appreciation –> exports decrease (slow down economic growth)

Question 5

What are the advantages of a fixed exchange rate?

Answer 5

• Price remains fixed even if demand increases, boosts export sales
• High level of certainty

Question 6

What are the disadvantages of a fixed exchange rate?

Answer 6

• Central Bank must regularly buy/sell own currency (expensive)
• Interest rate affects exchange rate (changing interest to keep exchange rate fixed has negative consequences on economy)

Question 7

What are the causes of exchange rate fluctuations?

Answer 7

• Relative interest (increases –> appreciation)
• Inflation (increases –> depreciation)
• Investment (increases –> appreciation)
• Quantitative easing (increases –> depreciation)
• Changes in tastes/preferences
• Speculation
• MNCs

Question 8

What are the consequences of exchange rate fluctuations?

Answer 8

• The current account (appreciates –> down exports, up imports), economic growth
• Inflation (depreciation –> cost push inflation)
• Unemployment, living standards (affected by exports)
• Depreciation –> more foreign direct investment

Question 9

How is the current account calculated?

Answer 9

Question 10

What causes current account deficits?

Answer 10

• Low productivity (lowers exports)
• Appreciation (lowers exports, increases imports)
• Inflation (lowers exports, increases imports)
• Rapid economic growth (increases imports)
• Non-price factors: poor domestic quality/design (lowers exports, increases imports)

Question 11

What causes current account surpluses?

Answer 11

• High productivity (increases exports)
• Depreciation (increases exports, lowers imports)
• Low inflation (increases exports, lowers imports

Question 12

What are the consequences of current account deficits?

Answer 12

• Increasing unemployment
• Fall in GDP (possible recession), lower standards of living
• Higher borrowing (if deficit is from imports, imports payed off through borrowing)
• Rising imports –> depreciation

Question 13

What are the consequences of current account surpluses?

Answer 13

• Increasing employment
• Economic growth, higher standards of living
• Demand pull inflation
• Rising exports –> appreciation

Question 14

What can be done to stabilise the current account balance?

Answer 14

• Nothing (allow market forces to correct it)
• Expenditure switching policies: protectionism, depreciate currency
• Expenditure reducing policies: Raise taxes, raise interest
• Supply-side policies: Investment in education/infrastructure

Question 15

What are the pros and cons of doing nothing to stabilise the current account balance?

Answer 15

• Pros: self-correcting system
• Cons: May be external factors, takes a long time (firms go bust in the meantime)

Question 16

What are the pros and cons of expenditure switching policies to stabilise the current account balance?

Answer 16

• Pros: changes consumers’ buying habits, spend more on domestic goods than imports, improves deficit
• Cons: Protectionism can lead to retaliation by trading partners, may offset improvement

Question 17

What are the pros and cons of expenditure reducing policies to stabilise the current account balance?

Answer 17

• Pros: reduces the amount consumer have to spend on imports, improves deficit
• Cons: demand falls, output falls, GDP falls & unemployment may increase

Question 18

What are the pros and cons of supply-side policies to stabilise the current account balance?

Answer 18

• Pros: improves quality/lowers costs, makes exports more attractive
• Cons: long term (time delay), opportunity cost