6.3 - Foreign Exchange Rates

Question 1

Exchange rate

Answer 1

The price of one currency in terms of another

Question 2

International currencies

Answer 2

Essentially products that can be bought & sold on the foreign exchange market (forex)

Question 3

What controls the exchange rate system of a country?

Answer 3

The central bank

Question 4

Floating exchange rate

Answer 4

A system in which demand and supply determine the rate at which one currency exchanges for another

Question 5

Fixed exchange rate

Answer 5

A system in which the Central Bank intervenes in the currency market to fix the exchange rate in relation to another currency

Question 6

Currency appreciation

Answer 6

Excess demand for the currency on the forex market -› price rises

Question 7

Currency depreciation

Answer 7

Excess supply of the currency on the forex market -› price falls

Question 8

How does the Central Bank influence appreciation or depreciation?

Answer 8

• When they want their currency to appreciate, they buy it on forex markets using their foreign reserves, thus increasing its demand
• When they want their currency to depreciate, they sell it on forex markets, thus increasing its supply

Question 9

Revaluation

Answer 9

If the Central Bank decides to change the peg and increase the strength of its currency

Question 10

Devaluation

Answer 10

If the Central Bank decides to change the peg and decrease the strength of its currency

Question 11

Advantages of floating exchange rate (name 3)

Answer 11

• Natural fluctuations in exchange rate based on demand and supply help maintain stable current account balances
• Appreciation may lower costs of imported materials -› help lower prices in the economy
• Lower exchange rate (depreciation) may increase economic growth as export sales increase
• Government does not need to monitor a fixed rate

Question 12

Disadvantages of floating exchange rate (3)

Answer 12

• Fluctuations can create uncertainty for firms -› reduction in investment
• Depreciation may cause increase in costs of imported raw materials -› cost push inflation
• Higher exchange rates (appreciation) may slow down economic growth as exports decrease

Question 13

Advantages of fixed exchange rate (2)

Answer 13

• Even if demand increases for exports, price will remain the same -› boost export sales over time
• Firms benefit: agree in prices with a high level of certainty as they know it will not fluctuate

Question 14

Disadvantages of fixed exchange rate (2)

Answer 14

• To maintain fixed exchange rate, central bank has to regularly intervene in the currency market by buying or selling its own currency -› can be an expensive policy to maintain
• Changing interest rate can also influence exchange rate -› can have negative consequences on consumption, investment, lending etc.

Question 15

Causes of exchange rate fluctuations (name and explain 4)

Answer 15

• Relative interest rates: influence short term investment in currency (flow of hot money)
• Relative inflation rates: higher inflation -› less demand for exports -› depreciation
• Net investment: foreign direct investment -› increases demand for currency -› appreciation
• The current account: as the exports are payed in the country’s currency and imports are payed in local currencies, increasing net exports -› appreciation, falling net exports -› depreciation
• Changes in tastes/preferences: upward pressure on currency as demand rises
• Speculation: traders buy a currencyin expectation that it will be worth more -› seell it to make profit
• Quantitative easing: increasing money supply to buy back gilts, many owned by foreigners -› increase supply of currency -› depreciation
• MNCs: increase in number of MNCs -› more money flows between countries

Question 16

Consequences of foreign exchange rate fluctuations

Answer 16

• Current account
• Economic growth
• Inflation
• Unemployment
• Living standards
• Foreign direct investment