6.3 - Foreign Exchange Rates Flashcards
What is an exchange rate?
The value of one currency in terms of another
What is appreciation?
A rise in the value of an exchange rate
What is a depreciation?
A fall in the value of an exchange rate
What are the 2 types of exchange rates?
Floating exchange rate - an exchange rate which can frequently change as it is determined by market forces
Fixed exchange rate - An exchange rate whose value is set at a particular level in terms of another currency and this level is actively managed by the government and or central
How does a floating exchange rate system work?
Different currencies can be bought & sold, just like any other product
The forces of demand & supply determine the rate at which one currency exchanges for another
As with any market, if there is excess demand for the currency on the forex market, then prices rise (the currency appreciates)
If there is an excess supply of the currency on the forex market, then prices fall
How does a fixed rate system work?
A system in which the country’s Central Bank intervenes in the currency market to fix (peg) the exchange rate in relation to another currency e.g US$
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
What causes the changes in demand and supply of a currency?
Bank of England - Hot money flows : The movement of money around the world to take advantage of differences in interest rates.
MNC’S - Foreign direct investment : An increase in investment in the country arising from a MNC setting up production plant can also cause the prices of currency to rise
Speculation : If it is believed that the currency will rise in price, speculators will act in a way that will help bring about their expectation by buying the currency
Balance of payments - Trade balance position : demand for exports results in a increased demand for the currency, whereas the demand for imports requires the domestic currency to be sold.
How can a fall in the rate interest rate affect a country’s exchange rate?
A fall in the rate of interests may increase spending on imports as the reward for saving decreases. This will increase the supply of the domestic currency resulting in a depreciation of the currency.
A fall in the rate of interest may disincentives foreigners from investing money into the country’s banks and this will reduce the demand for the currency, which results in a depreciation of the currency
Some domestic residents may decide to move funds abroad known as hot money flows. This will increase the supply of the currency and the currency will depreciate
A fall in the rate of interest may encourage foreign firms to invest in the country and spend more on capital goods. This will increase the demand for the currency and appreciate the exchange rate.
What are the advantages of a floating exchange rate mechanism?
Natural fluctuations in the exchange rate based on demand & supply help to maintain stable current account balances
If a currency appreciates, the country’s exports fall & imports rise
If a currency depreciates, the country’s exports rise & imports fall
Currency appreciation may allow costs of imported raw materials to decrease which may help lower prices in the economy
Lower exchange rates (or a depreciating currency) may help to increase economic growth as export sales increase
Government does not need to monitor & maintain a fixed exchange rate
What are the disadvantages of a floating exchange rate mechanism?
Fluctuations in the exchange rate can create uncertainty for firms, leading to a reduction in investment
Currency depreciation may cause costs of imported raw materials to increase resulting in cost push inflation
Higher exchange rates (or an appreciating currency) may reduce/slow down economic growth as export sales decrease
What are the advantages of a fixed exchange rate mechanism?
Even with an increasing demand for a country’s exports, the price of its exports will remain fixed as the currency will not appreciate with more demand
This can boost export sales over time
Firms (foreign & domestic) benefit as they can agree prices with a high level of certainty as the exchange rate will not fluctuate
What are the disadvantages of a fixed exchange rate mechanism?
In order to maintain the fixed exchange rate, the Central Bank has to regularly intervene in the currency market by buying or selling its own currency
This can be an expensive policy to maintain
Changing the interest rate can also influence the exchange rate
Changing the interest rate to maintain a fixed exchange rate can have negative consequences on consumption, investment, lending, saving & borrowing
What happenes to the economy when the currency appreciates?
Imports will increase as pound is worth more exports will decrease as it will cost more to consumers output goes down and unemployment goes up living standards and income goes down and GDP go down meaning economic growth goes down.
What happenes to the economy when the currency depreciates?
Exports will increase as it costs less to purchase to common goods
What are factors that influences the floating exchange rates?
Relative interest rates - Influences the flow of hot money between countries. If UK increases its interest rate then demand for pound by foreigners investors increase and appreciates. If depreciates interest rate then supply increases investors sell their pounds in favours of other countries currencies.
Relative inflation rates - : as inflation in the UK rises relative to other countries, its exports become more expensive so there is less demand for UK products by foreigners, which means there is less demand for £s & so the £ depreciates
Net investment: foreign direct investment (FDI) into the UK creates a demand for the £ which leads to the £ appreciating. FDI by UK firms abroad creates a supply of £’s which leads to the £ depreciating
MNCs: An increase in the number of MNCs globally will result in more money flows between countries, each of which influences exchange rates
