6.4 Exchange Rate Systems Flashcards
1
Q
What is the exchange rate of a currency?
A
- the weight of one currency relative to another.
2
Q
How exchange rates are determined in freely floating exchange rate systems?
A
- by the forces of supply and demand.
- In a floating exchange rate system, the market equilibrium price is at P1. When demand increases from D1 to D2, the exchange rate appreciates to P2.
- The demand for a currency=exports+capital inflows.
- The supply of a currency=imports+ capital outflows.
3
Q
How can governments intervene to influence the exchange rate?
A
- By a fixed exchange rate system
- By a manger exchange rate system
4
Q
What is a fixed exchange rate system?
A
- A fixed exchange rate has a value determined by the government compared to other currencies.
- In a fixed exchange rate system, the supply of the currency can be manipulated by the central bank, which can buy or sell the currency to change the price to where they want.
- On a diagram, the supply has been increased S1 to S2 by selling the currency so more is on the market Q1 to Q3.
-The currency depreciates as a result (P2 - P3), which makes exports more competitive.
5
Q
What is a managed exchange rate system?
A
- Combine the characteristics of fixed and floating exchange rate systems.
- The currency fluctuates, but it doesn’t float on a fully free market.
-This is when the exchange rate floats on the market, but the central bank of the country buys and sells currencies to try and influence their exchange rate. - For example the Japanese central bank has also attempted to make exports more competitive by manipulating the Yen, even though the Yen floats on the market.
- The Indian rupee fluctuates on the market, but the central bank intervenes when it falls outside a set range.
- Governments might try and influence their currency, such as by maintaining a fixed exchange rate.
6
Q
What is the impact of interest rates and the exchange rate system?
A
- An increase in interest rates, relative to other countries, makes it more attractive to invest funds in the country because the rate of return on investment is higher (FDI)
- This increases demand for the currency, causing an appreciation.
- This is known as hot money.
7
Q
What is the impact of Quantitative easing and the exchange rate?
A
- This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective.
- This has inflationary effects since it increases the money supply, and it can reduce the value of the currency.
- QE is usually used where inflation is low and it is not possible to lower interest rates further.
8
Q
What is the impact of foreign current transactions and the exchange rate system?
A
- The Bank of England uses this to manage the UK’s gold and foreign currency reserves, as well as managing the MPC’s pool of foreign currency reserves.
- It involves buying and selling foreign currency to manipulate the domestic currency.
- China kept large reserves of the US Dollar by purchasing government bonds, in order to undervalue the Yuan.
9
Q
What are the advantages of fixed exchange rate systems?
A
- Allows for firms to plan investment, because they know that they will not be affected by harsh fluctuations in the exchange rate.
- It gives the monetary policy a focused target to work towards.
- Reductions in the cost of trade (reduced hedging)
- Lower exchange rate uncertainty
10
Q
What are the disadvantages of fixed exchange rate systems?
A
- The government and the central bank do not necessarily know better than the market where the currency should be.
- The balance of payments does not automatically adjust to economic shocks.
- It can be costly and difficult for the government to hold large reserves of foreign currencies.
- Speculative attacks if the exchange rate is set too high or too low
11
Q
What are the advantages of floating exchange rate systems?
A
- Reduced need for currency reserves
- The exchange rate automatically adjusts to economic shocks.
- It gives the monetary policy more freedom to focus on other macroeconomic objectives.
- Acts as an automatic macroeconomic stabiliser
12
Q
What are the disadvantages of a floating exchange system?
A
- Reduced certainty -there is reduced price/cost certainty for imports and exports leading to decreased trade and decreased FDI
- Increased speculation- which can lead to large fluctuations in the exchange rate and macroeconomic instability
- Less protection from the economic shock from imported inflation -occurs when a fall in the value of the currency leads to an increase in the costs of imports, some of which may be essential (food, oil, etc)
13
Q
List and explain 2 points of evaluation for whether a fixed or floating exchange rate is more beneficial
A
- How economically developed the country is:
-many developing countries do not have sufficient foreign currency reserves to be able to maintain a fixed exchange rate - How export driven the economy is: if you rely heavily on exports
-(e.g. China) fixed may be better. If you rely more on domestic growth, floating may be better
14
Q
What is a currency/monetary union?
A
- An intergovernmental agreement that involves two or more countries sharing the same currency
15
Q
What is the impact of a currency union?
A
- This is more economically integrated than a customs union and free trade area.
-The Eurozone is an example of this. - A common central monetary policy is established when a monetary union is formed.
- Monetary unions use the same interest rate.
-The Euro, for example, floats against the US Dollar and the Pound Sterling. - Member nations are required to control their government finances, so budget deficits cannot exceed 3% of GDP.
-This is one of the four convergence criteria countries have to meet in order to join the Euro. - The other three are:
- Gross National Debt has to be below 6% of GDP
- Inflation has to be below 1.5% of the three lowest inflation countries
- The average government bond yield has to be below 2% of the yield of the
countries with the lowest interest rates-ensures there can be exchange rate stability.
