6.4 Exchange Rate Systems

Question 1

Exchange rate definition

Answer 1

The price of one currency expressed in terms of another currency

Question 2

What does a higher exchange rate for pounds mean?

Answer 2

That £1 will buy more foreign currency = more foreign goods for cheaper cost

Question 3

Floating exchange rate definition

Answer 3

When the exchange rate is determined by supply and demand and governments make no attempt to influence the value of the currency

Question 4

What are the factors that affect a floating exchange rate?

Answer 4

• interest rates
• foreign trade
• relative inflation
• FDI

Question 5

How do interest rates effect a floating exchange rate?

Answer 5

If interest rates increase relative to those in other economies, there will be an inflow of ‘hot money’ into the UK = increased demand for the pound = rise in value of the currency

Question 6

How does foreign trade effect a floating exchange rate?

Answer 6

• Increased demand for imports would mean an outflow of pounds in order to buy the foreign currency needed to purchase the imports
• increased supply of pounds = fall in exchange rate
  Or
• higher demand for Uk exports = more demand for pound = rise in currency

Question 7

How does relative inflation effect a floating exchange rate?

Answer 7

If UK inflation is higher than other economies = exports less price competitive = reduce demand for exports = lower exchange rate
- (greater supply of pounds and reduced demand for pounds)

Question 8

How does FDI effect a floating exchange rate?

Answer 8

Increasing FDI to the UK will increase demand for the currency = rise in exchange rate

Question 9

Advantages of a floating exchange rate

Answer 9

• gives the monetary policy more freedom to focus on other macroeconomic objectives
• the exchange rate automatically adjusts to economic shocks
• no need for governments to hold extensive stocks of foreign currency for open market operations to influence the currency value

Question 10

Disadvantages of floating exchange rates

Answer 10

• fluctuations in the price of the exchange rate makes investment planning hard
• affects unemployment in a country as exports and imports can change
• speculators may buy or sell currency’s which impact domestic businesses or create cost-push inflation

Question 11

Open market operations

Answer 11

Direct intervention into the foreign currency market to influence the demand for and supply of that currency

Question 12

Fixed exchange rate definition

Answer 12

Where the government intervenes in the foreign exchange market to stabilise a currency’s value against one or more other currencies

Question 13

What are the ways the government can intervene in exchange rates?

Answer 13

• monetary policy
• open market operations
• capital controls

Question 14

What are capital controls?

Answer 14

Restrictions on the quantity of currency that can leave or enter an economy
(Mostly hot money)

Question 15

Advantages of fixed exchange rate

Answer 15

• allows firms to plan investment, as no fluctuations in the exchange rate
• it gives the monetary policy a focused target to work towards

Question 16

Disadvantages of fixed exchange rates

Answer 16

• interest rates cannot be used for domestic purposes = must be kept in line with the economy which their exchange rate is fixed against
• large reserves of foreign currency may be needed for government intervention
• lack of adjustments to current account imbalances

Question 17

Eurozone definition

Answer 17

Those countries using the euro as their currency

Question 18

Currency union definition

Answer 18

A group of countries which share a common currency

Question 19

Arguments in favour of joining a currency union

Answer 19

• no costs involved in converting currencies between members
• no worries about the exchange rate being over-valued or under-valued against others members
• greater price transparency for consumers
• currency is less prone to speculative shocks

Question 20

Arguments against joining a currency union

Answer 20

• monetary policy has to be conducted for the currency union as a whole = may not be in each countries best interest
• businesses may not be able to compete with lower-cost producers that are members of the union and cannot benefit from a falling exchange rate
• one off cost of joining a currency union of changing labels and prices + changing people’s perceptions of cost can be significant