6.4 Exchange Rate Systems Flashcards
Exchange rate definition
The price of one currency expressed in terms of another currency
What does a higher exchange rate for pounds mean?
That £1 will buy more foreign currency = more foreign goods for cheaper cost
Floating exchange rate definition
When the exchange rate is determined by supply and demand and governments make no attempt to influence the value of the currency
What are the factors that affect a floating exchange rate?
- interest rates
- foreign trade
- relative inflation
- FDI
How do interest rates effect a floating exchange rate?
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
How does foreign trade effect a floating exchange rate?
- 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
How does relative inflation effect a floating exchange rate?
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)
How does FDI effect a floating exchange rate?
Increasing FDI to the UK will increase demand for the currency = rise in exchange rate
Advantages of a floating exchange rate
- 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
Disadvantages of floating exchange rates
- 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
Open market operations
Direct intervention into the foreign currency market to influence the demand for and supply of that currency
Fixed exchange rate definition
Where the government intervenes in the foreign exchange market to stabilise a currency’s value against one or more other currencies
What are the ways the government can intervene in exchange rates?
- monetary policy
- open market operations
- capital controls
What are capital controls?
Restrictions on the quantity of currency that can leave or enter an economy
(Mostly hot money)
Advantages of fixed exchange rate
- allows firms to plan investment, as no fluctuations in the exchange rate
- it gives the monetary policy a focused target to work towards
Disadvantages of fixed exchange rates
- 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
Eurozone definition
Those countries using the euro as their currency
Currency union definition
A group of countries which share a common currency
Arguments in favour of joining a currency union
- 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
Arguments against joining a currency union
- 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
