A2 exchange rate systems

Question 1

CASE STUDY: FILL IN

Gothabaya Rajabaksha reduced the value of Sri Lankan _______ in order to ________ with IMF to restructure its debt and to boost its currency reserves.

Consequences:

eroded purchasing ____ as prices of imports soared. Sri Lanka in 2021 was forced to import rice due to a 50% fall in produce following a ban on fertiliser, this raised price of rice by 93% and lentils by 111%

NOTE: Agriculture produce accounts for 8% of country’s GDP

Answer 1

rupees, negotiate, power

Question 2

Exchange rate

Answer 2

The value or price of a currency expressed in terms of another currency

Or

The number of units of foreign currency that can be purchased with one unit of domestic currency.

Question 3

Why is there demand for the pound sterling ?

Answer 3

Consumers and firms in another country DEMAND sterling to make investments or buy goods and services in the UK

Question 4

How is there supply of the sterling?

Answer 4

Consumers and firms in the UK SUPPLY sterling to acquire the currency of a country they wish to trade or invest with.

Question 5

Why is the foreign currency demand curve downward sloping?

Answer 5

RISE in exchange rate assuming ceteris paribus this would cause quantity demanded to reduce.

FALL in exchange rate, quantity demanded can rise as goods are cheaper

Question 6

Why upward sloping supply curve for foreign currency market?

Answer 6

as the supply price of sterling falls the quantity supplied falls too

Supply price rises the quantity supply rises too.

When the price of a foreign currency rises, then the purchasing power of the foreign currency rises when it comes to buying imported goods and services.

Question 7

exchange rate is determined

Answer 7

by intersection of demand and supply of currency

Question 8

Exchange rate diagrams

Answer 8

y axis: other country currency / our currency

x axis : quantity of currency

Question 9

depreciation of currency represented by either

Answer 9

demand for currency falls
supply for currency rises

Question 10

appreciation of currency represented by either

Answer 10

demand for currency rises
supply for currency falls

Question 11

Fixed exchange rate

Answer 11

an exchange rate fixed at a certain level by the country’s central bank and maintained by the central bank’s intervention in the foreign exchange market

Question 12

Exchange rate depreciation factors

• due to outflows (e.g. rise in import spending)

Answer 12

1. Inflation is high relative to other countries
2. Interest rate falling relative to other countries
3. Confidence in the UK falling

• e.g. importance of the UK’s credit ratings, CAD may be a sign that an economy is uncompetitive.

Question 13

Exchange rate appreciation factors :

• due to inflows (e.g. export spending rises)

Answer 13

1. Inflation low relative to other countries
2. Interest rate rising relative to other countries (HOT MONEY)
3. Confidence in UK rising

• e.g. CAS is a good sign for investors can be a sign economy is competitve, UK credit ratings etc.

Question 14

Effective exchange rates

Answer 14

an index that measures the average movement of an exchange rate on the basis of weightings determined by the value of trade with a country’s main trading partners.

Question 15

Exchange rate index case study

Answer 15

Between 01 Aug 2007 to 01 May 2009 (the hit of the 2007-8 recession) resulted in massive dips in confidence - large outflows of income as consequence the sterling effective exchange rate index fell dramatically from around 105 to below 80

Question 16

Effective exchange rate index recent case study

Answer 16

The existing effective exchange rate index is based on trade patterns in manufactured goods in 1989-91.

The Bank of England will be publishing the new effective exchange rate index on a regular basis from Spring 2005 to reflect current patterns of trade, incorporate trade in services and a broader set of countries including those in Asia

Question 17

Bilateral exchange rate

Answer 17

is the comparison of one currency against another. e.g sterling value against euro

Question 18

Free floating exchange rate

Answer 18

where the exchange rate is determined solely by market forces and is not influenced by direct intervention by central banks.

Question 19

Advantages of free floating exchange rate system

Answer 19

1. Monetary policy autonomy (able to adjust interest rates and size of QE to address growth, inflation and unemployment without being constrained by exchange rate considerations.)
2. Shock Absorption
   (A recession cause exchange rate to depreciate boosts export businesses and domestic firms facing import conditions which rebalances the economy)
3. Trade Balance Adjustment
   (a country is running a large trade deficit, currency depreciates exports boost price competitive and imports more expensive narrows deficit. EV: depends on the price elasticity of demand for exports and imports and the elasticity of supply of domestic firms.)
4. Currency reserves
   (Central bank does not need to hold large foreign currency reserves because there is no specific currency target, financial capital can flow freely across countries seeking the best returns)

Question 20

What factors determine a currency’s value?

Answer 20

1. Trade balances
2. Foreign Direct investment
3. Portfolio Investment
4. Interest rate differentials

Question 21

Disadvantages of free floating exchange rate systems

Answer 21

1. Exchange rate volatility
   (Currencies can experience rapid and unpredictable fluctuations, brings uncertainty for businesses in International trade and investment)
2. Inflation pass-through
   (Exchange rate fluctuations can lead to changes in import prices, impacts domestic inflation. A significant depreciation can contribute to imported inflation and erode real purchasing power)
3. Loss of exchange rate as a policy tool
   (While countries gain monetary policy autonomy they lose the ability to manage the exchange rate as a deliberate tool to influence trade and competitiveness.)

Question 22

Advantages of fixed exchange rate systems

Answer 22

1. Price stability
   (Since fluctuations in the exchange rate are minimised this helps control inflation and provide a predictable environment for businesses and consumers - improves confidence and price stability)
2. Trade confidence
   (Businesses can plan for transactions without worrying for sudden currency value changes. Cross border trade becomes more predictable and manageable.)
3. Foreign investment
   (A stable exchange rate attracts foreign investment as the country has predictable currency values reducing the risk associated with currency fluctuations)
4. Allows companies to engage in investments trade and long term contracts as fixed exchange rate eliminates currency risk

Question 23

Disadvantages of fixed exchange rate systems

Answer 23

1. Lack of flexibility
   (external economic shocks. Countries cannot independently adjust their exchange rates to address changing economic conditions.)
2. Loss of monetary policy autonomy
   (The country may be forced to adopt monetary policies that are not necessarily suited to its specific economic circumstances.)
3. Dependence of foreign exchange reserves
   (a country needs to have sufficient foreign exchange reserves. If reserves are inadequate, the country might struggle to defend the peg during times of market stress.)

Question 24

Explain why a currency may fall in a floating exchange rate system. (15marks)

Answer 24

1. Value of the currency is determined by the demand and supply of the currency

Here a depreciation occurs when currency demand falls and supply rises

2. Identify and explain a demand for currency falls (exports fall, tourism falls, inward FDI falls, interest rate falls - outflow of hot money)
3. Identify and explain why supply rises (rise in import spending, rise in FDI abroad, rise in tourism abroad, fall in interest rate - outflow of hot money)

Using a currency diagram here would help you can do for either demand or supply here and choose to do either 2 demand & 1 supply point or vies versa.

Question 25

Role of reserve currency

Answer 25

1. International Trade and Payments
   (Reserves are used to settle international trade and payments. When a country imports goods or services, it needs to pay in foreign currencies. Reserves provide the necessary funds to fulfill these obligations without putting excessive pressure on the domestic currency’s value.)
2. Exchange Rate Stability
   (Reserves can be used to intervene in the foreign exchange market to stabilize the value of the domestic currency. If the domestic currency is depreciating rapidly, the central bank can sell foreign currency from its reserves to buy back the domestic currency, which helps prevent excessive volatility and sharp declines in the currency’s value.)
3. Investment Opportunities (Some countries invest a portion of their foreign currency reserves in safe and liquid assets denominated in foreign currencies. These investments can generate income for the country and provide a potential source of returns.)

Question 26

what is the effect of a depreciation in the value of the pound sterling? (name 5 winners & losers)

Answer 26

winners
- exporters
- domestic tourist industry
- workers gaining jobs in export industry
- economic growth may increase
- current account deficit improves

losers
- consumers who buy imports (expensive)
- residents who holiday abroad
- firms buying imported raw materials
- fixed wage/income individuals see inflation rise faster
- foreign exporters/ tourist industry

Question 27

summarize benefits and drawbacks of depreciation of pound sterling

Answer 27

A depreciation in exchange rate makes exports more competitive and imports more expensive.

A depreciation helps UK exporters and improves UK growth prospects.

But causes higher prices and inflation.

Question 28

summarize effects of appreciation of pound sterling

Answer 28

A higher value of sterling makes US imports cheaper for British consumers, but, UK exports become more expensive.

An appreciation in the exchange rate will tend to reduce aggregate demand (assuming Price Elasticity for imports is relatively elastic) Because exports will fall and imports increase.

An appreciation is likely to worsen the current account (assuming Marshall Lerner condition and demand is relatively elastic)

Question 29

what is the Marshall Lerner condition

Answer 29

states that the devaluation will improve the balance of trade if the sum of price elasticity of exports and imports is greater than 1.

Question 30

how does the Marshall Lerner condition work?

Answer 30

if the demand for a country’s exports and imports is more sensitive to changes in price (is elastic = greater than 1) then a devaluation would make these goods and services cheaper, which would in theory increase demand for their exports and reduce demand for imports which improves the net balance of trade.

Question 31

what factors allow appreciation to reduce inflation

Answer 31

import prices low - improves SRAS

incentive for firms to cut costs - their exports are more expensive (demands on the price elasticity of their export)

Question 32

EVALUATE changes in the exchange rate on businesses

Answer 32

1. Elasticity of demand

(are their exports price elastic or inelastic: If UK firms are selling goods which are price inelastic, then the fall in their foreign price will only have a relatively small increase in demand. )

2. Economic growth in other countries

CASE STUDY: 2009/10, there was a significant depreciation in the value of the Pound. However, the global economy (and EU in particular) was in recession, therefore, demand for UK exports remained weak – despite the lower price.

3. Fixed contracts

There can be time lags between changes in the exchange rate and changing costs for business. Many businesses use fixed contracts to buy raw materials so exchange rate fluctuations may have little effect on SRAS as price of buying imports will be set up to 12 or 18 months ahead.

4. It depends why there was an appreciation/depreciation.

If due to UK labour productivity increasing, firms are likely to be able to absorb the stronger Pound (more profits, dynamic efficiency, reduce costs, economies of scale etc). However, due to speculative attacks or weakness of other countries (e.g. Euro crisis in 2011) then firms may become uncompetitive because the rise in the value of Pound is not related to increased productivity and competitiveness.

Question 33

will exchange rate depreciation ALWAYS lead to inflation. explain why not

Answer 33

During 2007 and 2008, we see that the value of the pound in sterling exchange rate index shows a depreciation by 20% this in theory should have caused inflation, which did occur in the end of 2008 but

Question 34

Currency union aka Monetary union

Answer 34

a group of countries that share a common currency which means that they have a single monetary policy and exchange rate

Question 35

Optimal currency areas

Answer 35

is a geographical region in which it is optimal for all member states to adopt a single currency rather than several independent national currencies. E.g. Eurozone - currently has 20 member countries

Question 36

Why are OCA criteria (Optimal currency areas) important?

Answer 36

This criteria is used to evaluate a region’s suitability for monetary union

Question 37

Criteria for OCA (Optimal Currency Area)

Answer 37

1. Symmetry of shocks
2. Integration (openess to trade)
3. Labour mobility
4. Fiscal transfers

Question 38

Symmetry of shocks

Answer 38

Refers to the similarity of member states business cycles. (are member countries experiencing booms at the same time or recessions??)

Question 39

As asymmetric shocks rises this….

Answer 39

reduces the stability of the eurozone

Question 40

Disadvantage of currency union

1. A key issue of currency unions is asymmetric shocks.

Answer 40

If all eurozone member states are experiencing a boom except for one, regardless of its required monetary policy the euro central bank would impose the same monetary policy in favour of majority.

Reduces countries monetary policy autonomy.

Question 41

Intergration

Answer 41

refers to the amount of intra-union trade amongst currency union member countries

Question 42

What is the ROSE EFFECT?

Answer 42

Is the perceived increase in intra-union trade that should occur when a country decides to become part of a single currency.

Question 43

Advantage of joining currency union:

1. Integration would boost intra-union trade via the rose effect

Answer 43

Adoption of a single currency
Eliminates FX risk
Increases certainty and stability
Lower transaction costs (no exch rate)
Boost intra-union trade
This is called the Rose Effect

Question 44

Labour mobility

Answer 44

refers to the ease in which laborers are able to move around within an economy and between different economies.

Question 45

Advantage of joining currency union

2. Intra-union labour mobility could offset cost of loss of national monetary policy

Answer 45

unemployed workers in a country experiencing a recession can move to a country experiencing a boom as there are lots of job opportunities. This would allow the boom’s affects on economic growth to be more sustainable and reduce inflationary pressures

Question 46

EV: barriers for point….

2. Intra-union labour mobility could offset cost of loss of national monetary policy

Answer 46

Language barriers
Cultural barriers
Skills barriers

Question 47

Fiscal transfers

Answer 47

refers to a fiscal system to redistribute income, this can be in the form of increased taxation in one region to finance developments in another or simply by increasing government spending in a region.

Question 48

Give an example of an OCA (Optimal currency area)

Answer 48

US
- Made up of 50 states
- Central bank = federal reserve

Question 49

Integration EV

Answer 49

Possibility of Insufficient rose effect
(joining a currency union may not increase intra-union trade as perceived)

due to

border effect

Question 50

Border effect

Answer 50

Trade between two different countries seperated by a border is lower than trade between states with a country

Question 51

Features of a Currency/Monetary union

Answer 51

• Single currency
  (Euro)
• A single union-wide central bank
  (ECB- European Central Bank)
• Fixed Exchange rates
  (between members - same currency)
• Capital Mobility