Balance of trade and exchange rates Flashcards
What are the four components of the financial account of the balance of payments?
- foreign direct investment (in and out)
- portfolio investment (equities and securities)
- other financial assets (eg derivatives)
- reserve assets (eg gold and foreign exchange held by BoE)
Has the UK financial account of BoP been in surplus or deficit since 2000?
surplus
Has the UK current account of BoP been in surplus or deficit since 2000?
deficit
How does UK fund its current account deficit?
selling assets to foreign investors and borrowing abroad (hence surplus on financial account)
What’s the key component of the (small) UK capital account of the BoP?
flows of capital due to migration, eg immigrant brings assets into UK
Name three key causes for deficit on current account of BoP due to more imports than exports.
- weak competitiveness
- inflation
- rapid economic growth
What was the Dollar Standard?
a system of fixed exchange rates where countries pegged their currencies to US dollar that was in place from WW2 to early 70s
Define foreign exchange reserves.
stocks of foreign currency and gold owned by central bank to enable it to meet any mismatch between supply and demand of the country’s currency
If there are fixed exchange rates and demand for exports increases over time, what will that do to foreign exhange reserves?
increase, as central bank has to buy pounds to keep exchange rate fixed
If fixed exchange rates and demand for imports increases over time, what will that do to foreign exhange reserves?
deincrease, as central bank has to sell pounds to keep exchange rate fixed
What is devaluation?
process where a government reduces the price of its currency relative to agreed rate of foreign currency
What is revaluation?
process where a government increases the price of its currency relative to agreed rate of foreign currency
If there’s persistent current account deficits and there’s a fixed exchange rate, what action would a government be likely to take?
devaluation
What effects do fixed exchange rates have on monetary policy?
They control it - have to use monetary policy to keep exchange rate fixed rather than for other objectives.
Does devaluation increase or reduce competitiveness?
increase, a exports now cost less (and imports more)
What is the J-curve effect?
sitatuation following a devaluation in which current account deficit moves further into deficit before improving
What are the two reasons for the J-curve effect?
inelastic domestic supply (so lower price means lower revenue)
inelasticity of demand (so no/little change in demand so lower price means lower revenue)
What is the Marshall-Lerner condition?
that devaluation will have positive effect on current account only if sum of elasticities of demand for exports and imports is less than -1
What is competitive devaluation?
when a country attempts to gain advantage by devaluing its currency, inducing response from other countries and therefore reducing trade overall
What is a floating exchange rate?
system in which exchange rate finds own level in market with no intervention by government or central bank
What was the Exchange Rate Mechanism (ERM)?
system set up by group of European countries in 1979 aiming to keep member countries’ currencies relatively stable against each other
What was the agreed aim for the ERM?
to keep currency within 2.25% of the ECU (European Currency Unit), which was a weighted average of members’ currencies
Was UK part of ERM?
not initially but joined in 1990 then left in 1992
Why did UK leave ERM?
initial rate at which sterling set against the Deutschmark was too high, then reunification made this worse (as substantial capital flowed into Germany), leading to depletion of BoE foreign exchange reserves and high interest rates
What are the four key influences on a floating exchange rate?
- relative interest rates and monetary policy
- relative inflation rates
- net investment into country
- speculation
If interest rates in UK are high relative to others, will this lead to appreciation or depreciation of sterling and why?
appreciation (as more demand for £)
If there is increased quantitive easing in UK, will this lead to appreciation or depreciation of sterling and why?
depreciation, as increased money supply will reduce interest rates and there will be outflows of hot money
What is the purchasing power parity theory of exchange rates?
that, in long run, exchange rates will adjust to offset any changes in relatiev inflation rates
If there is increased demand for exports, will this lead to appreciation or depreciation of sterling and why?
appreciation, as increased demand for sterling
If there is increased net investment into UK, will this lead to appreciation or depreciation of sterling and why?
appreciation, as increased demand for sterling
What is hot money?
stocks of funds moved around the world form country to country in serach of best return
What is a managed float?
when authorities occasionally intervene in a floating exchange rate system to stabilise the currency
What is a futures market?
market where can buy a commodity, eg foreign exchange, at fixed price for delivery at specified future date
What is hedging?
process of buying forwards to reduce risk
What’s the difference between depreciation of currency and devaluation of currency?
depreciation is under floating exchange system
devaluation is under fixed exchange system
What’s the difference between appreciation of currency and revaluation of currency?
appreciation is under floating exchange system
revaluation is under fixed exchange system
What is a real exchange rate?
nominal exchange rate adjusted for differences in relative inflation rate between countries
What is the best indicator to compare productivity between two countries?
GDP per hour worked
What is total factor productivity?
average productivity of all factors measured as total output divided by total input
