Ch-4 Exchange Rate And It's Economic Effects

Question 1

Q2) what are different types of exchange rate regimes ? Or list the point of indifference between fixed exchange rate and floating exchange rate ?

Answer 1

🔷 there are two major types of exchange rate regimes at the extreme ends ; namely :

FLOATING EXCHANGE RATE REGIME (ALSO CALLED AS FLEXIBLE EXCHANGE RATE)

1) Under floating exchange rate regime, the equilibrium value of the exchange rate of a country’s currency is market-determined i.e the demand and supply forces determine the exchange rate.
2) There is no predetermined target rate and the exchange rates are likely to change as per changing demand and supply .
3) There is no interference on the part of the government or the central bank of the country in the determination of exchange rate.
4) nearly all advance economics follow floating exchange rate regimes. ( For example newzealand, Sweden, and the United States. )
5) a floating rate has greater flexibility, but less stability.

FIXED EXCHANGE RATE

1) a fixed exchange rate, also referred to as pegged exchange rate , is an exchange rate regime under which a country’s Central Bank and / or government announces what its currency will be worth in terms of another country’s currency. Hence we can say that it is not market determined.
2) there is a predetermined target rate.
3) in order to maintain the exchange rate at the predetermined level, the central bank intervenes in the foreign exchange market.
4) it is preferred by developing economies . ( Bulgaria, cuba, Denmark )
5) a fixed rate lacks flexibility but provides more stability.

INTERMEDIATE EXCHANGE RATE REGIMES

🔷In the real world, there is a spectrum of ‘intermediate exchange rate regimes’ which are either inflexible or have varying degrees of flexibility that lie in between these two extremes (fixed and flexible).

🔷For example, a central bank can implement soft peg and hard peg policies.

🔷A soft peg refers to an exchange rate policy under which the exchange rate is generally determined by the market, but in case the exchange rate tend to be move speedily in one direction, the central bank will intervene in the market.

🔷 With a hard peg exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate.

🔷Both soft peg and hard peg policy require that the central bank intervene in the foreign exchange market.

Extra knowledge : hard peg is like a fixed rate regime only.

Question 2

Q3) what are the main advantages of a fixed rate regime ?

Answer 2

🔷A fixed exchange rate avoid currency fluctuations and eliminates exchange rate risks and transaction costs that can delay international flow of trade investment. A fixed exchange rate can thus greatly enhance international trade and investment.

🔷 A fixed exchange rate system imposes discipline on a country’s monetary authority and therefore is more likely to generate lower levels of inflation.

🔷The government can encourage greater trade and investment as stabilit encourages investment.

🔷 It can also enhance the credibility of the country’s monetary policy.

🔷the central bank maintains an adequate amount of Foreign exchange reserves so that they stands ready to intervene in the foreign exchange market.

Question 3

Q4) what are the main advantages and disadvantages of a floating exchange rate?

Answer 3

ADVANTAGES:

🔷A floating exchange rate has the great advantage of allowing a Central bank and /or government to pursue its own independent monetary policy

🔷Floating exchange rate regime allows exchange rate to be used as a policy tool which can increase the competitiveness of the tradeable goods sector.

🔷 As there is no obligation or necessity to intervene in the currency markets, the central bank is not required to maintain a huge foreign exchange reserves.

DISADVANTAGES:

🔷 Volatile exchange rates generate a lot of uncertainties.

🔷 Add a risk premium

🔷 A floating rate provides less stability.

Question 4

Q5) explain the following:

Answer 4

NOMINAL EXCHANGE RATE:

🔷 Nominal exchange rate simply states that how much of one currency (i.e money) can be traded for a unit of another currency when prices are constant.

REAL EXCHANGE RATE (RER) :

🔷 The real exchange rate describes how many of a good or service in one country can be traded for one of that good or service in a foreign country.

🔷 Real exchange rate which incorporates change in prices of goods and services is a better measure.

🔷 It is calculated a
Domestic price index
RER=Nominal exchange rate×__________________
Foreign price index

🔷 Extra knowledge: for example, if one wants to plan a trip to London, she needs to know how how expensive British goods are relative to goods at home . The measure that captures this is the real exchange rate .

REAL EFFECTIVE EXCHANGE RATE (REER)

🔷 Real effective exchange rate is the normal effective exchange rate ( a measure of the value of a domestic currency against a weighted average of various foreign currencies ) divided by a price deflation or index of costs.

🔷 An increase in in real effective exchange rate implies that exports become more expensive and imports become cheaper.

🔷therefore an increase in real effective exchange rate indicates a loss in trade competitiveness.