Chapter 38: Foreign exchangerates

Question 1

Reasons for demand of currency in a foreign exchange market

Answer 1

• Foreigners wishing to buy goods and services
• Foreign based branches of the country’s multinational companies sending profits back to the country
• Foreign banks buying currencies on behalf of their customers and paying interest on money held by the country’s residents
• Foreign firms paying dividends on shares held by the country’s residents
• The country’s citizens working abroad, wishing to send money back home to relatives
• Foreign firms and individuals wanting to buy shares in the country’s companies, to save in the country’s banks, and lend to the country’s firms or individuals
• Foreign governments wanting to hold the country’s currency as reserves
• Speculators buying the currency in the expectation that the value will rise in the future
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Question 2

Reasons for supply of currency

Answer 2

• The country’s people wishing to buy foreign goods and services
• Foreign multinational companies based in the country sending profits home
• The country’s banks selling currencies on behalf of their customers and paying interest on money held by foreign people
• The country’s firms paying dividends on shares held by foreigners
• Foreigners working in the country sending money home
• The country’s firms wishing to buy foreign firms and setting up production units in other countries
• The country’s firms and individuals wanting to buy shares in foreign companies, save in foreign banks and lend to foreign firms and individuals
• The government wishing to hold foreign currencies
• Speculators selling the country’s currency because they expect the price to fall
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Question 3

Causes of exchange rate fluctuations

Answer 3

• Increase in current account surplus would tend to cause the value of currency to rise - demand for currency rises
• Increase in investment in the country arising from a foreign MNC company setting up a production plant can cause price to rise
• Speculators act in a way which will help in brinign their expectation
• Government and its central bank can seek to influence the price of its currency - rate of interest, buying and selling currecny, introducing measures to increase exports and reduce imports

Question 4

Effect of a change in the exchange rate on export and import prices

Answer 4

• A rise in the rate would raise the price of its exports and lower the price of its imports
• Fewer exports sold
• Effect of export revenue depends on PED

Question 5

Effect of a change in the exchange rate on the macroeconomy

Answer 5

• Change in exchange rate may influence economic growth, employment, and inflation
• Fall in exchange rate, by lowing export prices and raising import prices likely to increase demand for domestic products
• Rise in aggregate demand can increase output and employment of the economy if not operating at full capcity initially
• Fall in the exchange rate can increase inflationary pressure - imported raw materials more expensive - finsihed imported products more expensive - reduces the pressure on firms to keep price rise to a minimum to remain competitive

Question 6

Advantages of a floating exchange rate

Answer 6

• May help eliminate a gap between export revenue and import expenditure
• Even with a deficit between what country has earned from exports and spent on imports, demand for the currency may rise - firms and individuals may still buy more of the currency to invest in the country if they think prospects are good
• Floating exchange rate allows government to concentrate on other objkectives
• Governmetns do not have to keep reserves of foreign currenct to influence the price

Question 7

Disadvantages of a floating exchange rate

Answer 7

• Can fluctuate making it difficult for firms to plan ahead
• Speculation may cause significant changes in the price of a currency
• Large depreciation may result in inflation

Question 8

Advantages of fixed exchange rates

Answer 8

• Creates certainty
• Firms that buy and sell products abroad will know the exact amount they will pay and receive in terms of their own currency

Question 9

Disadvantages of fixed exchange rates

Answer 9

• Can mean that a central bank has to use a considerable amount of foreign currency to maintain its value
• May have to implement policy measures which conflict with other government objectives
• If a government cannot maintain an exchange rate, it may have to cahnge its price and may cause a lsos of confidence

Question 10

International competitiveness

Answer 10

• Country might be called internationally competitive if it provides the goods and services desired by consumers at a price acceptable to them
• A competitive economy is likely to have a stable economic growth rate, a reasonable share of world trade, high levels of investment and expenditure on rnd, good quality education and training, and developed infrastructure
• A fall in exchange rate and inflation rate would be likely to make the country’s products more attractive to buyers at home and abroad
• Changes in productivity will have long lasting effects