Chapter 4.1.8 Exchange Rates

Question 1

Define ‘Exchange Rates’

Answer 1

The price of one currency in terms of another.

They are normally expressed as a value of one currency in terms of another currency.

They can also be expressed as the value of a currency against a range of other currencies (expressed in terms of a basket of currencies).

Question 2

What is the purpose of exchange rates?

Answer 2

ERs make it possible to trade currencies. There are 3 main reasons why currencies are traded:

1) To allow international trade to occur.
2) To allow for investment in other countries.
3) For speculative reasons: foreign exchange traders who try to make money by buying and selling foreign exchange based on their predictions about exchange rates.

Question 3

How does a change in the demand for exports cause a shift in the supply or demand of currencies?

Answer 3

If foreigners wish to purchase a country’s goods and services, they first need to purchase the currency.

A rise in the demand for exports leads to increased demand for the currency.

A fall in exports leads to decreased demand for the currency

Application: If the UK leaves the EU without a trade deal, Europeans will purchase fewer British exports, and so will therefore require fewer pounds. Consequently, the demand curve for the pound will shift inwards.

Question 4

How does a change in the demand for imports cause a shift in the supply or demand of currencies?

Answer 4

When domestic citizens wish to purchase foreign imports, they first need to purchase the foreign currency.

They do this by selling their own currency.

A rise in the demand for imports leads to an increased supply of the home currency.

A fall in the demand for imports leads to a decreased supply of the home currency.

Application: The Comprehensive Economic and Trade Agreement (CETA) is a free-trade agreement between Canada, the European Union. This would mean that Europeans are purchasing more Canadian dollars, shifting out the demand for that currency as well as the supply of Euros.

Question 5

How does a change in interest rates cause a shift in the supply or demand of currencies?

Answer 5

IRs are the reward for saving. If one country’s IRs increase relative to another country, there is an incentive for savers to convert to that currency so that they can take advantage of the higher IR.

This creates an inflow of ‘hot-money’, and means that the demand for the currency rises.

Question 6

How does a change in foreign investment cause a shift in the supply or demand of currencies?

Answer 6

If foreigners wish to invest in a country, they first need to exchange their money for that country’s currency.

Increased investment from foreigners leads to an increase in the demand for the currency.

Increased investment from home investors in foreign markets leads to an increase in the supply of the home currency.

Question 7

How does speculation cause a shift in the supply or demand of currencies?

Answer 7

If speculators believe that the value of a currency is likely to fall, they will stop purchasing that currency and try to sell what they currently have.

If speculators believe that a currency will increase in value, they will try to purchase that currency.

Question 8

Which factors cause shifts in the supply and demand of currencies?

Answer 8

1) A change in the demand for exports
2) A change in the demand for imports
3) A change in interest rates
4) A change in foreign investment
5) A change in expectations about the ER (speculation)

Question 9

Define a ‘Floating Exchange Rate’ system

Answer 9

An ER system where the government does not intervene in the forex market and so the value is determined entirely by the forces of supply and demand.

There are no controls over how much currency can be purchased or sold.

The government/CB does not undertake its own buying and selling of currencies to try to manipulate the exchange rate

Question 10

Define a ‘Fixed Exchange Rate” system

Answer 10

An ER system which governments actively intervene in the forex markets to maintain a fixed ER with another currency.

The government first decided on a desirable exchange rate with another currency which becomes its ‘peg’.

When market forces change and apply upwards or downwards pressure on the ER, the government will intervene to counteract those forces and maintain the peg.

Question 11

Definition of a ‘Managed Exchange Rate’ system

Answer 11

An ER system where free market forces are one determinant of the ER.

However, the government also plays some part in determining the ER of the currency through direct intervention (buying and selling currency using the gold and foreign currency reserves held by its central bank), or it could intervene indirectly by changing the IR.

Question 12

Definition of an ‘Adjustable Peg’ system

Answer 12

An ER system where currencies are fixed in value in the short-term but can be devalued or revalued in the longer term.

Question 13

Definition of a ‘Crawling Peg’ system

Answer 13

An adjustable peg system of exchange rates where there is an inbuilt mechanism for regular changes in the central value of the currency.

Question 14

How is the ER under a managed exchange rate influenced?

Answer 14

1) Buying and selling currency
2) Changing the IR
3) Currency Controls
4) Borrowing from international institutions like the IMF
5) Devaluation and revaluation

Question 15

Define the ‘Appreciation of a currency’

Answer 15

When the value of a currency rises because of free market forces or with a dirty float, because of government intervention.

Question 16

Define ‘Currency or Exchange Rate Controls’

Answer 16

Limits on the purchase and sales of foreign currency, usually through its central bank.

Question 17

Define the ‘Depreciation of a currency’

Answer 17

When the value of a currency decreases because of free market forces or with a dirty float, because of government intervention.

Question 18

Define ‘Exchange Rate Systems’

Answer 18

Systems which determine the conditions under which one currency can be exchanged for another.

Question 19

Define ‘Forex Markets’

Answer 19

Trading arrangements where currencies are purchased and sold for each other.

Question 20

Define the ‘Revaluation of a currency’

Answer 20

When a government or central bank officially fixes a new higher exchange rate for the currency in a fixed or pegged system of exchange rates.

Question 21

Fixed Exchange Rate (Degree of Certainty for Shareholders)

Answer 21

The predictability of ERs encourages international trade and foreign investment since exporters, importers and investors know how much they will pay or receive even months/years later when a large order or investment is complete.

Question 22

Floating Exchange Rate (Degree of Certainty for Shareholders)

Answer 22

Currency movements are extremely volatile (even large percentage changes over the course of a few days); this is a barrier to international trade and international investment because of the risks involved with each transaction.

EVALUATION: Payments in foreign currencies can be made in advance in order to hedge against future movements in ER and lock in the current price. Future markets can also help firms to manage the uncertainty of currency movements.

The government can also mitigate volatility by guaranteeing ERs for large, long-term export orders where payment may only be due in a several years’ time (e.g. for a contract to build a power station or deliver turbines to generate electricity).

Question 23

Fixed Exchange Rate (Robustness/Risk from speculation)

Answer 23

Fixed ER systems are vulnerable to collapse, particularly if the currency becomes targeted by speculators; all of the largest fixed exchange rate systems (the Gold Standard, Bretton Woods, the ERM) collapsed due to speculative pressure. This is because the gold or reserve assets that a CB would use to prop-up the value of its currency are limited in relation to the large amounts of speculative money that could be used to force devaluation.

EVALUATION: A managed or dirty float is less vulnerable to speculation as the government is not bound to intervene, making them less tied to a course of action which speculators could take advantage of.

Question 24

Floating Exchange Rate (Robustness/Risk from speculation)

Answer 24

Freely floating ER systems involve a range of influences on supply and demand, generating an extremely strong and robust system for the determination of ERs, which is unlikely to collapse from speculative pressure.

EVALUATION: On a day-to-day basis, floating ER are more vulnerable to speculative activity which can cause large swings in a currency’s value (there are estimates that around 95% of currency trading occurs due to speculation).

Speculators expectations also often become self-fulfilling prophecies, driving currency price movements.

Question 25

Fixed Exchange Rate (Need for reserve assets)

Answer 25

There is a need to hold large reserves of foreign currencies. These are needed to both carry out day to day interventions, but also to convince speculators that reserves are sufficient to support the peg and prevent speculative selling off.

Reserve assets can also run out, leaving only IR rises (causing painful reductions in AD) or protectionist measures (which harm consumers and risk retaliation) as possible tools to maintain the ER.

Question 26

Fixed Exchange Rate (Ability to correct structural imbalances in the economy)

Answer 26

There is no automatic or easy way to tackle current account deficits.

When reserve assets deplete, the only way to tackle the problem is through painful contractionary demand-side measures such as raising IRs or through protectionist barriers.

Question 27

Floating Exchange Rate (Ability to correct structural imbalances in the economy)

Answer 27

Offer an automatic (and less painful way) to correct structural imbalances in the balance of payments (persistent or large deficits on the current account, for example).

A current account deficit in which imports are larger than exports causes downwards pressure on the ER. The depreciation of the ER boosts international competitiveness and therefore improves exports; this corrects the imbalance.

Question 28

Fixed Exchange Rate (Flexibility of monetary policy)

Answer 28

Require active intervention, especially when a currency is at risk of devaluation; this means that there is little freedom to use MP for other goals or to use alternative monetary tools (like IRs).

Demand management policies to control growth and inflation and therefore entirely limited to fiscal policy.

Question 29

Floating Exchange Rate (Flexibility of monetary policy)

Answer 29

Allow CBs freedom and flexibility to use monetary tools (IRs and the money supply) for other important objectives such as targeting growth or inflation.

Question 30

Problems associated with devaluation (Cost-Push Inflation)

Answer 30

Devaluation can cause or fuel an inflationary spiral which means that the increased competitiveness achieved by devaluation is quickly eroded.

Question 31

Problems associated with devaluation (Competitive Devaluation)

Answer 31

A country which deliberately devalues or depreciates its currency to gain a competitive advantage runs the risk that other countries will follow suit in retaliation, especially if its running a CA surplus and still devalues.

EVALUATION: Where a country is running a persistent CA deficit, there will be an international recognition that this is likely to cause economic problems for the country concerned. Therefore, competitive devaluations are unlikely to occur.

Question 32

What is the impact of ERs on inflation?

Answer 32

An appreciation/revaluation is likely to moderate inflation for 2 reasons:

A higher ER will tend to lead to a fall in import prices, which then feed through to consumers through lower domestic prices.

EVALUATION:
The extent to which this occurs depends upon what proportion of importers choose to cut prices and their desire to increase the size of their profit margins.
—————–
A higher ER will lead to a fall in AD, causing a fall in inflation.

EVALUATION:
The extent to which AD falls depends upon the PEDx and PEDm. The higher the price elasticities, the greater will be the change in export and import volumes to changes in prices brought about by the exchange rate movement.

DEPRECIATION CAUSES THE OPPOSITE:
=> Higher AD and an increase in inflation.

Question 33

What is the impact of ERs on economic growth?

Answer 33

Appreciation causes a fall in short-run output because exports fall and imports rise, causing AD to fall.

DEPRECIATION CAUSES THE OPPOSITE:
=> Higher AD and thus higher equilibrium output.

Question 34

What is the impact of ERs on unemployment?

Answer 34

Appreciation causes unemployment to increase because of the fall in AD and so a fall in equilibrium output.

DEPRECIATION CAUSES A FALL IN UNEMPLOYMENT

EVALUATION:
Changes in unemployment will be felt unequally in different sectors of the economy. In those industries which export a significant proportion of output, or where imports are important, there will tend to be larger changes in employment.

Question 35

Define ‘hot-money’

Answer 35

Money that flows freely and quickly around the world looking to earn the best rate of return.