Economics 4.1.2

Question 1

“What are national currencies?”

Answer 1

“National currencies are essentially products that can be bought & sold on the foreign exchange market (forex).”

Question 2

“Who controls the exchange rate system in a country?”

Answer 2

“The Central Bank of a country controls the exchange rate system that is used in determining the value of a nation’s currency.”

Question 3

“How many exchange rate systems are there?”

Answer 3

“There are three exchange rate systems: A floating exchange rate, A fixed exchange rate, A managed exchange rate.”

Question 4

“What is a floating exchange rate?”

Answer 4

“In a floating exchange rate system, if there is excess demand for the currency on the forex market, prices rise (the currency is worth more) - this is called an appreciation. If there is excess supply, prices fall (the currency is worth less) - this is called a depreciation.”

Question 5

“What is a fixed exchange rate?”

Answer 5

An exchange rate that is fixed against other major currencies through action by governments or central banks, usually within small margins of fluctuation around the central rate.

Question 6

“What is a managed exchange rate?”

Answer 6

“A managed exchange rate is a combination of the fixed & floating mechanisms. The Central Bank determines the preferred currency value, and the currency is free to fluctuate within a certain range of this value (e.g., 0.75%). The Central Bank intervenes by buying or selling its own currency to keep it within the range.”

Question 7

“How can interest rates influence exchange rates?”

Answer 7

“Raising interest rates appreciates a currency as returns on investment/savings become more attractive to foreigners, increasing demand for the local currency. Decreasing interest rates depreciates a currency as returns become less attractive, leading foreigners to sell the local currency.”

Question 8

“What factors influence floating exchange rates?”

Answer 8

“Numerous factors influence floating exchange rates, including relative interest rates, relative inflation rates, net investment, and the current account.”

Question 9

“How do relative inflation rates affect exchange rates?”

Answer 9

“As inflation in the UK rises relative to other countries, its exports become more expensive, reducing demand for UK products and £’s, leading to depreciation of the £.”

Question 10

“How does net investment affect exchange rates?”

Answer 10

“Foreign direct investment (FDI) into the UK creates demand for the £, leading to appreciation. FDI by UK firms abroad creates a supply of £’s, leading to depreciation.”

Question 11

“How does the current account affect exchange rates?”

Answer 11

“UK exports have to be paid for in £’s, and imports in local currencies, requiring £’s to be supplied to the forex market. An increasing trade surplus results in appreciation of the £, and an increasing deficit results in depreciation.”

Question 12

“What is speculation in currency trading?”

Answer 12

“Speculation occurs when traders buy a currency in the expectation that it will be worth more in the short to medium term, at which point they will sell it to realize a profit.”

Question 13

“What is quantitative easing?”

Answer 13

increase the supply of money in the banking system designed to encourage commercial banks to lend at cheaper interest rates

Question 14

“How does government intervention in currency markets work under a managed exchange rate system?”

Answer 14

“Government intervention in currency markets under a managed exchange rate system is managed by the Central Bank and takes place in two ways: changing interest rates and buying & selling currency in the forex market.”

Question 15

“How do changing interest rates affect a country’s currency?”

Answer 15

“If the Central Bank wants to appreciate the country’s currency, it would raise interest rates, making it more attractive for foreigners to move money into the country’s banks. Decreasing interest rates has the opposite effect and causes a depreciation.”

Question 16

“How does buying & selling currency in the forex market affect a country’s currency?”

Answer 16

“The Central Bank can change the demand or supply for their currency using their reserves. To appreciate the currency, they buy it on the forex market using foreign currencies. To depreciate the currency, they sell their own currency and buy foreign currencies.”

Question 17

“What are the consequences of competitive devaluation/depreciation?”

Answer 17

“When a currency is intentionally devalued/depreciated by a government, it makes the country’s exports cheaper. If demand for their exports is price elastic, the country is likely to experience higher export volumes and revenues. However, it can be anticompetitive, upset international competitors, and lead to increased costs of imports used in production.”

Question 18

“What is the impact of changes to exchange rates on the current account?”

Answer 18

“Depreciation of the £ causes exports to be cheaper for foreigners to buy and imports to the UK more expensive. The extent to which this improves the current account balance depends on the Marshall-Lerner condition and the J-Curve effect.”

Question 19

“What is the Marshall-Lerner condition?”

Answer 19

“The Marshall-Lerner condition states that in order to increase revenue, firms should lower prices for products that are price elastic in demand. If the combined elasticity of exports/imports is less than 1 (inelastic), a depreciation will worsen the current account balance.”

Question 20

“What is the J-Curve effect?”

Answer 20

“The J-Curve effect explains that there is a time lag between the depreciation of the £ and any subsequent improvement in the current account balance. It takes time for firms and consumers to respond to changes in price.”

Question 21

“How do changes in exchange rates impact economic growth?”

Answer 21

“Net exports are a component of aggregate demand (AD). Changes in exchange rates can affect the volume of exports and imports, thereby influencing economic growth.”

Question 22

“What is cost-push inflation?”

Answer 22

“Cost-push inflation is likely to occur as the price of imported raw materials increases with currency depreciation.”

Question 23

“How does currency depreciation affect aggregate demand?”

Answer 23

“A depreciation that results in an increase in net exports will lead to an increase in aggregate demand, which may lead to an increase in demand-pull inflation. An appreciation of the currency will have the opposite effect.”

Question 24

“How does currency depreciation affect unemployment?”

Answer 24

“If depreciation leads to an increase in exports, unemployment is likely to fall as more workers are required to produce the additional products demanded. An appreciation of the currency will have the opposite effect.”

Question 25

“How does currency depreciation affect living standards?”

Answer 25

“The impact of a depreciation on living standards can be muted. As imports are more expensive, households face higher prices & less choice, which detracts from living standards. Rising exports can decrease unemployment & increase wages/income, improving the standard of living for some households. An appreciation will have the opposite effect.”

Question 26

“How does currency depreciation affect foreign direct investment (FDI)?”

Answer 26

“Depreciation of a currency makes it cheaper for foreign firms to invest in the country, increasing FDI. The money they have available to invest is worth more when the currency has depreciated. An appreciation has the opposite effect.”