Exchange Rate Flashcards
ER definition
The price of an currency in another currency
Floating ER definition
Determined only by demand and supply of the currency
No G intervention
Advantage of Floating ER
Correct CAD
- M > X
- S of Currency > D of Currency
- RM depreciates
- Price of RM decreases
- P of X decreases
- Restore competitiveness
- Evaluation: not only D for M and D for X that determine the D and S of a currency. Speculation also.
Decrease need for currency reserves
- not necessary to keep high level of reserve of foreign currencies and gold
- Opportunity cost
Disadvantage of Floating ER
Uncertainty
- ER may fluctuate significantly
- discourages investments
Fixed ER definition
G or central bank require to hold large amount of currency reserve
Buy and sell currency
Advantages of Fixed ER
Certainty
- promote international trade and investment
Keep inflation low
- ensures that loss of international price competitiveness does not put inflationary pressure on the ER
Disadvantages of Fixed ER
Large level of foreign currency reserve needed
- Opportunity cost
Risk that G may sacrifice other policy objective in order to maintain fixed ER
- may need to raise interest rate to maintain ER
- High interest rate decreases AD and increases unemployment
Definition of Managed Float ER
Combines features of a floating ER system and a fixed ER system
Usually involves G allowing ER to be determined by the market forces within a given band
(Bad) Impacts of Appreciation
Lower growth
- AD decreases
- potential CAD
Increase unemployment
- Exporting industries: D of X decreases
- Domestic industries: High competition with cheaper imports abroad
(Good) Impacts of Appreciation
Lower inflation
- AD decreases
Cheaper imports
- higher living standards
Potential efficiency gains for domestic producers
Marshall-Lerner Condition
Currency depreciation will only correct a current account deficit of PEDx + PEDm > 1
Why is it J-Curve?
In the short term,
Firms and consumers have contract that cannot change
Take time to find alternatives
An increase in Pm may cause domestic producers to increase production but this takes time
