Exchange rate Flashcards
What is the exchange rate?
An exchange rate is a rate at which one currency will be exchanged for another currency and affects trade and the movement of money between countries.
How is the exchange rate determined in a free market?
Through demand and supply forces.
Why is the demand curve sloping downward?
When the value for instance of the UK pound increases, goods are expensive, foreigners may demand less, when the pound depreciates, goods are relatively cheaper, and foreigners may demand more.
Why is the supply curve upward-sloping?
The supply curve is upward sloping from left to right. This is because, when the value of the UK pound depreciates, foreign goods become expensive, therefore we supply fewer pounds. If the value was to increase, foreign good become cheaper, and we’d supply more pounds.
When does a depreciation of a currency occur?
When the supply exceeds demand.
Demand may fall due to a fall in demand for exports or due to high prices and low quality. May also fall if interest rates fall.
Supply may increase, due to higher imports and more investments abroad.
It can be shown in a diagram by either a decrease in Demand for pounds or by an increase in supply for pounds.
When does an appreciation of a currency occur?
This occurs when the demand for a currency exceeds the supply.
This can be shown by the increase in demand or a fall in supply in a demand and supply diagram.
What may cause a change in the exchange rate?
01)Bop disequilibrium - If a country runs a deficit, then it’s supplying more of its currency, this will cause a depreciation.
02) Rate of inflation - A country with high inflation will find that people lose confidence in holding its currency.
03) Interest rates - Investors seek high returns for their investments and may therefore invest in countries that pay high-interest rates.
04) Foreign direct investment - inflows of money to build factories, will increase the exchange rate.
05) Speculation - If people expect the exchange rate of a country to fall or rise, they will either sell or buy the currency, to make a profit by buying back at a lower price or selling at a higher price.
What are the effects of the depreciation of a currency?
01) Exports are cheap and Imports are expensive, this would reduce the current account deficit.
02) Since exports become cheap, it may lead to increased competitiveness, may lead to an expansion in production.
03) There would be an increase in demand for factors of production. If the economy is not operating at full capacity, there’d be a rise in employment with increased production
04) If the economy is operating at full employment, resources become scarce, and workers may demand higher wages, this may increase costs of production and charged to consumers, increasing inflationary pressure.
05) Depreciation will deteriorate terms of trade as export prices fall and import prices rise.
06) There may be a lack of competition as there are fewer imports. This may also create less variety for consumers.
What’s the impact of appreciation on the economy?
01) Imports become cheaper and exports become expensive leading to a current account deficit
02) Volume of imports will rise and exports will fall
03) Domestic consumers may switch spending to imports
04) Since domestic sales decline, it may lead to unemployment
What are the effects of changing exchange rates on the economy?
01) Inflation - If the exchange rate falls, imports will be expensive. This will push up the prices of imported raw materials, and this will have drastic effects if imports are inelastic
02) Unemployment
03) Economic growth - A fall in the exchange rate will make exports cheaper, thus if the Marshall learner condition holds, then exports will increase and imports will reduce, thus increasing AD, more employment, and growth
04) Hot money - lower interest rates, are generally associated with a fall in the exchange rate, this means that hot money will leave the country seeking higher interest rates.
What’s a managed exchange rate system? ( dirty floating )
The government will allow the exchange rate to fluctuate according to demand and supply, but the government sets the upper limits and lower limits for the currency to fluctuate.
How does a government intervene to manage the exchange rate?
01) Direct method - the government will buy and sell currency directly, by holding foreign reserves.
02) Indirect method - the government will make alterations to the exchange rate through changes in interest rates.
How is the exchange rate measured?
nominal exchange rate X domestic price index / foreign exchange rate
What’s the trade-weighted exchange rate?
the price of one currency against a basket of currencies
What’s the nominal exchange rate?
Refers to the price of one currency against another. It is the rate usually quoted.
