Exchange rate Flashcards
What is Exchange rate?
The price of a countries currency in terms of another currency
Whats the difference between Nominal and Real exchange rate?
Nominal is exchange rate that isn’t adjusted to inflation whilst real is adjusted.
Real exchange rate formula
(Nominal exchange rate x Domestic price index) /Foreign price index
What is Trade weighted exchange rate?
This is the value of a countries currency in terms of a basket of currencies, it is used to determine the relative importance of trade between a country and other trading partners.
Define Floating exchange rate and its benefits & drawbacks
This is when the value of a countries currency is determined by the forces of demand and supply in the foreign market.
Benefits: Self adjusts, no need for gov intervention
The exchange rate will represent the information of the market allowing businesses to operate better.
Drawbacks: They often change a lot hence making it hard for investors and businesses to work with.
Governments cant use it as a monetary tool.
Define Fixed exchange rate.
This is when the government controls the price of their currency in terms of another currency. They ensure the currency stays there by fluctuating demand and supply of the currency, to increase demand the use foreign reserves to by their own currency, they can also increase interest rates in order to attract hot money flows.
To fluctuate supply they buy the foreign currency.
Benefits & Drawbacks of Fixed exchange rate.
Benefits: Creates certainty for investors of which can promote international trade and investment.
It stops imported inflation.
Drawbacks: Expensive since central bank has to keep foreign reserves.
Policies to devalue its currency could lead to sacrificing other policy objectives.
Define Managed system.
This is a floating exchange rate that is managed by the government to ensure that it stays within certain bandwidths.
