exchange rate Flashcards
freely floating exchange rate
the exchange rate is determined solely by the interplay of demand for, and supply of the currency
why does demand for a currency increase
foreigners are demanding the pound
-increase in relative interest rates, hot money inflows into UK, so they demand the currency
-speculators anticipate increase in currency
-increase in FDI, firms enter UK, pay for FoP in UK currency
-rise in incomes abroad, foreigners demand for UK exports and pay for exports in UK pounds
-increase in competitiveness
why does supply for pounds increase, currency depreciates
-decrease in interest rates
-speculators anticipate decrease in currency
-firms move away from UK
-increase in incomes domestically, increase in imports
fixed exchange rate
an exchange rate fixed and maintained at a certain level by the countrys central bank by the central bank intervention in the foreign exchange market
to maintain a fixed exchange rate, the government or central bank must hold large amounts of currency reserves
how to solve an overvalued fixed exchange rate
central banks need to sell the pound, currency reserves to foreign currency increasing the supply of the pound
how to solve an undervalued exchange rate
central banks need to increase demand by using their foreign currency reserves to buy up the pound on the foreign exchange market
impact of a appreciation of the pound
SPICED
net exports and AD decrease
-lower growth, potential current account deficit
-higher unemployment in exporting and domestic industries
-lower inflation
-cheaper imports and price, increase in living standards
-potential efficency gains for domestic products
impact of a depreciation of the pound
WIDEC
increase in AD
-increased employment in export and domestic industries
-higher growth
-higher inflation
-decrease in living standards
floating exchange rate and automatic correction of a current account deficit
effect of CA deficit is that there is a large trade deficit which means the supply of pound is more than the demand of the pound as we need to buy the pound to buy all these imports
this depreciates the pound - WIDEC occurs
imports become more expensive so trade deficit reduces
marshal Lerner condition
states that a currency depreciation will only correct a current account deficit if
PEDx + PEDm > 1
J curve effect
in the short term demand tends to be inelastic but it takes time for businesses and consumers to adjust to a depreciation (increase in imports)
takes time for foreign countries to realise UK goods are cheaper
when a currency depreciates the CA deficit will worsen until it gets better as as time passes demand for imports becomes more elastic as people adjust to a cheaper exchange rate
PPP
the rates of currency conversion that equalise the purchasing power of different currencies
pros of a floating exchange rate
-no need for currency reserves which can be very costly
-freedom of domestic monetary policy, some fixed ER systems require the manipulation of intrest rates to keep the ER fixed
-can help correct a CA deficit automatically
-useful instrument for macroeconomic adjustment (reduction in value of ER can help prop up export and general growth)
-reduced risk of currency speculation as its valued perfectly
cons of floating exchange rate
-volatility reduces incentives for foreign investors and put off trade
-self-correction of trade deficits is unlikely as they is many factors effecting the ER such as speculative flows
pros of fixed exchange rate
-stable which promotes FDI and make trade easier
-some flexibility is permitted
-reductions in costs of trade (reduced hedging)
-discipline on domestic producers as they have to maintain competitiveness and increase efficiency, invest, innovate (R+D)
cons of fixed exchange rates
-interest rate effects
-large levels of foreign currency reserves needed
-speculative attacks if ER is set too high or low
