exchange rate 4.1

Question 1

A free-floating currency

Answer 1

where the external value of a currency depends wholly on market forces of supply and demand – there is no central bank intervention to influence a currency’s price

like UK

Question 2

A managed-floating currency

Answer 2

when the central bank may choose occasionally to intervene in the foreign exchange markets to influence the value of a currency to meet specific macroeconomic objective

like Japanese Yen

Question 3

A fixed exchange rate system e.g. a hard currency peg

Answer 3

when gov sets currency against another, either as part of a currency board system or membership of the ERM Mark II for those EU countries eventually intending to join the Euro. Currencies trade at an officially announced level.

Question 4

What factors cause changes in the currency in a floating system?

Answer 4

1. Trade/current account balances
2. Foreign direct investment (FDI)
3. Portfolio investment
4. Interest rate differentials
   - demand for UK exports or put money in UK banks
   - speculation on pound, level of UK spending overseas

Question 5

Trade/current account balances

Answer 5

– countries that have strong trade and current account surpluses tend (other factors remaining the same) to see their currencies appreciate as money flows into the circular flow from exports of goods and services and from inflows of investment income

Question 6

Foreign direct investment (FDI)

Answer 6

an economy that attracts high net inflows of capital investment from overseas will see an increase in currency demand and a rising exchange rate

Question 7

Portfolio investment

Answer 7

strong inflows of portfolio investment into equites and bonds from overseas can cause a currency to appreciate.

Question 8

Interest rate differentials

Answer 8

countries with relatively high interest rates can expect to see ‘hot money’ flowing coming in and causing an appreciation of the exchange rate.

Question 9

the impact of higher interest rates on a floating exchange rate:

Answer 9

• rise in policy interest rates by central bank
• currency more attractive for investors
• attracts inflows of short term hot money
• causes outward shift in currency demand
• currency appreciates in value in a floating system

Question 10

the effect of a fall in export demand on a floating exchange rate:

Answer 10

• recession in a trading partner
• causes a fall in export sales
• worsening of trade balance
• inward shift of currency demand
• currency will depreciate

Question 11

Managed Floating Exchange Rates examples

Answer 11

• Brazilian Real
• Indian Rupee

Question 12

With managed exchange rates

Answer 12

• Currency is usually set day-to-day by market forces:
• A central bank may intervene occasionally to influence the price:
  o Buying to support a currency (i.e. selling some of their FX reserves).
• Changes in policy interest rates to affect hot money flows i.e. increase rates to attract inflows of money into the banking system looking for a favourable rate of return.
• In a managed floating system, the currency becomes a key target of a country’s monetary policy.
  o Stronger exchange rate might be wanted to control demand-pull and cost-push inflationary pressures.

Question 13

Policy Tools for Managing Floating Exchange Rates part 1

Answer 13

Changes in monetary policy interest rates:
o Changes in interest rates e.g. lower interest rates to depreciate the exchange rate.
o Causes movements of “hot money” banking flows into or out of a country.
* Quantitative easing (QE):
o Increase liquidity in the banking system arising from QE, usually causes an outflow of money leading to depreciation of the exchange rate

Question 14

Policy Tools for Managing Floating Exchange Rates part 2

Answer 14

• Direct buying / selling in the currency market (intervention):
  o Direct intervention in the currency market.
  o Buying and selling of domestic / foreign currencies
• Taxation of overseas currency deposits and capital controls:
  o Taxation of foreign deposits in banks cuts the profit from hot money inflows.
  o A government might introduce controls on the free flow of capital into and out of a country perhaps `restricting how much currency a foreign investor can take out at a given time.

Question 15

How can a central bank influence the value of a currency?

Answer 15

• in managed floating system, can change interest rates
• e.g. if they want to achieve depreciation then lower MPC interest rate
• lower IR reduces returns on overseas money held in a country’s banking system.
• cause outflow of short term hot money from banks to other nations
• cause outward shift of AS for currency as investors look for currencies with higher expected returns
• = depreciation

Question 16

Competitive Devaluations / “Dirty Floating”

Answer 16

• Competitive devaluations occur when a country deliberately intervenes to drive down the value of their currency to provide a competitive lift to aggregate demand, output and jobs in their export industries.

Question 17

when may a country use competitive devaluation?

Answer 17

• They may try this when faced with a deflationary recession or perhaps to attract extra foreign investment.
• For nations with persistent trade deficits and rising unemployment, a competitive devaluation of the ER can become an attractive option - but there are some risks involved.
• Devaluing an exchange rate can be seen by other countries as a form of trade protectionism that invites retaliatory action such as an import tariff.
• Cutting the exchange rate makes it harder for other countries to export negatively affecting their growth rate which in turn can damage the volume of trade that takes place between nations

Question 18

Fixed Exchange Rates examples

Answer 18

• hong kong - pegged to US dollar
• bulgarian lev pegged to Euro

Question 19

In a fixed exchange rate system

Answer 19

The gov/central bank fixes currency value:
o The external value is pegged to one or more currencies (known as “anchor” currency).
* Pegged exchange rate becomes official rate:
o Trade takes place at this official exchange rate.
o There might be unofficial trades in shadow currency markets.
* Adjustable peg system:
o Occasional realignments of a currency may be needed.
o E.g. a devaluation or revaluation depending on macroeconomic circumstances – the currency may have
drifted from the fundamental value and be a cause of a widening trade deficit and job losses.

Question 20

Ways Exchange Rates Impact Business Activity

Answer 20

1. Price of exports in international markets
2. Cost of goods bought from overseas
3. Revenues and profits earned overseas
4. Converting cash receipts from customers overseas

Question 21

winners from lower ER

Answer 21

• Businesses exporting into international markets.
• Businesses earning substantial profits in overseas currencies

Question 22

losers from lower ER

Answer 22

• Businesses importing goods and services and raw materials
• Overseas businesses trying to compete in the domestic market
• consumers with higher prices

Question 23

Impact of a currency depreciation

Answer 23

• A currency depreciation usually has a similar effect on the macro-economy as a cut in interest rates.
• A currency depreciation may help to provide a partial auto-correction of a large trade deficit.

Question 24

Evaluating Effects of a Currency Depreciation part 1

Answer 24

1. Time lag
2. The scale of any change in the exchange rate
3. temporary or longer lasting?
4. PED - Marshall Lerner

Question 25

Evaluating Effects of a Currency Depreciation part 2

Answer 25

5. Multiplier/ accelerator?
6. economic stage
7. The type of economy - dev vs developed
8. The degree of openness of the economy to international trade.

Question 26

Advantages of Floating Exchange Rates:

Answer 26

o less need for central bank to hold large currency reserves.
o Freedom to set interest rates
o to prevent imported inflation.
o Insulation for an economy after an external shock especially for export-dependent countries.
o Partial automatic correction for a current account / trade deficit.
o Less risk of a currency becoming significantly over/undervalued.

Question 27

eval floating ER

Answer 27

o No guarantee floating exchange rates stable.
o Volatility detrimental to inward investment.
o A lower ER not necessarily correct a persistent current account deficit - non price + j curve

Question 28

Advantages of fixed exchange rates:

Answer 28

o Certainty of currency value= confidence for FDI
o Currency stability helps control inflation.
o stable currency lead to lower borrowing costs - i.e. lower yields on government bonds
o responsibility on government macro policies e.g. to keep inflation under control.
o Less speculation in the currency market.

Question 29

Evaluation points: fixed exchange rates

Answer 29

o less freedom to alter interest rates
o developing countries don’t have foreign currency reserves to maintain a fixed exchange rate
o Difficult for countries to use a competitive devaluation
o Devaluation of a fixed exchange rate can lead to a surge in cost-push inflation

Question 30

Floating versus Fixed Exchange Rates

Answer 30

• Fixed optimal for developing countries to control inflation.
• Export-dependent economies favour managed floating rate to offset fluctuating world prices.
• scale of foreign currency reserves needed to influence currency price

Question 31

changes in the currency

Answer 31

An appreciation of the currency is an increase in the value of the currency using floating exchange rates, whilst depreciation is a fall in the value of the currency under floating exchange rates.

Question 32

revaluation of the currency

Answer 32

when the currency is increased against the value of another under a fixed system, whilst devaluation of the currency is a decrease in the value of one currency against another under a fixed system.

Question 33

government intervention

Answer 33

• use interest rates to alter demand
• use gold and foreign currency reserves to manipulate currency value, can increase supply by buying foreign currency or gold with pounds or vice versa by selling currency

Question 34

problems with competitive devaluation:

Answer 34

• can cause inflation which may reduce competitiveness, falling BoP
• other countries may follow = currency war