Exchange rate

Question 1

Nominal exchange rate

Answer 1

the price of one currency in terms of another currency

Question 2

Trade-weighted exchange rate

Answer 2

the price of one currency against a basket of currencies

Question 3

Real exchange rate

Answer 3

a currency’s value in terms of its real purchasing power

Question 4

Floating exchange rate

Answer 4

An exchange rate that is determined by the market forces of demand and supply

Question 5

Fixed exchange rate

Answer 5

An exchange rate set by the government and maintained by the central bank

Question 6

Managed float exchange rate

Answer 6

An exchange rate that is both determined by the market forces of demand and supply and the government

Question 7

Depreciation

Answer 7

The decrease in the international price of a currency caused by market forces

Question 8

Devaluation

Answer 8

A decision by the government to lower the international price of the currency

A fall in the value of a fixed exchange rate

Question 9

Advantages of floating exchange rate

Answer 9

1. BoP self-correcting.
2. No government intervention is needed
3. Greater flexibility
   (flexibility to change policy by lower or higher interest rates without conflicting GEOs)

Question 10

Disadvantages of floating exchange rate

Answer 10

1. exchange rate volatility
2. depreciation = cost-push inflation
3. appreciation = demand-pull inflation

Question 11

Advantages of fixed exchange rate

Answer 11

1. encourage stability

2. reduces inflationary pressure if fixed against main trade partners

Question 12

Disadvantages of fixed exchange rate

Answer 12

1. large foreign reserves are needed to maintain the fixed exchange rate (opportunity cost)
2. targeting the exchange rate may conflict with other GEOs (cannot change interest rates)
3. less flexibility, BoP not self-correcting