Exchange Rate Systems

Question 1

What are exchange rates?

Answer 1

The value of one currency in terms of another.

Question 2

What are the 3 types of exchange rate systems?

Answer 2

1) Floating exchange rates.
2) Fixed exchange rates.
3) Managed exchange rates.

Question 3

What is a fixed exchange rate?

Answer 3

When a government or central bank sets the exchange rate that they like by tying the exchange rate to other currencies, gold, or to a basket of currencies.

Question 4

What is a floating exchange rate?

Answer 4

When the exchange rate is set by the market forces of supply and demand.

Question 5

What is a managed exchange rate?

Answer 5

A floating exchange rate that is influenced or affected by the intervention of a central bank/government - a mix of fixed and floating.

Question 6

What is the most common type of exchange rate system?

Answer 6

A managed exchange rate system.

Question 7

What is appreciation of currency?

Answer 7

An increase of the value of a country’s currency in relation to other currencies, under a floating exchange rate system.

Question 8

What is depreciation of a currency?

Answer 8

A decrease of the value of a country’s currency in relation to other currencies, under a floating exchange rate system.

Question 9

What is revaluation of currency?

Answer 9

An increase of the value of a country’s currency in relation to other currencies determined by a county’s central bank/government, under a fixed exchange rate system.

Question 10

What is devaluation of currency?

Answer 10

A decrease of the value of a country’s currency in relation to other currencies determined by a county’s central bank/government, under a fixed exchange rate system.

Question 11

What exchange rate system does appreciation/depreciation occur under?

Answer 11

A floating exchange rate system.

Question 12

What exchange rate system does revaluation/devaluation occur under?

Answer 12

A fixed exchange rate system.

Question 13

What are the advantages of a floating exchange rate system (3)?

Answer 13

1) Correction of balance of payment deficit under an automatic adjustment mechanism.
2) Protection from external shocks, as the exchange rate will change in response.
3) Less need for central banks to hold reserves of foreign currency.

Question 14

What are the disadvantages of a floating exchange rate system (2)?

Answer 14

1) Instability, as exchange rates are volatile. This created uncertainty amongst firms and governments.
2) Speculation allows for exchange rates to change unrelated to the underlying pattern of trade.

Question 15

What are the advantages of a fixed exchange rate system (2)?

Answer 15

1) Certainty over the exchange rate can encourage domestic investment and FDI.
2) Reduced speculation, as it is known that the central bank will aim for the exchange rate target, with little chance of re/devaluation.

Question 16

What are the disadvantages of a fixed exchange rate system (2)?

Answer 16

1) Policy conflicts, as a fixed exchange rate may be incompatible with an objective of low inflation or low unemployment.
2) Difficulty in responding to external shocks.

Question 17

What are the advantages of a managed exchange rate system (3)?

Answer 17

1) Market forces determine the day-to-day value of the currency.
2) Government intervention is only required to make adjustments when necessary.
3) Predictability, as consumers and firms have a clear expectation of the value of the currency.

Question 18

What is a disadvantage of a managed exchange rate system?

Answer 18

Loss of control of interest rates, as although the central bank/government would still have control of the base interest rate, it would have to be set to maintain the value of the currency at the desired level. This means that interest rates can not be used to control inflation.

Question 19

What is competitive devaluation, and how effective is it?

Answer 19

The deliberate devaluation of a currency to give the country a competitive advantage. Its exports will be cheaper, making exports more competitive, increasing AD. This is a risky strategy as it is not guaranteed, with it only working if other countries do not similarly retaliate.

Question 20

What two ways can governments intervene in currency markets (explain)?

Answer 20

1) Changing interest rates: If a country raises the interest rate, it is more attractive for foreigners to place cash in the country’s banks. This increases the demand for the currency, raising its price, with the extent depending on the PED of the currency and what happens to supply.
2) Intervention on the foreign exchange market: In order to increase the value of its currency, a central bank may buy its own currency, increasing the demand, and therefore the price of the currency.

Question 21

What does SPICED stand for?

Answer 21

Strong pound = imports cheaper, exports dearer.

Question 22

What does WPIDEC stand for?

Answer 22

Weak pound = imports dearer, exports cheaper.

Question 23

What is the Marshall-Lerner condition?

Answer 23

That the devaluation/depreciation of a currency will only lead to an improvement in a country’s current account position if the combined price elasticities of imports and exports is greater than one.

PED(x) + PED(m) > 1

Question 24

What is the J-curve effect?

Answer 24

That in the short-run, a devaluation/depreciation of a currency will lead to a worsening of the current account position, before improving in the long-run.

Question 25

Explain the impact of a fall in the exchange rate on FDI.

Answer 25

A fall in the value of a currency will lead to a rise in FDI flows, as foreign firms will be able to spend less in their own currency to purchase the same UK assets (investment is cheaper). This will not be the case if the currency is continually falling, as it suggests the economy is volatile.

Question 26

Explain the impact of a fall in the exchange rate on the rate of inflation.

Answer 26

The costs of imports will rise, resulting in higher inflationary pressure. E.g. a fall in the value of the pound will make oil more expensive.

Question 27

Explain the impact of a fall in the exchange rate on employment.

Answer 27

If exchange rates fall, imports are likely to decrease, and exports to increase, causing an increase in AD. Because of economic growth, more jobs will be created, especially in the export sector, increasing employment.