Exchange rate systems Flashcards
What is an exchange rate ?
The external price of a currency , usually measured against another currency
What is a freely floating exchange rate ?
The Value of the exchange rate is determined by the supply and demand in foreign exchange markets for example based on : Interest rates , Inflation , BOP
Explain a FFER diagram
When the ER of the £ rises , fewer £’s are needed to buy a n.o of foreign currency - imports will increase because they are cheaper for UK consumers
Explain with a diagram how a budget deficit is eliminated in a FFER
Increased demand for imports from foreign countries causes supply to shift to the left .
At the old level , there is an excess supply for pounds as people want the other countries currency to buy their imports - this excess is spent on the FEM which depreciates the value of the £
This increases price competitiveness in the UK economy - thus more people will buy UK goods which reduces the deficit
What are the advantages of a freely floating exchange rate ?
Inflation control - Can respond to inflation pressure as adjustments stabilise prices
Investment attraction - Can attract FDI based on making choices based on economic conditions
Automatic adjustment- ER can adjust to economic conditions . E.G in a deficit by making ER cheaper for exports which improves GOVT finances
What are the disadvantages of a freely floating exchange rate ?
Exchange rate volatility - currencies fluctuate which can cause uncertainty for business / higher costs
Loss of monetary policy control - Have limited ability to use ER instead relying on Interest rates for monetary policy
Speculation and uncertainty - Market speculation can cause destabilisation and hurt long term planning by reducing FDI
How does a freely floating exchange rate impact upon cost push inflation ?
If BoP worsens , this causes ER to fall to restore competitiveness which may cause a cumulative down spiral of inflation
Falling ER increases import prices and ay raise the rate of domestic cost - workers demand more money to restore real wage
Increased cost of wages reduces export competitiveness causing a further fall in ER to recover lost advantage
How does a freely floating exchange rate affect demand pull inflation ?
With a FFER , there is no need to deflate the domestic economy to deal with a BoP deficit
If a nations ER falls at the same time as an increase in AD , this can lead to excess demand on a worldwide scale which fuels global inflation which can be imported by countries
What is a fixed exchange rate ?
A country’s currency is tied to another major currency like the dollar . Central banks will buy and sell its own ER on foreign exchange markets in order to maintain their exchange rate at a certain level
How do central banks manage foreign exchange markets ?
If the value of domestic currency goes away from the pegged value , the central bank will buy or sell its own currency to keep it at the target
To maintain this , the CB needs large reserves of foreign currency’s such as the £ or $ that it can be used to buy its own currency
What are the advantages of a fixed exchange rate ?
Predictability - Businesses and investors benefit from stable ER’s as investments / loaning is less risky
Control of inflation - By pegging it to another currency it can reduce inflationary pressure especially in low income economies
Encourage trade - Eliminates risk of currency fluctuations which improves FDI towards that nation
What are the disadvantages of a fixed exchange rate ?
Requires large reserves - Maintaining the ER needs a lot of foreign currency which can be costly during an economic crisis
Risk of economic imbalances - If inflation is not in line with ER it could lead to a surplus or a deficit
Vulnerable to speculation - If the currency is over or undervalued , it puts pressure on CB’s which can force revaluation or abandoning of the peg
Examples of nations that use fixed exchange rates ?
Hong Kong , Saudi Arabia and Denmark
