Exchange Rate Systems

Question 1

The central bank can manage the exchange rate of a currency in two main ways.

Answer 1

The central bank can manage the exchange rate of a currency in two main ways. They can either change the interest rate to shift the supply and demand of the currency, or they can use foreign currency transactions.

Question 2

How can a country change the value of their fixed exchange rates?

Answer 2

Revaluing or devaluing the currency

Question 3

Revaluation

Answer 3

When a country raises their fixed exchange rate.

Question 4

Devaluation

Answer 4

When a country lowers their fixed exchange rate.

Question 5

fixed exchange rate system

Answer 5

the government or central bank will intervene to maintain the exchange rate at an exact value.

Question 6

managed exchange rate system

Answer 6

In a managed exchange rate system, the government or central bank will only intervene to keep the exchange rate within a certain range .

Question 7

The value of the Qatari riyal is fixed to the value of the dollar. If demand for the Qatari riyal increases, what can the central bank of Qatar do to maintain the fixed exchange rate?

Answer 7

To decrease demand back to D, they could decrease the interest rate. Or, they could use foreign currency transactions to buy foreign currency reserves and sell their own currency, increasing the supply of their currency to S1.

Question 8

How does an increase in the base interest rate affect the value of Australia’s exchange rate?

Answer 8

If the Reserve Bank of Australia increases its interest rate, the demand for Australian dollars will increase.This is because hot money investors searching for a high interest rate will want to save in Australia. To do so they must purchase Australian dollars. This will shift demand for the Australian dollar to the right and cause an increase (an appreciation) in the exchange rate.

Question 9

Fixed Exchange Rates

Answer 9

The government, or central bank, fix the value of one currency to the value of another.

Question 10

Managed Exchange Rates

Answer 10

The government, or central bank, will only intervene to keep their exchange rate within a certain range.

Question 11

Floating Exchange Rates

Answer 11

The government or central bank does not intervene at all. The exchange rate is simply determined by market forces.

Question 12

nominal exchange rate

Answer 12

The nominal exchange rate tells us the price of one currency in terms of another.

Question 13

What does a price level tell us?

Answer 13

The average price of goods and services in an economy

Question 14

formula for the real exchange rate?

Answer 14

The formula for the Real Exchange Rate is (Nominal Exchange Rate x Domestic Price Level)/Foreign Price Level.

Question 15

A tourist is visiting America from the United Kingdom. Why might it be useful for them to know the real exchange rate?

Answer 15

The real exchange rate tells us how much one currency will really be worth in a different country in terms of the number of goods and services it will actually pay for.

Question 16

The real exchange rates from UK pounds to US dollars increases. Which of the following is a possible reason for this?

Answer 16

So, for the real exchange rate to increase, either the numerator (top of the fraction) must increase or the denominator (bottom of the fraction) must decrease. So, an increase in the nominal exchange rate could increase the real exchange rate. This is because an increase in the nominal exchange rate will mean that £1 will buy you more dollars - it will be worth more (in terms of the number of goods and services it will buy) in America. Or, an increase in the domestic price level in the UK could increase the real exchange rate.

Or, a decrease in the foreign price level would increase the real exchange rate. A decrease in the American price level means that goods are getting cheaper in America (deflation) and so £1 will buy you more goods and services in America.

Question 17

Nominal Exchange Rate

Answer 17

The nominal exchange rate tells us the price of one currency in terms of another.

Question 18

Real Exchange Rate

Answer 18

The real ER tells us how much a currency is worth relative to the prices of goods and services in another country.

Question 19

Real Exchange Rate Formula

Answer 19

Real Exchange Rate = (Nominal Exchange Rate x Domestic Price Level)/Foreign Price Level

Question 20

The real exchange rate from UK pounds to US dollars decreases. Which of the following is a possible reason for this?

Answer 20

So, for the real exchange rate to decrease, either the numerator (top of the fraction) must decrease, or the denominator (bottom of the fraction) must increase. So, a decrease in the nominal exchange rate could decrease the real exchange rate. This is because a decrease in the nominal exchange rate will mean that £1 will buy you fewer dollars - it will be worth less (in terms of the number of goods and services it will buy) in America. Or, a decrease in the domestic price level in the UK could decrease the real exchange rate.

Or, an increase in the foreign price level would decrease the real exchange rate. An increase in the American price level means that goods are getting more expensive in America (inflation) and so £1 will buy you fewer goods and services in America.

Question 21

The nominal exchange rates from Indian Rupee to Japanese yen was 1 rupee = 1.65 yen in 2018. The price level in India is 12400 rupees and the price level in Japan is 32400 Yen. What is the real exchange rate? Give your answer to 2 decimal places.

Answer 21

The real exchange rate formula is:
Real ER = (Nominal ER x Domestic Price Level)/Foreign Price Level
The nominal ER is 1.65 yen and the domestic price level (in India) is 12400 rupees. The foreign price level (in Japan) is 32400 Yen. So,
Real ER = (Nominal ER x Domestic Price)/Foreign Price
Real ER = (1.65 x 12400)/32400
Real ER = 20460/32400
Real ER = 0.63148
Real ER = 0.63 (to 2dp)