exchange rate year 2 Flashcards
What are exchange rates?
The value of one currency in terms of another.
What are the 2 main types of exchange rates? what is the 3rd?
Floating
Fixed
Managed
What is a floating exchange rate?
This allows the exchange rate to be set by the market forces of demand and supply for a currency.
What is a fixed exchange rate?
This occurs when a government or central banks set the exchange rate they would like by tying the exchange rate to another currency, gold or to a basket of currencies.
What is a managed exchange rate system?
A combination of fixed and floating and is the most common.
The currency freely floats but the government might intervene from time to time to change the value of the currency.
What 4 factors influence a county’s exchange rate system?
Rise in exports
Rise in imports
Rise in UK interest rates
Increase in investment
Revaluation and devaluation
The terms used under a system of fixed exchange rates to describe increases and decreases in the value of a country’s currency in relation to other currencies determined by the country’s central bank.
Advantages of a floating exchange rate
Correction of balance of payment deficits under an automatic adjustment mechanism.
Protection from external shocks- the exchange rate will change in response to shocks such as a rise in the oil price.
Less need for central banks to hold reserves of foreign currency.
Disadvantages of a floating exchange rate
Instability- exchange rates can be volatile. This can make it difficult for firms, and governments, to plan ahead as uncertainty exists.
Speculation- leads to changes in exchange rates unrelated to the underlying pattern of trade.
Advantages of a fixed exchange rate
Certainty over the exchange rate can encourage domestic investment and FDI
Reduce speculation- dealers know that the central bank will aim for the exchange rate target and there will be little chance of devaluation or revaluation.
Disadvantages of fixed exchange rates
Policy conflicts- a fixed exchange rate may be incompatible with an objective of low inflation or low unemployment.
Difficulty in responding to external shocks. In a floating system the exchange rate will adjust automatically in response to domestic and international shocks.
Advantages of a managed exchange rate
Market forces determine the value of currency from day to day.
Government intervention is only required to make adjustments when necessary.
Predictability- consumers and firms have a clear expectation of the value of the currency and can plan on this basis.
Disadvantages of managed exchange rates
Loss of control of interest rates- a central bank/government would still have control of the bank/ government would still have control of the base interest rate but this would have to be set to ensure the currency was maintained at the desired level. Therefore it could not be used to control inflation.
cost push inflation exchange rate model answer
The economy is initially in equilibrium where real output is Y and the average price level is P. If there is a depreciation of the pound, import prices rise. If firms import factors of production, costs rise for firms across the economy, meaning they can produce less. This causes SRAS to shift to the left to SRAS1. The new equilibrium is where real output has fallen to Y1 and the average price level has increased to P1. The increase in the average price level due to increased costs is cost-push inflation.
j marshal curve model answer
Initially the economy has a current account deficit, where the value of imports exceeds the value of exports, plus net primary and secondary income. Due to a depreciation of the currency at point A, exports become cheaper and imports become more expensive. In the short term, the demand for imports and exports is relatively inelastic and thus the Marshall Lerner Condition is not met. This may be due to companies having inflexible contracts with suppliers or customers. As a result, export revenue falls and import expenditure rises, worsening the current account deficit, as shown from point A to B. Over time, export and import demand become more elastic as contracts run out and firms switch to cheaper suppliers; as a result, export revenue increases and import expenditure falls, improving the current account deficit after point B. The Marshall Lerner Condition is met where PEDx + PEDm ≥ 1 at point B.
international competitiveness model answer
The UK economy is initially in equilibrium where the average price level is P and real output (Y) is less than potential output (Yf). T-levels improve the quality of labour which is a factor of production. Improved labour raises international competitiveness because a higher supply of skilled labour lowers unit labour costs and raises the productivity. As a result, exporters’ costs fall and the quality of products rises. If the demand for exports rises as a result, AD will shift right to AD1, as exports are a component of AD. As the quality and quantity of factors of production improve, LRAS will also shift right to LRAS1, as the economy’s potential output rises. The economy is now in equilibrium where the average price level is still P and real output has risen to Yf1. An improvement in international competitiveness has resulted in non-inflationary long run growth and an improvement to the country’s trade balance.
However, whether this is the case depends on the change in the UK’s unit labour costs and productivity relative to other countries. If other countries’ unit labour costs fall more quickly, the price of their exports may also fall more quickly, meaning they may have lower relative prices, lowering the demand for UK exports.
how is it an automatic corrective mechanism
A ntrualliy automatic corrective mechnisime. Increase in export has resulted in an imbalance
As they is an increase in the value you will see an increase in your supply as imports become cheaper the supply of the currency will increase - extension along the curve therefore exports will become more expensive for other countries causing there to be a balance in a floating country system
