Exchange Rates

Question 1

Exchange Rate systems

Answer 1

• Free-floating (wholly on market forces)
• Managed-floating (occasionally intervene)
• Fixed exchange rate (e.g. hard currency peg)

Question 2

Causes of changes in floating

Answer 2

• Trade/current account balances
• Foreign Direct Investment (FDI)
• Portfolio investment
• Interest Rate differentials (countries with high-interest rates = hot money slows coming in)

Question 3

Managed exchange rates

Answer 3

• Freedom for exchange rate on a daily basis
• may intervene occasionally e.g. buying or selling the currency
• changes in policy interest rates to attract hot money flows
• Currency = key target of a country’s monetary policy

Question 4

Fixed Exchange rate

Answer 4

• Government /central bank fixes the currency value
• pegged to one or more currencies
• must have sufficient reserves
• pegged exchange rate
• adjustable peg system - occasional realignments may be necessary

Question 5

Effect of currency depreciation on Macro objectives

Answer 5

• Inflation - Higher import prices = higher consumer prices - threatens real living standards
• Economic Growth - weaker currency = stimulus to GDP growth - many exports require imports
• Unemployment - more competitive currency = increase in production = positive export multiplier effect - stimulate AD + jobs
• Balance of trade - dependant on PED for X&M - possible J curve effect in short-run
• Business investment - help improve profitability
• Wider macroeconomic effects - Depreciation is similar to a cut in interest rates