Exchange Rates

Question 1

Define ‘exchange rate’.

Answer 1

The value of one currency in terms of another

Question 2

What are the 2 equations related to exchange rates?

Answer 2

Foreign Currency = Home Currency x Exchange Rate

Home Currency = Foreign Currency ➗ Exchange Rate

Question 3

Define ‘appreciation’.

Answer 3

When one currency gets stronger against another

Question 4

Define ‘depreciation’.

Answer 4

When one currency gets weaker against another

Question 5

How does an appreciation of a currency affect the 4 macroeconomic objectives?

Answer 5

Economic growth: ↓
Inflation: ↓
Unemployment: ↑
CA: worsens

Question 6

How does a depreciation of a currency affect the 4 macroeconomic objectives?

Answer 6

Economic growth: ↑
Inflation: ↑
Unemployment: ↓
CA: improves

Question 7

What are the 6 factors that affect the demand for a currency?

Answer 7

Demand for exports ↑
Increased FDI in home country
Relatively high interest rates
Relatively low inflation
Increased tourism
Increased speculation of appreciation

Question 8

What are the 6 factors that affect the supply of a currency?

Answer 8

Demand for imports ↑
Increased FDI in foreign countries
Relatively low interest rates
Relatively high inflation
Decreased tourism
Increased speculation of depreciation

Question 9

How does the demand for exports increasing affect the exchange rate? (2 steps)

Answer 9

1) Demand for home currency increases

2) Causes currency to appreciate

Question 10

How does the demand for imports increasing affect the exchange rate? (2 steps)

Answer 10

1) Increase in demand for imports leads to more supply of home currency available
2) Causes the currency to depreciate

Question 11

How does increased FDI in a country affect its exchange rate? (2 steps)

Answer 11

1) Causes demand for home currency to increase

2) Causes currency to appreciate

Question 12

How does increased FDI in foreign countries affect the home country’s exchange rate? (2 steps)

Answer 12

1) Domestic companies investing in foreign countries leads to FDI in other countries
2) Causes home currency to depreciate

Question 13

How do relatively high interest rates affect the exchange rate? (2 steps)

Answer 13

1) They can attract more “hot money” inflow - demand for currency increases
2) Currency appreciates

Question 14

How do relatively low interest rates affect the exchange rate? (2 steps)

Answer 14

1) Can cause “hot money” flow outwards

2) Causes currency to depreciate

Question 15

How does relatively high inflation affect the exchange rate? (3 steps)

Answer 15

1) Can cause exports to become less competitive
2) Preference for imports increases
3) Supply of currency increases - depreciation

Question 16

How does relatively low inflation affect the exchange rate? (3 steps)

Answer 16

1) Domestic goods become more competitive

2) Demand for exports increases - appreciation

Question 17

How does increased tourism affect the exchange rate? (2 steps)

Answer 17

1) Increased demand for foreign currency

2) Appreciation

Question 18

How does decreased tourism affect the exchange rate? (2 steps)

Answer 18

1) Tourists leave the domestic economy - increased supply of currency
2) Depreciation

Question 19

How does increased speculation of appreciation affect the exchange rate?

Answer 19

1) Demand for currency increases

2) Appreciation

Question 20

How does increased speculation of depreciation affect the exchange rate?

Answer 20

1) Supply of currency increases

2) Depreciation

Question 21

How does a current account deficit correct itself? (5 steps)

Answer 21

1) Demand for imports increases (M > X)
2) Supply > Demand - depreciation
3) WPIDEC - Weak Pound, Imports Dearer, Exports Cheaper
4) M↓, X↑
5) Current account improves

Question 22

How does a current account surplus correct itself? (5 steps)

Answer 22

1) Demand for exports increases (X > M)
2) Demand > Supply - appreciation
3) SPICED - Strong Pound, Exports Cheaper, Imports Dearer
4) X↓, M↑
5) Current account worsens

Question 23

How might self correction not take place?

Answer 23

Due to inelastic goods traded like oil:
If a country is in a CA deficit and their currency’s weakening, they’ll still purchase relatively the same amount of oil at a higher price - CA worsens

Question 24

What are the 2 features of a free-floating exchange rate system?

Answer 24

Value of currency based on demand and supply

No intervention by the central bank

Question 25

What are the 3 features of a fixed exchange rate system?

Answer 25

Value of one currency fixed against another

Requires a high level of intervention - price highly monitored by both central banks

Revaluation/devaluation ONLY occurs in this system

Question 26

Define ‘revaluation’.

Answer 26

When the official exchange rate is intentionally increased in strength against another currency

Question 27

Define ‘devaluation’.

Answer 27

When the official exchange rate is intentionally reduced in strength against another currency