exchange rates

Question 1

what is a floating exchange rate

Answer 1

The value of the exchange rate in a floating system is determined by the forces of supply and demand

The demand for a currency is equal to exports plus capital inflows – the supply of a currency is equal to imports plus capital flows

Question 2

floating exchange rate on a diagram

Answer 2

In a floating exchange rate, the market equilibrium price is at p1 – when demand increases from D1 to D2 – exchange rate appreciates to p2

Question 3

advantages of floating exchange rate (2)

Answer 3

• The exchange rate automatically adjusts to economic shocks

- It gives the monetary policy more freedom to focus on other macroeconomic objectives

Question 4

disadvantages of floating exchange rate (3)

Answer 4

• The fluctuations in the price of the exchange rate can be unpredictable – which can make investment planning difficult
• It can also affect the exports and imports of a country – which could cause a lot of unemployment if an industry is affected in particular
• It could make the exchange rate vulnerable to speculative shocks

Question 5

what is a fixed exchange rate

Answer 5

A fixed exchange rate has a value determined by the government compared to other currencies

In a fixed exchange rate system – supply of the currency can be manipulated by the central bank – who can buy or sell currency in order to change the price to where they want –

Question 6

fixed exchange rate in a diagram

Answer 6

In diagram – supply has been increased from S1 to S2 – by selling the currency so more is on the market Q1 to Q3 – as a result the currency depreciates P2 – P3 – making exports more competitive

Question 7

advantages of a fixed exchange rate (2)

Answer 7

• Allows firms to plan investment – because they know that they will not be affected by harsh fluctuations in the exchange rate
• It gives the monetary policy a focused target to work towards

Question 8

disadvantages of a fixed exchange rate (3)

Answer 8

• The government and the central bank do not necessarily know better than the market where the currency should be
• The balance of payments does not automatically adjust to economic shocks
• It can be costly and difficult for the government to hold large reserves of foreign currencies

Question 9

what is a managed exchange rate

Answer 9

Combines characteristics of fixed and floating exchange rate systems – currency fluctuates but doesn’t float on a fully free market – this is when the exchange rate floats on the market – but the central bank of the country buys and sells currencies to try and influence their exchange rate

Question 10

how to interest rates impact exchange rates

Answer 10

An increase in interest rates relative to other countries makes it more attractive to invest funds into the country because the rate of return on investment is higher – this increases demand for the currency – causing appreciation – hot money

Question 11

how does Quantative easing impact exchange rates

Answer 11

This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective – this has inflationary effects as it increases the money supply – can reduce the value of the currency – QE is usually used when inflation is low and it is not possible to further decrease interest rates

Question 12

what are foreign currency transactions

Answer 12

The Bank of England uses this to manage the UK’s gold and foreign currency reserves – as well as managing the MPC’s pool of foreign currency reserves – involves buying and selling foreign currency to manipulate the domestic currency

China kept large reserves of the US Dollar by purchasing government bonds in order to undervalue the YUAN