Exchange Rates

Question 1

Define exchange rate

Answer 1

The exchange rate is the rate at which one currency trades against another on the foreign exchange market.

Question 2

What is the REAL exchange rate?

Answer 2

The exchange rate after being adjusted for the effects of inflation
It most accurately reflects the purchasing power of a currency

Question 3

What is a floating exchange rate?

Answer 3

When the exchange rate of a currency is determined by market forces of supply and demand.

Question 4

What is a managed floating exchange rate?

Answer 4

When the government may choose to intervene in the FOREX markets to affect the value of a currency to meet macro objectives.

Question 5

How might a government intervene in a managed floating ex. rate?

Answer 5

• Making changes to foreign currency reserves.

- adjusting the interest rates relative to other countries

Question 6

What is a fixed exchange rate?

Answer 6

When the government seeks to keep the value of a currency at a certain level compared to other currencies.

Question 7

What factors influence exchange rates?

Answer 7

Interest Rates - hot money flows
Economic Growth - high growth - appreciation
Inflation - high inflation leads to less competitive exports and reduces currency demand - depreciation
Confidence in currency/economy
Current account deficit / surplus - large deficit - more likely to cause a depreciation
as money is leaving the economy

Question 8

What may occur from an appreciation in the exchange rate?

Think SPICED

Answer 8

• UK exports will become more expensive abroad - lower demand for £
• Imports into the UK will be cheaper and so rise in the supply of the £
• Appreciation tends to reduce inflation as deterioration of the trade balance lowers AD
• reduced growth - due to reduced demand from exports

Question 9

What occurs from a depreciating or devalued exchange rate?

Answer 9

• Increase exports
• decreased imports
• increased growth
• also increased inflation

Question 10

EVALUATION

Answer 10

Elasticity of demand - export rise from an appreciation depends on the elasticity of demand. Inelastic demand will lead to a small increase in Qd and vice versa

Time lag - in the short term, demand for exports is often inelastic but becomes more price elastic over time

Reasons for appre/depreciation - more successful countries see appreciation. Currency appreciates through more demand for their exports.