exchange rates

Question 1

what is meant by a fixed exchange rate system

Answer 1

when the value of a currency in terms of another currency is fixed against the target currency

Question 2

why might a country want to fix its exchange rate

Answer 2

sometimes to stabilise the currency if it has been volatile. also when fixing it against major trading partners, it provides firms with predictability in planning and forecasting income flows between countries.

Question 3

what is meant by a devaluation or a revaluation

Answer 3

a devaluation is where a government deliberately reduces the exchange rate in either a managed or a fixed exchange rate system.
a revaluation is when a government deliberately increases the exchange rate in a managed or fixed exchange rate system.

Question 4

what is meant by a floating exchange rate system

Answer 4

where the exchange rate is determined by supply and demand of that currency on the international market

Question 5

identify and explain 4 factors that would increase the demand for pound sterling

Answer 5

• an increase in exports - as more domestic currency would be demanded by overseas consumers to pay for the goods/services
• an increase in interest rates, as more domestic currency would be demanded by overseas depositors looking for a bank with a high interest rate = hot money flows
• speculation that the currency will appreciate - investors will purchase the currency whilst the exchange rate is low, expecting it to rise in value
• an increase in foreign tourists in the UK.

Question 6

identify and explain four factors that would increase the supply of £ sterling

Answer 6

• an increase in imports as UK residents need to sells £ in order to purchase the imports
• a decrease in interest rates, anyone with money in UK banks will want to withdraw their money and sell it in order to transfer it to another country
• speculation that the currency will depreciate - investors will sell the currency at a high price before the currency falls in value.
• an increase in UK tourism abroad - UK residents will sell £ in order to purchase foreign currency to pay for things on their holiday

Question 7

what can cause the exchange rate to appreciate

Answer 7

anything that causes an increase in the demand for a currency or a fall in the supply

Question 8

what can cause an ER to depreciate

Answer 8

anything that causes a decrease in the demand for a currency or an increase in the supply

Question 9

what is the difference between devaluation and a depreciation

Answer 9

a depreciation is when a currency falls in value in a floating exchange rate system, or because of a fall in the demand/rise in the supply of the currency on the free market.
a devaluation is where the same thing happens but because of deliberate intervention by the gov

Question 10

difference between revaluation and appreciation

Answer 10

an appreciation is when a currency increases in value in a floating exchange rate system or the due to demanad/supply changing. a revaluation is when it happens due to intervention by the government.

Question 11

what is meant by the purchasing power parity theory of exchange rates

Answer 11

the value of a currency adjusts so that the same product costs the same in every market in which it is sold.

Question 12

what is meant by hot money

Answer 12

stocks of money that are moved globally in search of the best relative exchange rate or the best return

Question 13

what are the advantages and disadvantages of a floating exchange rate

Answer 13

+ it adjusts so that there is always a zero balance on the balance of payments
+ it helps an economy adjust to external shocks
+ monetary policy is free to serve the interests of the domestic economy rather than to maintain a fixed or managed exchange rate

• uncertainty amongst investors
• lack of investment - may discourage FDI
• speculation - fluctuations in exchange rates may cause increased hot money flows abroad and cause more exchange rate fluctuations.

Question 14

what are the advantages and disadvantages of a fixed ER

Answer 14

AD:
- creates stability and predictability - firms can plan income flows with more certainty and so less foreign exchange risk
- avoid currency fluctuations
- incentive to keep inflation low
DIS:
- conflict with other macro-economic objectives
- less flexibility
- current account imbalances

Question 15

what is meant by a managed exchange rate

Answer 15

when a combination of free market forces and intervention takes place to take control of the ER

Question 16

how can the government and/or central bank influence exchange rates

Answer 16

the central bank is independent of government interference in the UK, unlike in many other countries. in these other countries the government can instruct the central bank to buy and sell its own currency on the free market, but also buy and sell reserves of other currencies that it has stocks of. this is manipulating supply and drmand for its currency and brings about a devaluation or revaluation.

Question 17

what are the consequences of competitive devaluations or depreciations? use the J-curve and Marshall-Lerner condition to answer.

Answer 17

the J curve suggests that demand for exports and imports is inelastic in the short run, as producers and consumers take time to change their behaviour folowing the change in the exchange rate. producers often sign contracts with suppliers with notice periods meaning they cannot switch suppliers in the short run. if this is the case then a depreciation and devaluation will result in a worsening in the current account deficit before it eventually improves.

the marshall lerner condition holding states that if demand for exports is sensitive to a change in price, then a depreciation/devaluation will mean that proportionally more exports will be sold, increasing the domestic currency value of the exports. similarly, if demand for imports is sensitive to a change in price, then a depreciation/devaluation will mean that proportionally less imports will be bought, decreasing the domestic currency value of the imports. if exports rise in value and imports decrease, then the current account deficit will improve. however if the marshall lerner condition does not hold, then a depreciation/devaluation could cause it to worsen.

Question 18

how does the exchange rate influence other macro-economic indicators

Answer 18

it impacts net trade therefore impacting AD. if an economy is operating under a fixed or managed exchange rate system, then they may have to give up control over interest rates and money supply in order to achieve their exchange rate objectives.

in a floating exchange rate system, a strong exchange rate may cause a decrease in net trade as M rises and X falls, causing AD to fall. it will also cause deflationary pressure on the economy, resulting in a fall in real GDP or negative economic growth, as well as higher unemployment and a negative output gap. there may also be multiplier effects as this would represent a withdrawal from the circular flow of income.

Question 19

what is FDI

Answer 19

foreign direct investment is when an overseas company invests in fixed capital in another country. for example they may set up a factory in another country.

Question 20

how does the exchange rate influence FDI

Answer 20

a weaker or lower ER may make a country more attractive for attracting FDI. it means that investors money can go further and purchase more capital than if the currency is strong.