Exchange Rates Flashcards
What is an exchange rate
Rate or price at which one country’s currency can be exchanged for other currencies in the foreign exchange market
What are the main exchange rate systems
Free-floating
Manged-floating
Fixed
What is a free-floating exchange rate
An exchange rate system where the external value of a currency depend wholly on markets forces of supply and demand
What is a manged-floating exchange rate system
An exchange rate system where the central bank may choose occasionally to intervene in the foreign exchange markets to influence the value of a ccurency
What is a fixed exchange rate system
An exchange rate system where currencies trade at an officially announced level
What is depreciation
Fall in the value of a currency in a floating exchange rate system
What is devaluation
Fal in the value of a currency in a fixed exchange rate system
What is appreciation
Rise in the value of a currency in a floating exchange rate system
What is revaluation
Rise in the value of a currency in a fixed exchange rate system
What factors cause changes in the currency in a floating system
Trade / Current Account Balances
FDI
Portfolio Investment
Interest Rate Differentials
Policy tools for Managing Floating Exchange Rates
Changes in Monetary Policy Interest Rates
Quantitive Easing
Direct Buying/Selling in the Currency Market
Taxation of Overseas Currency Deposits and Capital Controls
Advantages of Floating Exchange Rates
Reduces the need for a Central Bank to hold large amounts of currency reserves
Freedom to set Monetary Policy Interest Rates
May help to prevent imported inflation
Less risk of a currency becoming significantly under/overvalued
Evaluation for Floating Exchange Rates
No guarantee that they will be stable
Volatility may be detrimental to attracted inward investment
Lower exchange rate does not necessarily correct a persistent current account deficit
Advantages of fixed exchange rate
Certainty of currency value gives confidence for inward investment from overseas businesses.
Reduced need to engage in and costs of “currency hedging” for businesses such as airlines.
Currency stability helps to control inflation
A stable currency can lead to lower borrowing costs
Imposes responsibility on government macro policies
Less speculation in the currency market if the fixed exchange rate is regarded by traders as credible.
Evaluation points for Fixed Exchange Rates
Reduced freedom to use interest rates for other macro objectives
Many developing countries do not have sufficiently large foreign currency reserves to be able to maintain a fixed exchange rate over a period of time.
Difficult for countries to use a competitive devaluation of their fixed exchange rate – this creates political tensions and might lead to a protectionist response.
Devaluation of a fixed exchange rate can lead to a surge in cost-push inflation – this is damaging for competitiveness and has regressive effects on poorer families.
