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Economic macro > Exchange rates > Flashcards

Exchange rates Flashcards

1
Q

Floating system

A
  • The value of the exchange rate in a floating system is determined by the forces of demand and supply.
  • In a floating exchange rate system, the market equilibrium is at P1, and when demand increases from D1 to D2 the exchange rate appreciates to P2.
  • Demand for the currency is equal to the exports plus the capital flows.
  • Supply is equal to imports plus capital outflows.
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2
Q

Causes of exchange rate changes

A
  • Inflation
  • Interest rates
  • Speculation and confidence
  • Balance of payments
  • Government finances
  • International competitiveness.
  • Government intervention
  • QE
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3
Q

Causes of exchange rate changes - Inflation

A

A lower inflation rate means exports are relatively more competitive, this increases the demand for UK goods.

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4
Q

Causes of exchange rate changes - Interest rates

A

If Uk interest rates rise relative to elsewhere it will become more attractive for foreign investors to deposit money in the UK, therefore demand for the pound will rise.

This is rising inflows of ‘Hot money’

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5
Q

Causes of exchange rate changes - Speculation and confidence

A

If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise.

If confidence in the economy is high, strong growth and stability, demand for the currency will increase.

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6
Q

Causes of exchange rate changes - Balance of payments

A

A deficit on the current account means that the value of imports is greater than the value of exports, if this is financed by a surplus on the financial account than this is ok but a currency that struggles to attract capital inflows to finance a current account will see a depreciation.

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7
Q

Causes of exchange rate changes - Government dept

A

The value of government dept makes market fearfula and uncertain, investors will sell their bonds causing a fall in the value of the exchange rate.

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8
Q

Causes of exchange rate changes - Government intervention

A

Some governments attempt to influence the value of their currency. For example, China has sought to keep its currency undervalued to make Chinese exports more competitive. They can do this by buying US dollar assets which increases the value of the US dollar to Chinese Yuan.

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9
Q

Causes of exchange rate changes - QE

A
  • QE has inflationary effects as it increases the money supply.
    BUT used when inflation is low and not possible to lower interest rates further.
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10
Q

Impacts of the exchange rate on policy objectives

A

A reduction in the exchange rate causes exports to become cheaper, which increases exports, this assumes that demand for exports is price elastic, it also causes imports to become relatively expensive. UK current account deficit would likely improve.

Inflationary due to the increase in price of imported materials, prodcution costs for firms increases, causing cost push inflation.

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11
Q

Marshall-Lerner condition

A

This states that a devaluation in a currency only imrpoves the balance of trade/current account deficit if the PED for imports plus the PED for exports must be greater than 1. This means that they are elastic.

This could not be met if there are little domestic subisitutes, low quality subsitutes.

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12
Q

J curve

A

Even if a country DOES meet the Marshall learner condition, in the short term traded goods tend to have inelastic demand.

When a currency is devalued, the currency causes imports to become more expensive, at first the total value of imports increases, which worsens the deficit. Eventually the value of exports decrease which leads to a reduction in the trade defici.

There is a time lag in changing the volume of imports and exports, due to trade contracts and price inelastic demand for imports in the short run, because it takes time to find subsitutes, while consumers look for alternative.

In the long run consumers might start purchasing domestic products, improving the deficit.

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13
Q

The effect of exchange rates on firms

A
  • Depreciation in the pound means ecports become more competitive.
  • If firms are net importers of raw materials, costs of production will increase because imports
    are relatively more expensive when the pound is weaker. This could make the firm less
    internationally competitive, and it could mean they make lower profits.
  • However, if firms
    have fixed contracts for how long they import materials from another country, then changes
    in the exchange rate will not affect quantity purchased or the price paid.
    -
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14
Q

Exchange rate index

A

This measures how on currency performs against another, for example the US dollar is measured against 6 other currencies using the US dollar index.

An exchange rate index is a way of measuring the performance of a currency against a basket of other currencies.
An exchange rate index shows the percentage change in the value of the currency against its main competitors.

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15
Q

Managed float system

A

Managed float exchange rate systems combine the characteristics of fixed and floating
exchange rate systems. The currency fluctuates, but it 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.
The Japanese central bank has also attempted to make exports more competitive by
manipulating the Yen, even though the Yen floats on the market.
The Indian rupee fluctuates on the market, but the central bank intervenes when it falls
outside a set range.

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16
Q

Pros and cons of policies that hold exchange rates to a artificaly high level

A
  • When firms know what the value the currency is relative to another currency, it allows for them to plan investment, because they know that they will not be affected by harsh fluctuations.
  • Costly for government to hold large reserves of foreign currency
17
Q

Impact on ToT

A

A appreciation in the currency will increase the price of exports and decrease the price of imports, this causes the ToT to rise.

Improving terms of trade mean the economy can import more goods for each unit of export. This
can help reduce the effects of cost-push inflation, since import prices are falling relative to export
prices. It could also help improve standards of living for consumers in the country.
However, it can mean that the balance of payments worsens, since there are fewer exports and
more imports.
Worsening terms of trade means that for every import, the country has to export more. It could
make the price of new technology more expensive, which might limit productivity.
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It could lead to a fall in living standards, and because it is more difficult to earn foreign currency, it
becomes harder to pay foreign debt.

18
Q

Advantages of a floating exchange rate

A
  • Central banks require foriegn currency reserves in a fixed exchange rate system so they can intervene, a floating exchange rate will reduce the need for such reserves.
  • Floating exchange rate can help reduce a current account deficit, deficit will lead to a fall in the value of the currency because there is high purchase of imports and low purchase of exports, demand for exports increase and imports decrease, reducing the deficit.
  • Floating exchange rate means that the government doesnt need to use monetary policy to maintain the exchange rate and it can be used for other objectives.
19
Q

Disadvantages of a floating exchange rate

A
  • This will fluctuate to a great degree, makes business planning difficult, could lead to uncertainty and a fall in invesment.
  • Speculation can artificlaly strengthen a exchnage rate, this would mean the country loses export competitveness.
  • If demand for imports is price inelastic, falls in the exchange rate can be inflationary.
20
Q

Advantages of a fixed exchange rate

A
  • Speculation can be reduced, unless dealers feel that the exchnage rate is no longer sustainable.
  • Devaluation, export led growth, AD up.
  • Competitive pressures are placed on firms, they need to keep costs down and remain competitive.
  • Certainty encourages FDI and invesment.
21
Q

Disadvantages of a fixed exchange rate

A
  • If speculators feel a fixed exchange rait isnt sustainable they might take advantage of this by selling currency.
  • Loses control of interest rates as they have to keep exchange rates at the desired level
  • Difficult to maintain.
22
Q

What is a fixed exchange rate

A

This involves maintaining the exchange rate at a target rate, it will be controlled at the target rate by selling and buying currency and interest rates.

Pegged exchange rates happen when the value of a currenncy is pegged to another.

23
Q

Managed float

A

The exchange rate is mainly left to maket forces but the government can intervene in order to influence the exchange rate, for example reduce the impact of a economic shock on the currency.

24
Q

Government intervention in the exchange rate

A
  • A devaluation of the exchange rate occurs when the rate is formally lowered by the government, they can achieve this by selling their domestic currency.
  • Goverments can devalue their own currency in order to improve international competitiveness.
  • Central banks can sell foreign currency reserves.
  • Interest rates rise, people turn their foreign money into, pounds, demand goes up and value rise.
25
Q

Impact on the current account

A

If the value of the currency falls, exports will become cheaper and more competitive, demand for exports increase, imports become more expensive so demand for imports fall. A current account deficit should therefore reduce.

This will ONLY happen if the Marshall-Lerner condition holds.

The J curve shows that it could actually worsen in the short run and improve in the long run

26
Q

Devaluation impact on other macro economic objectives

A
  • Exports increase and imports decrease, resulting in economic growth and a rise in AD.
  • Unemployment will fall.
  • Inflation may rise, only if demand for imports is price inelastic.
  • Increased import prices can cause cost push inflation.

Economic macro (15 decks)

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