Exchange Rates

Question 1

Real Exchange Rate

Answer 1

A direct / non-adjusted currency:currency comparison

Question 2

Nominal Exchange Rate

Answer 2

When the nominal rate is adjusted to reflect the rate of inflation.

Question 3

Free-floating ER

Answer 3

External value of a currency depends wholly on the market forces of supply + demand.

Question 4

Managed-Floating ER

Answer 4

Central banks may choose to intervene in FOREX markets to affect the value of currency to meet Macroeconomic objectives.

However usually left floating

Question 5

Fixed ER

Answer 5

A nation pegs their currency to another as part of a currency board. Maintained by selling foreign currency reserves (demanding £’s instead) in order to increase the demand for the £ on the FOREX + Increase interest rates in order to increase the D for the £ on the FOREX from hot money inflows.

Question 6

How are floating ER determined ?

Answer 6

Supply + Demand (market forces)

Eg. An increase in the supply of the £ will lead to a reduction in the value of the £

Question 7

Key causes of ER fluctuations

Answer 7

Speculation
Govt / Central Bank action
Relative inflation/interest rates
Confidence
Current Account Balance

Question 8

Advantages of a floating ER

Answer 8

Reduced need for holding currency reserves
Freedom to set interest rates in order to achieve Macro objectives
Some protection from external shocks
Some automatic correction for current account deficits
Less risk of severe under/ overvaluation of the currency

Question 9

Disadvantages of a floating ER

Answer 9

No guarantee that floating ER will be stable → market forces / failure
Volatility from floating exchange rates may deter FDI
Futures trading - inefficient
Speculation likely

Question 10

Advantages of Fixed ER

Answer 10

Certainty → Increased Investor confidence
Reduced costs incurred from trading on the futures market (FOREX)
A fixed ER → stable price expectations (Inflation)
Reduced speculation due to fixed exchange rate

Question 11

Disadvantages of Fixed ER

Answer 11

Maintaining ER may conflict with other objectives
Currency reserves required to maintain a fixed ER.
Potential for political conflict / protectionist retaliation
Regressive Effects
Less flexible to external shocks
Overvalued currency - CA deficit

Question 12

Causes of ER appreciation

Answer 12

Strong economic performance
High interest rates - hot money
Political stability
Positive Trade balance
Optimistic Speculation

Question 13

Causes of ER Depreciation

Answer 13

Relatively Low Interest rates
High Inflation
Political instability
Trade Deficit
Pessemistic Speculation

Question 14

Positive Effects of ER appreciation

Answer 14

Cheaper imports / increased Qm
Increased living standards
Increased purchasing power
Attract foreign investment

Question 15

Negative effects of ER appreciation

Answer 15

Reduced exports
Reduced competitiveness
Job losses
Worsening Balance of Trade
AD falls - slower growth

Question 16

Positive effects of ER depreciation

Answer 16

Boost in exports
Increased domestic investment
Improve trade balance (MLC)

Question 17

Negative effects of ER depreciation

Answer 17

Increased price of Imports
Falling confidence
Cost-push inflation
Falling living standards

Question 18

What is a currency union ?

Answer 18

All member states utilised a standardised currency and therefore, have a common monetary policy - usually controlled by a central bank.

Question 19

Advantages of joining a Currency Union

Answer 19

Lower transaction costs between member states
Easier to compare prices
Provides an incentive to keep inflation low
Eliminates uncertainty
Increased volume of trade between member states.

Question 20

Disadvantages of joining a currency union

Answer 20

Loss of monetary policy autonomy
Countries cannot manipulate their ER - eg. devalue to increase competitiveness
Lack of fiscal union - eg. policy may not benefit all member states
High cost of leaving
High conversion cost for non-member currencies