Exchange Rates

Question 1

What causes the demand for the £ to increase and thus the Value to Appreciate?

Answer 1

1) Increase in the relative interest rates (increase in hot money)
2) Speculators anticipate an appreciation in the £
3) Increase in FDI
4) Rise in incomes abroad
5) Increase in competitiveness

Question 2

What causes the Supply of the £ to increase and thus the Value to Depreciate?

Answer 2

1) Decrease in interest rate (exit of hot money)
2) Speculators anticipate depreciation in £
3) Firms moving away from Britain (decrease in FDI)
4) Increase in incomes domestically

Question 3

Cons of £ appreciation?

Answer 3

1) Lower growth ~~~~> potential current account deficit

2) Higher unemployment in exporting industries

3) Higher unemployment in domestic industries. These industries have to compete with price competitiveness abroad.

Question 4

Pros of £ appreciation?

Answer 4

1) Lower inflation ~~> DP + CP
2) Cheaper imports ~~> increase living standards
3) Potential for lower prices domestically

Question 5

Pros of £ depreciation?

Answer 5

1) increased employment in exporting industries
2) increased employment in domestic industries generally

Question 6

Cons of £ depreciation?

Answer 6

1) Higher inflation ~~> DP + CP

Question 7

Advantages of free floating exchange rate?

Answer 7

1) May partially adjust current account deficit – e.g. external deficit leads to depreciation – leads to expenditure switching.

2) Central bank doesn’t hold large reserves.

3) Monetary policy can be anchored to domestic objectives (monetary trilemma)

Question 8

Disadvantages of a free floating exchange rate?

Answer 8

1) Fall can lead to cost-push inflation

2) Speculation Volatility - inhabit trade + investment

3) Uncertainty - business planning difficult

Question 9

Cons of fixed exchange rate?

Answer 9

1) The balance of payments does not automatically adjust to
economic shocks.

2) It can be costly and difficult for the government to hold large reserves of foreign currencies.

Question 10

Pros of fixed exchange rate?

Answer 10

1) Creates certainty

2) Competitive pressures placed on firms

3) Can be used to aid BoP

Question 11

What is the monetary trilemma?

Answer 11

Impossible to have all 3:

• free capital flows
• fixed exchange rate
• independent monetary policy