Exchange Rates Flashcards
Exchange rates
The price of a nations currency in terms of another currency
Factors affecting exchange rates (6)
Net trade
IR: hot money flows
Price level
Speculation
EG/events
Y: Income (MPI)
Floating exchange rate
Currency value is set by market forces and there is no intervention by the central bank. There’s no target for the exchange rate.
How an appreciation in the exchange rate occurs
• Hot money flows
• increased demand for pounds
• Price then increases
How an appreciation of an exchange rate can affect
N: increase in X and fall in M
IR is increased
Price level falls
Speculation is positive
EG/Events are positive
Y falls: MPI
How a depreciation of the exchange rate can occur
• Brexit: recession fears
• Speculation of low IR
• Selling of pounds
• Increase in supply
• Fall in the price of the pound
Depreciation of exchange rate how it affects NIPSEY
N: increase in M, decrease in X
IR low
Price level high
Speculation is negative
Events/EG are negative
Y- income increases (MPI)
Impact of depreciating currency on inflation
Increasing import prices could increase the PL for consumers
Impact of depreciating currency on EG
Stimulus for EG as net exports will increase
Depreciating exchange rate affect on UE
• Competitive currency: increases domestic consumption
• Possible multiplier effect: more tourism and foreign students
Depreciating exchange rate affect on BOP
Usually good but it depends on the PED for exports. There could be a possible J-Curve effect.
Depreciating currency affect in business investment
Increased profitability because overseas earnings will be worth more in terms of pounds
J-Curve effect
• Currency depreciation
• Should see a fall in imports but first the situation gets worse before contracts have to be fulfilled
• LT trade position improves
Marshall Lerner condition
A depreciation of exchange rates will lead to an increase in net trade balance if PED for X+M is greater than 1
Evaluation of currency depreciation
• The scale of the change in the exchange rate (5%,10%, 15%)
• Change LT or ST?
• When currency movement takes place: recession/recovery/boom
Floating exchange rates advantages (3)
• Little reserve holding required
• Can set IR to meet domestic objectives
• Partial autocorrection for current account deficit
Floating exchange rate disadvantages (2)
• No guarantee of stability
• Volatility may scare investors
Fixed exchange rates
Government/central bank fixes the value. The pegged exchange rate becomes the official rate and is adjustable
Fixed exchange rate advantages (4)
• Certainty of value: attracts investment
• Export dependant economies may favour managed system due to less volatility (China)
• Stability helps control inflation: discipline to keep unit costs low
• Imposes macro responsibility on gov/central bank
Fixed exchange rate disadvantages (3)
• Reduced freedom to use IR for other MEPOs
• Requires large reserves some countries are unable to hold
• Devaluation of fixed exchange rate can lead to cost push inflation
