Exchange rates Flashcards
Freely Floating exchange rate
A freely floating exchange rate is when the value of a currency is determined by the market mechanism in an economy. (demand and supply)
Advantages of a Freely Floating exchange rate
Balance of payments corrected automatically;
current account deficit (M>E) causes the exchange rate to depreciate - Cheaper exports, Dearer imports.
Freedom for monetary policy - absence of an exchange rate target allows Interest rates to be set to meet domestic aims , such as controlling inflation.
Disadvantages of a Freely Floating exchange rate
Government place less emphasis on controlling inflation if the exchange rate does it automatically.
- depreciation in the exchange rate could lead to inflation If the price of imports increase.
If PED of imports is inelastic, BOP will not improve.
Fixed exchange rates
When the value of a currency has a fixed value against other currencies (currency peg eg.AED to USD).
Advantages of Fixed exchange rates
Reduces exchange rate uncertainty promoting trade & investment as import & export prices are more stable.
Disciplines domestic firms to boost productivity, as they can’t rely on a fall in the exchange rate to restore competitiveness.
Disadvantages of Fixed exchange rates
Domestic monetary policy restricted as interest rates are used to set the exchange rate - conflicts with macro-economic objectives.
High amounts of foreign currency reserves to intervene in the FOREX market - money could’ve been spent on economic growth.
Marshall Learner Condition
For the depreciation in the exchange rate to create a net improvement in the trade balance, the sum of PED for exports and imports needs to be > 1.
J-curve effect *BOOK FOR DIAGRAM
When devaluation of the pound occurs, the current account deficit initially gets worse in the short run as economic agents need time to react eg. contracts.
In the Long run, a current account surplus occurs, as customers and economic agents awareness raises and switch to alternatives.
Semi fixed exchange rate
A hybrid system that attempts to achieve a balance between a fixed and a floating exchange rate.
Adjustable peg system - Semi fixed exchange rate
When the rate is fixed in the short term but adjusted in the long term to prevent sustained over / under valuation.
Managed floating systems - Semi fixed exchange rate
When the rate is allowed to float but the central bank intervenes to prevent large fluctuations.
Exchange rate band systems - Semi fixed exchange rate
When the exchange rate is allowed to float between an upper and a lower band - intervention occurs when the rate hits the upper or lower band.
Difference between effective exchange rate, and purchasing power parity
EER is the measure of a currency value against a weighted basket of all other currencies values.
PPP is the measure of a currency’s value against what they can buy in other currencies. - goods should cost the same in both currencies
