Exchange Rates

Question 1

define nominal ER

Answer 1

the price of one currency in terms of another, for instance 1 AED buys approximately 20 INR

Question 2

define real ER

Answer 2

currency’s value in terms of real purchasing power, adjusted for inflation. It reflects international price competitiveness of exports

RER = (nominal ER*domestic CPI)/foreign CPI)

e.g. if real ER depreciates, making X more price competitive, but domestic inflation is very high, this will offset the competitiveness gain and increase X prices

Question 3

define trade-weighted ER

Answer 3

price of one currency against a basket of currencies, belonging to that country’s main trading partners, weighted according to the relative importance of those countries in trade

e.g. if India carries out thrice as much trade with China than US, Chinese renminbi is weighted thrice as much as the dollar

Question 4

define fixed ER

Answer 4

ER set by the government and maintained by the central bank at a given level either by buying and selling the currencies or changing the IR to influence demand and supply of the currency

e.g. the UAE dirham is pegged to the dollar at 1 AED = 0.27 USD

Question 5

define floating ER

Answer 5

the ER is determined by the interaction of demand and supply of the currency ITO another and is free to increase and decrease as demand and supply changes

e.g. GBP has floated freely for many years

Question 6

define devaluation

Answer 6

government lowers the value of a fixed ER

Question 7

define revaluation

Answer 7

government increases the value of a fixed exchange rate

Question 8

define managed floating ER

Answer 8

govt allows ER to be determined by market forces within a give upper and lower limit, but if it exceeds or falls below these limits, it will intervene to maintain the ER within the limits

Question 9

why is a re/devaluation carried out?

Answer 9

1. as a policy tool to control macro performance
2. because the current ER is unsustainable

Question 10

how might re/devaluation be used as a policy tool?

Answer 10

re: to lower inflation (M, incentives)

de: to lower CA deficit and increase growth and lower unemployment

Question 11

how might re/devaluation be used if the current ER is unsustainable?

Answer 11

re: if there is too much upward pressure on the currency, the govt will not want to sell large quantities of the currency to lower the ER as this will increase money supply and inflation

de: if there is too much downward pressure on currency, CB risks running out of the reserves with which it can buy its own currency; increasing the IR to maintain will also dampen econ growth, output and employment

Question 12

what is the Marshall-Lerner condition?

Answer 12

for a devaluation/depreciation of ER to reduce a CA deficit, the sum of the price elasticities of demand for X and M must exceed 1. If less than 1, revaluation is better

the greater the combined PED, the smaller the fall in the ER needed to improve the CA deficit

Question 13

what is the J-curve effect?

Answer 13

a fall in the ER will cause a CA deficit to worsen in the SR before it improves in the LR due to low SR PED for X and M

this could be because of binding contracts, the time to recognise prices have changed. the time to search for cheaper alternatives

** draw diagram

*** reverse J curve - appreciation in ER will increase CA surplus in SR but lower it in LR

Question 14

what are the 4 main influences on a floating ER?

Answer 14

1. demand for X and M
2. inward and outward FDI
3. speculative activity
4. changes in the relative IR

Question 15

pros of a floating ER

Answer 15

1. reduced need for currency reserves - expensive and OC
2. allows autonomy of monetary policy to meet macro objectives
3. can help to meet other macro objectives - depreciation may boost CA and growth, appreciation can keep inflation under control (Eurozone)
4. partial automatic correction of CA deficit due to expenditure-switching effects

Question 16

cons of floating ER

Answer 16

1. volatility creates uncertainty for investment and trade
2. will not always self-adjust as speculation more influential than trade on the ER
3. can worsen inflation by depreciating currency
4. ER cannot be manipulated to meet macro objectives, e.g. devalue to increase growth if IR ineffective

Question 17

floating ER eval

Answer 17

• depends on magnitude of change
• non-price factors like quality/design may be more important
• impact of depreciation - ML and JC
• may not see benefits of devaluation if trading partners have trade barriers
• impact of devaluation depends on incomes at home and abroad

Question 18

pros of fixed ER

Answer 18

1. less volatility and uncertainty
2. incentive for domestic producers to increase price and non-price competitiveness - SR and LR growth (AD and AS)
3. lower cost of hedging
4. some flexibility possible if needed

Question 19

cons of fixed ER

Answer 19

• must hold large amounts of FX reserves
• cannot use IR to manage macro performance
• semi-permanent CA deficit

Question 20

eval of fixed ER

Answer 20

• easier to maintain with reserves if ER fixed close to natural equilbrium ER since reduces extent of intervention
• self-correcting deficit limitied anyways
• re/devaluation can invite currency war/retaliation
• extent of CA deficit depends on how high or low the peg is

Question 21

fixed or floating eval

Answer 21

1. use a managed float - combines flexibility of floating with less volatility of fixed
2. fixed ER may be better for developing countries - stability to attract FDI to support sustainable growth and development
3. depends on if country has enough FX reserves like China due to being net exporter
4. if conventional monetary policy has not helped to reduce inflation then may have to use devaluation
5. managed float may be better for net exporters like China