Exchange Rates

Question 1

Exchange rate

Answer 1

The price of one currency in comparison to another

Question 2

Factors influencing exchange rates

Answer 2

Depend on the supply and demand of a currency

Appreciation (increase in demand):
- Relative interest rates: foreigners will want to put their money in UK banks in order to get a better rate of return. Increased demand
- Speculation: if there is an anticipation in the rise of the pound they will move their money into pounds, increasing demand
- Increase in FDI: foreign firms set up in the UK, pay for everything in pounds, increasing demand
- Rise in incomes abroad: foreigners may demand UK exports, have to buy in pounds, swapping currency increasing demand
- Increase in competitiveness, make UK exports more competitive, more exports sold, have to buy in pounds increasing demand

Depreciation (increase in supply):
- Decrease in interest rates: investors no longer want their money in UK banks, move money out of UK
- Firms moving away from Britain
- Increase in income domestically: people in the UK get richer, demand more imports, selling the pound for dollars

Question 3

Floating exchange rate system

Answer 3

Exchange rate is determined by supply and demand
Governments do not actively intervene to fix the rate

Question 4

Fixed exchange rate

Answer 4

The government or central bank sets a specific exchange rate and is committed to maintaining it
To keep the rate stable, the authorities may buy or sell their own currency as needed

Question 5

Managed exchange rate

Answer 5

Where authorities occasionally intervene to influence the exchange rate.

Question 6

Revaluation

Answer 6

AN increase in a fixed exchange rate

Question 7

Devaluation

Answer 7

Reduction of exchange rate in a fixed exchange rate system

Question 8

Governments can influence exchange rates through…

Answer 8

• foreign currency transactions: buying or seeking their own currency in the foreign exchange market
• interest rates: attract or deter foreign capital inflows

Question 9

Competitive devaluation

Answer 9

Occurs when multiple countries intentionally lower their exchange rates to gain a competitive advantage in international trade

Question 10

Consequences of competitive devaluation

Answer 10

• trade tensions
• protectionism
• potential disruptions to the global economy

Question 11

Marshall-Lerner condition

Answer 11

if the demand for a country’s exports and imports is more sensitive to changes in price than the supply of these goods, the balance of trade will improve after the currency depreciates.

Question 12

How the change of exchange rates effect FDI flows

Answer 12

• a weaker currency may make a country’s assets more appealing to foreign investors

Question 13

Effects of a devaluation of a currency

Answer 13

1. Exports cheaper: More competitive price -> appear cheaper -> increase demand for exports . Assets also become more attractive -> e.g. UK property might seem cheaper
2. Imports more expensive: Reduce demand for imports
3. Increased AD: (X-M) in the formula for AD. Higher AD is likely to cause economic growth (maybe inflation)
4. Inflation: Imports more expensive causing cost push inflation (shifts SRAS). AD is increasing causing demand pull inflation.
5. Improvement of the current account: higher exports and lower imports. Reduce current account deficit. Large in the UK in 2016 so devaluation necessary
6. Wages: Makes the UK less attractive for foreign workers. In the UK 30% of the food manufacturing industry workers are from the EU. Uk firms may have to push up wages to keep foreign labour.

EVAL:
- elasticity of demand for exports and imports: If demand is price inelastic, then a fall in the price of exports will lead to a small rise in quantity. Therefore value of exports may actually fall. An improvement in the current account on the balance of payments depends on the Marshall Lerner condition: if PEDx + PEDm > 1 then a devaluation will improve the current account
- State of the global economy: if the global economy is in a recession then a devaluation ma be insufficient to boost export demand.
- Inflation: the effect on inflation will depend on: spare capacity in the economy, whether firms pass increased import costs onto consumers, other factors determining inflation
4. Depends on why the currency is being devalued. If i is due to a loss of competitiveness, then a devaluation can help to restore competitiveness.

Example:
- UK devaluation of 1967