Exchange Rates

Question 1

Strong / weak pound

Answer 1

Strong pound - imports increase / exports decrease
Weaker pound - imports decrease / exports increase

Question 2

Freely floating exchange rates

Answer 2

A freely floating exchange rate is determined by the demand and supply for the currency.

The demand for a currency is determined by a number of factors such as:

• foreign trade (demand for imports and exports)
• the potential to make financial gain (linked to hot money flows)
• foreign direct investment (FDI)

Question 3

Hot money flows

Answer 3

Short term investments that are rapidly moved between countries or financial markets in search of the highest short term return or interest rates.

Question 4

What factors would lead to a fall in the value of the exchange rate

Answer 4

• A fall in the relative interest rates (i.e. a fall in UK interest rates or rise in foreign interest rates)
• A rise in imports
• A fall in exports
• A rise in inflation (relative to inflation rates in the trading partners economies)
• A fall in productivity (relative to productivity rates in other economies)
• A fall in Foreign Direct Investment
• Speculation about a fall in the exchange rate, causing a fall in the currency.

Question 5

Exchange rate - supply and demand diagram

Answer 5

Question 6

Factors influencing exchange rates

Answer 6

Interest rates - higher interest rates encourage hot money flows and demand for a currency. This causes appreciation

Economic growth - higher economic growth will tend to cause appreciation in the currency, this is because markets expect higher interest rates - when growth is rapid.

Inflation - higher inflation makes exports less competitive and reduces demand for currency. This causes depreciation.

Confidence in the economy/currency

Current account deficit/surplus - a large current account deficit is more likely to cause a depreciation in the value of the currency because money is leaving the economy to buy imports.

Question 7

Appreciation

Answer 7

Rises in value

Question 8

Depreciation

Answer 8

Decreases in value

Question 9

Appreciation of exchange rates

Answer 9

UK exports more expensive abroad – leading to lower demand.

Imports into the UK will be cheaper, increasing demand for imports

An appreciation will tend to reduce inflation

Lower economic growth – due to reduced demand for exports.

Worsening of the current account deficit (because imports are cheaper and quantity of imports rises, but exports are more expensive and quantity falls)

Strong Pound = Imports Cheaper, Exports Dearer. SPICED

Question 10

Depreciation

Answer 10

UK exports become more competitive, increasing demand for exports

Imports become more expensive, leading to lower demand for imports

A depreciation will tend to increase economic growth but also cause inflation.

Question 11

Exchange rate

Answer 11

Is the price of one currency in terms of another - the purchasing power of one currency against another.