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SH ECON CARDS XTENDED > EXCHANGE RATES > Flashcards

EXCHANGE RATES Flashcards

1
Q

What is an Exchange Rate?

A

The rate at which one currency can be exchanged for another

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2
Q

What are the Axes labelled on an ER Diagram?

A

Y-Axis - Exchange Rate
X-Axis - Quantity of Currency

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3
Q

Factors Affecting Exchange Rates

A
  • Imports and Exports (net balance of trade)
  • Speculation
  • Relative Interest Rates
  • Relative Inflation Rates
  • FDI
  • Quantitative Easing
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4
Q

How Do Exports affect Exchange Rates?

A
  • More Exports - More people wanting to convert to £s - Demand for £ increases (Right Shift) - Exchange Rate decreases
  • Less Exports - Less people wanting to convert £s - Demand for £ decreases (Left Shift) - Exchange Rate increases
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5
Q

How do Imports affect Exchange Rates?

A
  • More Imports - More people selling £s - Supply of £s increases (Right Shift) - Exchange Rate Decreases
  • Less Imports - Less people selling £s - Supply of £s decreases (Left Shift) - Exchange Rate Increases
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6
Q

How does Speculation affect Exchange Rates?

A
  • Speculation over future exchange rates will affect exchange rates now
  • People/Investors will act now in anticipation of future changes which will end up affecting current ERs
  • E.g. People may predict a depreciation in ER in 4 MONTHS time so will sell off currency NOW, increasing Supply of Currency and Decreasing the ER NOW (not up to point expected in 4 months though)
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7
Q

How do Relative Interest Rates affect Exchange Rates?

A

HOT MONEY FLOWS; E.g. UK
- IR in UK Increases - Hot Money Flows into the UK as Investors wish to save in UK for higher reward on savings - Demand for £s increases (Right Shift) - ER Increases
- IR decreases - Hot Money Flows out of the UK as Investors wish to save money elsewhere for higher reward - Supply of £s increases (Right Shift) - ER decreases

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8
Q

How do Relative Inflation Rates affect Exchange Rates?

A
  • Lower Inflation Rate means Appreciation in Currency
  • If the Inflation Rate is higher in Country A than B, that Country A’s prices are increasing faster than B; making Country B’s good more internationally competitive - Exports from B increase - Demand for Currency B increases (Right Shift) - ER Increases
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9
Q

How does FDI affect Exchange Rates?

A
  • More FDI means Appreciation in Currency
  • More FDI into UK means Foreign Investors would be forced to exchange their currency to the currency of the UK - Demand for £s increases (Right Shift) - ER Increases
  • Opposite is also True
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10
Q

How does Quantitative Easing affect Exchange Rates?

A
  • More QE means Depreciation in Currency
  • More QE would mean increased Creation of Money - Supply of £s increases (Right Shift) - ER decreases
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11
Q

Impacts on a Country of Changes to their Exchange Rate

A
  • Growth and Employment
  • Inflation rate
  • FDI flows
  • Current Account
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12
Q

Effect of ER on Growth and Employment

A
  • ER Increase - Growth and Employment Decrease
  • Decreased ER - WPIEEC so increased AD; “X(up) - M(down)” - AD Shift Right - Increase in RNO and Economic Growth - Increase in Derived Demand for Labour and Decrease in Cyclical Unemployment
  • However, could make it more Expensive to Import Raw Materials - Costs of Production increase - SRAS Decrease (Left Shift) and counteracting effects on Growth and Employment
  • Opposite is also True
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13
Q

Effect of ER on Inflation

A
  • Decreased ER - WPIEEC so Less Imports and More Exports which increases AD (X-M) - AD Shift Right - Price Level Increase; Demand Pull Inflation
  • Could also make it more Expensive to Import Raw Materials for Production - Costs of Production increase - SRAS Decrease (Left Shift) - Price Level Increase ; Cost-Push Inflation (Imported Inflation)
  • Opposite is also True
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14
Q

Effect of ER on FDI

A
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15
Q

Effect of ER on Current Account

A
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16
Q

Explain the J-Curve

A
  • In the short-run, Import Demand is INELASTIC due to contract agreements so firms cannot respond as quickly to (App/Dep) in Exchange Rates.
  • This will cause the Current Account to worsen in the SR as firms are forced pay the increased price of their imports, however in the LR, Import Demand becomes ELASTIC and firms will be able to demand cheaper goods after contracts have expired; improving the Current Account
17
Q

What is Marshall-Lerner Condition?

A

States that:
PED for Exports + PED for Imports (must be) > 1 in order for a country’s current account to improve following an exchange rate depreciation

18
Q

Explain the Marshall-Lerner Condition

A

Following a currency decrease,
- In the SR, PED for X is Inelastic therefore the DECREASE in Price (WPIEEC) of X will DECREASE Exports Expenditure
- PED for M is also Inelastic therefore the INCREASE in Price (WPIEEC) of M will INCREASE Imports Expenditure
Overall, since PED for X and M is Inelastic (<1), Current Account worsens and means that for CA to improve PED for X and M must be >1

19
Q

What are Fixed Exchange Rates?

A

When the value of a currency is determined by Gov’t or the Central Bank compared to other currencies or Gold; typically the USD$

20
Q

How can a country maintain its Fixed Exchange Rate?

A
  • Changing Interest Rates - Country could increase interest rate to allow for hot money to flow into the country; increasing demand for the currency and bringing its value back up to fixed point
  • Foreign Currency Transactions - Country could sell its own currency on currency market; increasing its supply and bringing the value back down to the fixed point
21
Q

How would a Country change ‘Fixed Value’ of its Exchange Rate?

A
  • (De/Re)valuation
  • When they carry out a measure to manipulate their exchange rate (IR changes/Currency Transactions) and KEEP it there
22
Q

What is a Floating Exchange Rate?

A

When the Exchange Rate is left to freely respond to changes in demand and supply

23
Q

Advantages of Fixed Exchange Rates

A
  • Creates certainty for investors; leading to more investment/FDI in that country, AD and LRAS increase
  • Can allow for ‘Competitive Devaluation’ - When a country purposefully devalues their currency to increase the competitiveness of their exports; quicker process than a policy in a Floating ER System
  • Disciplines domestic producers as they can not rely on ER depreciations to increase competitiveness of their exports; only their own efficiency and quality in production
24
Q

Advantages of Floating Exchange Rate

A
  • ‘Monetary Sovereignty’ - Allows for Country to use Monetary Policy (IR manipulation) to control economy
  • Prevents over-valuation of a Currency as Rate is completely dependent on D/S; over-valuation can cause an (increased) Current Account Deficit
  • Can be self-correcting; if Current Account is in Deficit (X<M), this will increase Supply of £s - ER decrease - More internationally competitive Exports - Increased X - Self Corrected CA deficit
25
Q

Disadvantages/Evaluation of Fixed Exchange Rate

A
  • Inability to use Monetary Policy
  • Large Amounts of Foreign Currency Reserves needed
  • No guarantee that decided Exchange Rate will be the correct Purchasing Power value; potential (Over/under)-Valuation
26
Q

Disadvantages/Evaluation of Floating Exchange Rate

A
  • Less certainty for investors looking to invest in that country; could deter FDI/general investment into economy and decrease Economic Growth
  • Self-correcting only really in theory as Net Exports doesn’t have as much impact on Exchange Rate as Speculation for example
27
Q

Nominal Exchange Rate + Formula

A
  • The value of a currency in terms of another currency
  • Value of Currency : Equivalent in other currencies
    1 : X
28
Q

Real Exchange Rates + Formula

A
  • How much a currency is worth relative to the price of goods and services in a another country
  • (Nominal ER x Domestic Price Level) / Foreign Price Level

SH ECON CARDS XTENDED (13 decks)

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