Exchange Rates 🧟♀️ Flashcards
How can you measure exchange rates?
- nominal exchange rate
- real exchange rate
- bilateral exchange rate
- effective exchange rate
What is nominal exchange rate
- direct comparison of currencies
What is real exchange rate
- adjusts nominal ExR to take price levels into account - shows true value of currency
What is bilateral exchange rate
- ExR between two countries
- e.g £:$
What is an effective exchange rate
An ExR measured against a basket of currencies of trading partners
- weigh each country by the proportion of your trade you do with it
- gives an overall summary of the value you of currency against others
What is an adjustable peg?
- fixed in the short term but regularly adjusted to a new fixed rate
What is a crawling peg?
- fixed but regular small adjustments to fixed rate
What is a managed float
- Floating but central bank intervenes to avoid large fluctuations
What is a managed float
- Floating but central bank intervenes to avoid large fluctuations
Exchange rate band systems
- free float with a permitted band, intervention takes place if ceiling or floor is reached
What is a free floating exchange rate?
Value of one currency in terms of another is determined without interference; it is determined by the forces of demand and supply
- trade flows and capital flows affect the exchange rate
- no target exchange rate
- no need for official intervention in the currency market by central bank
What determines the demand of the £?
- Speculation on the future of value of the £
- Interest rates
- FDI inflows
- Exports
- Government ‘open market’ operations (selling forex reserves and buying £s) in the FOREX market
- Inflation rates (demand for exports)
What may cause short run buying of £?
Speculation that £ will rise
What may cause long run buying of £s?
- hot money inflows (UK interest rates are rising)
- FDI rising
What may cause an increase in exports (irrelevant to exchange rate)
- derived demand
What are the 5 main arguments for a floating exchange rate?
- Reduced need for currency reserves
- Useful instrument of macroeconomic adjustment
- Partial automatic correction for a trade deficit (however, dependent on J curve)
- Reduced risk of currency speculation
- Freedom for domestic monetary policy
Why is it good to have a reduced need for currency reserves?
- little requirement for central bank to hold large scale reserves of foreign currency to use in possible intervention in the markets
What is the benefit of having a floating exchange rate for macroeconomic adjustment
Depreciation can increase exports and therefore stimulate growth
- however, this assumes that this isn’t diluted by higher wage claims or export prices
How does a floating exchange rate reduce currency speculation?
- currency market speculators often target an exchange rate target they believe to be fundamentally over or undervalued
Why is freedom for domestic monetary policy good
- allows short term interest rates to be set to meet domestic MEO such as stabilising growth or controlling inflation
Are floating exchange rates always volatile?
No
- Sterling
- businesses have learnt to cope with modest fluctuations - which is helped by having a flexible labour market
What are the disadvantedges of floating exchange rates
- Can lead to volatile exchange rates
- can be bad for business planning - uncertainty
- can make it more difficult to conduct businesses abroad - If an ExR falls it could lead to cost push inflation
- FoPs more expensive - Speculation can lead to an artificially high exchange rate (X-M could worsen)
- could lead to imported cost push inflation if PED for M is inelastic
Fixed exchange rates
- the value of a currency is fixed to the value of another currency or certain commodities
How is the value of a currency maintained?
- The central bank will either set interest rates to increase hot money inflows
- Buy and sell own currency in forex markets
- Restrict amount of currency allowed to leave its economy
What is a revaluation?
- when the value of a currency is increased
What are open market operations?
- buying or selling currency on the forex market
What are the benefits of fixed er
- Stability; reduced uncertainty
- more certainty for exporters when pricing and businesses spend less on currency hedging - Reduced costs of trade
- firms no longer need to hedge against exchange rate movements - Increased investments (more attractive)
- Forces domestic firms to be internationally competitive as there is no adjustment made on their behalf
- ER can be adjusted
What are disadvantages of fixed ER
- Opportunity cost: high levels of foreign currency reserves
- Loss of monetary policy
- Fixed ExRates hard to maintain
- Speculation
- currencies can become over or undervalued (they wont match domestic conditions and trade patterns) - speculators will buy or sell the currency causing huge volatility - No automatic correction - may cause firms to cut costs during an appreciation
- Retaliation
How does a fall in the value of a currency affect consumers?
- Increase in price of imports could lead to lower living standards (lower PPP,) decreases disposable income
- increase in employment in the export industry as derived demand for export increases (depends on PEDx)
How does depreciation affect firms
- Price of imported FoPs increase, SRAS (shifts left and up). Oil and energy contribute largely (UK imports most of these)
- higher revenues as foreign demand for exports increases (depends on PEDx)
Eval: depends on firms - exporters benefit, firms that import FoPs suffer
What is the effects of a depreciation on the government?
Tax revenues fall
- disposable income falls so VAT revenue falls
- Corporation tax revenue falls (depends on firm nature)
- Debt in foreign currency increases
How can economic growth be affected by depreciation?
- export led growth
- cost of imported fops increases - opposite effect?
How is unemployment affected by deprivation?
- export industry grows
- firms that rely on import fops have to cut costs - lay off workers
How is inflation affected by a depreciation?
- costs push inflation (oil. Energy)
- demand pull (X-M) increases
What is the J curve an eval for
- how a depreciation will reduce the current account deficit
How can a depreciate reduce income inequality
- Exporting industry grows
- more labour needed, putting upward pressure on. Wages
- trickle down
Eval:
- inflation can reduce PPP of low income households - particularly those who rely on imported goods
What is the effect of a depreciation on public finances?
- debt bad
- export led growth could increase tax revenues and improve budget position
What is a monetary union?
When a group of countries share:
1. A common market: where goods, services, labour are able to move freely
2. A common currency: eliminating exchange rate fluctuations within the union
3. Governance by a common central bank: monetary policy for entire union
When was the Euro formed
1999
What are the benefits of a monetary union
Exchange rate risk
- avoids fluctuation in currency values (eliminates risk)
- which avoids uncertainty in trade and investment
Price transparency and competition
- easy comparison - enhancing completion
- motivate producers to lower prices and increase efficiency
Greater economic integration and stability
- as monetary policy is shared, economic cycles are more synchronised -> stability
Global influence
- stronger voice in global financial affairs
Drawbacks of monetary union
Individual countries cannot set own interest rates or implement monetary policy tailored to specific conditions
- imbalances (Greece)
- cant stimulate growth
- harder for debt heavy countries
Risk of asymmetric shocks
Need to adhere to strict fiscal rules, which limits budget deficits and public debt levels.
- can restrict countrys ability to increase public spending during recession
Describe the change in the value of the £ before and after brexit
- Before and after referendum day the GDP/USD dropped from 1.3 to 1.08
- fluctuated massively until we left in 2021
- slight growth and recovery to 1.2 but still influenced by uncertainty
Example of fixed er
- ## Ecuador + Zimbabwe (fixed to $)
Example of managed floating system
- South Africa
- japan
- Sweden
- Mexico
