Exchange Rates

Question 1

What is an exchange rate?

Answer 1

Rate at which one country’s currency can be exchanged for other currencies in the foreign exchange

Question 2

What is the effective exchange rate?

Answer 2

Weighted index of sterling’s value against a basket of currencies

Question 3

What is a free floating currency exchange rate system ?

Answer 3

• External value of a currency depends wholly on market forces
• No intervention by central bank
• No target for exchange rate

Question 4

What factors cause changes in currency in a floating system?

Answer 4

• Trade balances
• Foreign direct investment
• Portfolio investment
• Interest rate differentials
• Speculation

Question 5

What is a managed floating exchange rate?

Answer 5

• Currency is usually set by market forces
• Central bank might intervene to influence the price
• Currency becomes key target of monetary policy

Question 6

What policy tools are used in a managed floating exchange rate system?

Answer 6

• Changes in interest rates
• Quantitative easing
• Direct buying/selling of currency
• Taxation of overseas currency deposits

Question 7

What is competitive devaluations?

Answer 7

• Country deliberately intervenes to drive down the value of their own currency to provide a competitive lift to demand, output or jobs in export industries
• Good for countries with trade deficits and rising unemployment
• Can invite retaliatory action

Question 8

What is a fixed exchange rate system?

Answer 8

• Government/Central Bank fixes currency value
• Pegged exchange rate becomes official rate
• Adjustable peg

Question 9

Evaluating effects of currency depreciation

Answer 9

Currency depreciation stimulates aggregate demand, but it is dependent on
• Time lags
• Magnitude of change in exchange rate
• PED
• Size of multiplier of effect
• Type of economy (developed vs emerging)