Exchange rates

Question 1

What is a free floating exchange rate?

Answer 1

Value of a currency is determined by free market forces with the value of a currency changing from day to day - gov does not intervene

Question 2

What are the benefits of a free floating exchange rate?

Answer 2

• Monetary policy can be focused on domestic economic conditions rather than maintaining exchange rate
• Monetary policy is reinforced by exchange rate
• Partial automatic correction for a current account imbalance
• Reduced speculation

Question 3

What are the disadvantages of free floating exchange rates?

Answer 3

• Depreciation will not fix trade imbalance unless Marshall Lerner condition is met
• Fluctuating exchange rate leads to lack of uncertainty for investments
• No guarantee floating exchange rate will be stable

Question 4

What is a fixed exchanged rate system?

Answer 4

Where a currency has a fixed value against another currency or commodity e.g. Gold standard

Question 5

What are the types of fixed exchange rates?

Answer 5

• Conventional exchange rates = one currency fixed against an anchor currency
• Currency board system = extreme form where domestic currency has to be backed by foreign exchange rates
• Fixed currency with no separate legal tender

Question 6

What are the benefits of fixed exchange rates?

Answer 6

• Reduce exchange rate uncertainty - no need for hedging
• Reduces costs of trade
• Imposes discipline on domestic firms which helps control inflation

Question 7

What are the costs of fixed exchange rates?

Answer 7

• Have to hold large amounts of foreign currency reserve to support currency
• Conflicts of interest over the use of monetary policy for ER versus domestic economy
• International retaliation

Question 8

What is a managed exchange rate?

Answer 8

Free markets determine the value of a currency but where central banks intervene from time to time to change the value of their currency

Question 9

How to determine exchange rate?

Answer 9

• Buying and selling foreign reserves
• Adjusting interest rates
• Borrowing from international monetary fund (IMF)

Question 10

Revaluation and devaluation of a currency

Answer 10

Re - When a gov or central bank officially fixes a new higher exchange rate for the currency
De - When a gov or central bank officially fixes a new lower exchange rate for the currency

Question 11

What is an adjustable peg system?

Answer 11

Where currencies are fixed in value in the short term but can be devalued or revalued in the long term

Question 12

What are the benefits of a managed exchange rate?

Answer 12

• Reduced exchange rate allows price of imports/exports to remain more stable and therefore higher rate of trade and investment
• Reduced cost of trade - reduced use for hedging
• Imposes discipline on domestic firms

Question 13

What are the disadvantages of a managed exchange rate?

Answer 13

• Need to maintain and spend foreign currency reserves
• Conflicts over interest over use of monetary policy for ER
• Speculative attacks
• International retaliation