Exchange rates Flashcards
What is the exchange rate
The price of one currency in terms of another
How is the exchange rate determined
Supply and demand of that currency in foreign exchange market
Give 5 factors that cause changes in the demand for a currency
- Changes in RELATIVE interest rates
- Speculation that the currency will appreciate/depreciate
- Changes in FDI
- Changes in incomes abroad
- Change in competitiveness
How does an increased relative interest rate increase demand for the pound
- UK assets such as bonds and savings account are more attractive to foreigners as there is higher rate of return causing hot money to flow in
- Foreign investors need to buy £s to invest in UK assets, increasing demand for the £
How would speculation anticipating a rise in the £ lead to increased demand for the £
- This speculation may be based on higher relative interest rates, strong growth or political stability
- They start buying £s now to profit from future appreciation, causing shift in demand
How would increased FDI cause an increase in demand for the £
- The foreign firms need to exchange their currency for £s if they want to pay for factories and workers
How does rising incomes abroad increase the demand for the £
- As incomes rise, marginal propensity to import rises as foreigners have more disposable income to spend on luxury/exotic goods and services from the UK e.g. education
- Need to exchange to £s to buy these goods and services
How does increased international competitiveness of UK exports increase demand for £
- International competitiveness increase caused by lower union labour costs for businesses, lower inflation rates and more investment
- Means higher demand for UK exports so higher demand for £
Give 5 factors that increase supply of currency
- Lower relative interest rates as hot money outflows
- Speculation in anticipation of a fall in the value of the £
- Firms moving from UK to another country (opposite of FDI)
- Incomes rise domestically
How does firms moving from UK to another country increase supply of £
- When they leave, they exchange their £s for the new currency they need
- To exchange £s they need to increase supply of them in forex market
How does incomes rising domestically increase supply of £
- Marginal propensity to import of UK citizens increases
- To trade £s for another currency (from the country they want to import from), they need to supply these £s to the forex market
How does a country maintain a fixed exchange rate
Pick an exchange rate they want and manipulate supply and demand for the currency using domestic and foreign currency reserves to maintain that rate
e.g. if they want to increase the exchange rate, supply more foreign currency reserves to buy domestic currency
What is the condition for a country to be able to have a fixed exchange rate
Large reserves of foreign and domestic currency
What is devaluation and revaluation
Where a government decides to change the target set for the fixed exchange rate e.g. instead of fixing at £1 = $1.60 they want to change to £1 = $1.50
Revaluation is increasing the target and devaluation is decreasing the target
This is different from appreciation/depreciation which is for a floating exchange rate
How can a government change the exchange rate to keep it fixed without currency reserves
Changing the interest rate as high interest rate increases exchange rate and low interest rate decreases exchange rate
What are the drawbacks of changing interest rate to keep a fixed exchange rate
- It is not directly changing the exchange rate so may not work
- Could have side effects on the economy e.g. increasing interest rates reduces AD, unemployment
Therefore, using currency reserves is more common
What are the drawbacks of an exchange rate appreciation
- Lower economic growth as X-M is negative
- Higher unemployment in exporting industries as exports are dearer and high unemployment in domestic industries as imports are cheaper so they can’t compete
What are the benefit of an exchange rate appreciation
- Lower demand pull inflation as AD falls and lower cost push inflation as SRAS increases (as cheaper imports reduces costs of production)
- Cheaper imports improves choice and reduces costs for consumers buying foreign goods so improves living standards
- If imports are cheaper, domestic firms will have to become more productively efficient to compete
What are the benefits of a depreciation in the exchange rate
- If the country has a strong exporting base, would lead to increased growth as X-M increases
- Derived demand for labour in exporting industries and domestic industries increases as exports cheaper and imports dearer so unemployment falls
What are the drawbacks of a depreciation in the exchange rate
Higher demand pull inflation as AD rise and higher cost push inflation as SRAS fall as imports dearer so firms cost of production rise
What are the evaluation points when considering the impact of an appreciation or depreciation of the exchange rate
- How much the exchange rate has changed
- The change in revenue generated from exports and expenditure on imports depends on PED for exports and imports
- Protectionism would reduce the benefits from a depreciation of exchange rate
How could a current account deficit automatically correct
- CA deficit probably means high imports less exports as trade is a key component
- To import, you need to supply more of your domestic currency to exchange for the foreign one
- Supply shifts out means exchange rate falls, so export revenue might increase and import expenditure decrease, so reduced CA deficit
Why does the theory of an automatically correcting CA deficit not happen in the real world
- There are other factors determining the supply and demand of a currency apart from trade
- e.g. speculation is the main driver of appreciation/depreciation and its effect overrides the impacts of trade
What is the Marshall Lerner condition
A currency depreciation will only correct a CA deficit if the PED for exports + PED for imports is >1 (e.g. elastic)
Explain why the Marshall Lerner condition is true
If PED is inelastic during a devaluation policy:
- Exports are cheaper so price is falling but quantity demanded doesn’t rise much as PED for exports is inelastic so total revenue (price x quantity) from exports will fall
- Imports are dearer so price is rising but quantity demanded doesn’t fall much so total expenditure (price x quantity) on imports will rise
CA deficit measures the value of imports and exports (expenditure and revenue) so will worsen
How does the J curve show the Marshall Lerner condition
- Graph of CA deficit against time where y>0 is surplus and y<0 is deficit
- At lower times, the depreciation will cause current account deficit to worsen as PED is inelastic as firms and consumers don’t have time to respond to price changes
- As time increases, CA deficit changes to surplus as PED becomes more elastic
What is purchasing power parity
Where the exchange rate is at the level where you can buy the same level of goods and services in each country
so if £1 = $1.60 then PPP is if, for example, £1000 can buy the same amount in UK as $1600 can buy in the USA
How does inflation affect purchasing power parity
- Before, £1 = $1.60 and £1000 can buy the same amount in UK as $1600 can buy in the USA
- Inflation in USA could cause the same level of goods and services to cost $1700 dollars in the USA so nominal exchange rate no longer reflects PPP and the £ is undervalued against the dollar and $ is overvalued against £
Why do economists use the real exchange rate instead of nominal
Takes into account inflation so shows how much you can actually buy with £s in the USA for example
e.g. when nominal exchange rate was £1 = $1.60 and £1000 can buy the same amount in UK as $1700 can buy in the USA then the real exchange rate is £1 = $1.70
How does the nominal exchange rate adjust to reflect purchasing power parity
- If the $ was overvalued against £ so £ was undervalued against $, then people in the USA would exchange their $s for £s as they can buy more goods and services in the UK with the same amount of money
- Increased demand for £ causes £ to appreciate so £1 can now buy more than $1.60 so eventually will reflect purchasing power parity
Why does the nominal exchange rate not adjust to reflect PPP in reality
Demand for imports and exports is not the only thing that determines the demand and supply of currency
Speculation drives changes and overrides effects of trade
What are the advantages of a floating exchange rate
- Less need for currency reserves
- More freedom for monetary policy
- Could help automatically correct CA deficit
- Less risk of speculative attacks
How does a floating exchange rate mean more freedom for monetary policy
The country doesn’t need to worry about changes to interest rates changing exchange rate and missing the fixed target
Therefore, they have freedom to use monetary policy to fix issues like growth and unemployment`
How does a floating exchange rate mean less risk of speculative attacks
- In theory, floating exchange rate adjusts to reflect purchasing power parity so currency is not over or under valued, which is what causes speculators to increase demand or supply
What are the drawbacks of a floating exchange rate
- Volatility of exchange rate puts of FDI and trade as it is too unstable for countries and businesses to trust
- Self correction of CA deficits or purchasing power parity is unlikely as speculation overrides impacts of trade on demand and supply for a currency
- Higher inflation caused less exports more imports so exchange rate falls, which increasing import costs and AD rising causes inflation to rise even more
What are the advantages of a fixed exchange rate
- Less volatility of exchange rate means more FDI and trade
- Still some flexibility permitted
- Forces domestic producers to increase efficiency and innovate as they can’t rely on exchange rate depreciation
How is there still some flexibility with a fixed exchange rate
- Most countries with a fixed exchange rate allow a small band of exchange rates to be allowed
- Country can devalue or revalue if it wants
What are the drawbacks of a fixed exchange rate
- Country may need to change interest rates to bring exchange rate back leading to side effects
- Government needs to hold large currency reserves which is expensive
- Exchange rate may not reflect PPP so overvalued or undervalued leading to speculative attacks
What is a managed exchange rate
Where the country uses a floating exchange rate most of the time but government intervenes to change exchange rate if necessary e.g. China
(idea is best of both worlds)
