Exchange Rates 4.1

Question 1

Exchange Rate Systems

Answer 1

Floating - determined by supply & demand

Fixed - Usually against the dollar, done by some in South America

Managed - Hybrid of the floating and fixed. Done sometimes on the Rupee

Question 2

Revaluation vs Appreciation of Currency

Answer 2

Revaluation - Currency’s value is increased relative to a baseline, like gold or another currency, in a fixed ER system

Appreciation - When the value of the currency increases

Question 3

Devaluation vs Depreciation

Answer 3

Devaluation - Value of a currency is lowered in a fixed ER system

Depreciation - Value of a currency falls relative to another currency

Question 4

Factors influencing floating exchange rates

Answer 4

Inflation

Speculation

Government finances (sell stocks due to high risk of defaulting e.g. Argentina 2001)

Question 5

Government intervention in currency markets through foreign currency transactions and the use of interest rates

Answer 5

Interest rates - An increase in interest rates, relative to other countries, makes it more attractive to invest funds in the country This increases demand for the currency, causing an appreciation. This is known as hot money

Quantitative easing: This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective. This has inflationary effects since it increases the money supply, and it can reduce the value of the currency. QE is usually used where inflation is low and it is not possible to lower interest rates further.

Question 6

Competitive devaluation/depreciation and its consequences

Answer 6

A devalued currency makes exports cheaper and imports more expensive. It could increase economic growth as a result. However, inflation is likely to increase due to the higher costs of imports and demand pull inflation from the increase in AD It also depends on the PED of exports and imports. Inelastic exports will not increase significantly if price falls. If the main trading partners are in a recession, then demand for exports is likely to be low, and depreciating the exchange rate is unlikely to affect it

Moreover, Marshall-Lerner condition states that sum of LR Import & Export PED must be equal to or greater than 1 for an increase in the balance of payments to be seen

Question 7

Marshall-Lerner Condition

Answer 7

states that a devaluation in a currency only improves the balance of trade if the absolute sum of long run export and import demand elasticities is greater than or equal to 1.

Question 8

J-Curve

Answer 8

The J-curve effect occurs when a currency is devalued. Since devaluing the currency causes imports to become more expensive, at first the total value of imports increases, which worsens the deficit. Eventually, the value of exports decreases, which leads to a reduction in the trade deficit.