Exchange Rates: 4.3

Question 1

Define exchange rates.

Answer 1

The value of one currency to another

Question 2

Define freely floating exchange rates.

Answer 2

Demand and supply forces determine the equilibrium for exchange rates

Question 3

Define fixed exchange rates.

Answer 3

• Maintain a fixed exchange rate pegged to another currency
• Done by manipulating D&S using foreign reserves

Question 4

Factors of an increasing floating exchange rate

Answer 4

Demand increases

• increase in relative interest rates
• speculation
• increase in FDI investments
• rise in incomes abroad
• increase in competitiveness of exports

Question 5

Factors of a decreasing floating exchange rate

Answer 5

Supply increases

• decrease in relative interest rates
• speculation
• firms moving away from domestic country
• increase in incomes domestically

Question 6

Impacts of exchange rate

Answer 6

Strong currency - SPICED
* Strong pound, imports cheap, exports dearer
* Imports: demand increases, expenditure increases
* Exports: demand falls, expenditure falls
* (X-M) falls, AD falls
* Reduction in demand-pull inflation

Weak currency - WIDEC
* Weak, imports dearer, exports cheap
* Imports: demand falls, expenditure falls
* Exports: demand increases, expenditure increases
* (X-M) increases, AD increases
* Stimulates demand-pull inflation
* expensive imports -> expensive inputs/raw materials -> COP increases -> cost-push inflation

Question 7

Evaluation of exchange rates

Answer 7

• depends on PED of exports and imports
• depends on the size of appreciation/depreciation
• trade barriers (foreign countries may be restricting domestic countries from exporting due to trade protectionism)
• offset by other factors

Question 8

Pros and cons of freely floating exchange rate

Answer 8

Pros

• no need for gov intervention
• automatic correction of current account imbalances
• no need to hold foreign currency reserves
• gov can focus on using fiscal and monetary policies to deal with domestic problems

Cons

• sudden fluctuations cause instability
• uncertainty for firms, importers, exporters
• currency speculation creates more fluctuations

Question 9

Pros and cons of fixed exchange rates

Answer 9

Pros

• Firms, importers, and exporters have a high degree of certainty over future exchange rates, positively benefit investment and trade
• More difficult for currency speculation

Cons

• Need for constant intervention by the central bank
• Need to hold foreign currency reserves
• Loss of monetary policy to deal with domestic problems