Exchange Rates Flashcards
Determinants of exchange rates
T- taste and preferences of domestic and foreign consumers –> increase in D= appreciate
I- relative interest rates: high IR= appreciate as investors demand more of that currency
P- APL: inflation= depreciation of that nation’s currency as M are seen as relatively cheaper/ deflation = appreciate of that nation’s currency as its exports are more demanded due to their competitive prices
S- speculation: expectations about future appreciation will create appreciation as speculators buy that currency before it value rises too high, and expectations about depreciation causes depreciation as speculators sell the currency before it is too weak.
Y- relative income levels: if income increase more quickly in the EU than in USA than there is more disposable income for EU and they import more goods = appreciation for the dollar in EU and a depreciation of the euro as they have to sell it to obtain dollars.
FLOATING EXCHANGE RATES
PROS AND CONS
\:) domestic policy freedom self-adjustment and balance of payment --> no persistent surpluses or deficits no surplus of currency reserves flexible response to external shocks central bank policy allowed to be adjusted for domestic objective as change in IR can be reversed to manage domestic AD and not exchange rate
:(
uncertainty among international investors
–> fluctuations in exchange rates
influences of random events prevent automatic adjustment
risk of imported (M) inflation
–> if a country depends on imported goods or technology, a volatile exchange rate could lead to swings in the domestic price level
GOV METHODS TO SUSTAIN A HIGH FIXED EXCHANGE RATE ( I am an EMO)
OFFICIAL RESERVES
buy up currency with other currency to keep up with it
–> X unsustainable
–> big pressure on foreign exchange reserves
INTEREST RATES
increase in IR: higher relative rate of return= attracts foreign depositors to buy currency = capital inflow
EXCHANGE CONTROLS
limits imposed on the quantity of foreign currency bought by domestic residents
–> restrict supply of currency on market: effective but frustrating
IMPORT LIMITS
slowing demand of foreign currency
–> contractionary fiscal policy: decrease AD
–> deflation = appreciation as M are seen as more $
GOV METHODS TO SUSTAIN A LOW FIXED EXCHANGE RATE (COCk MiX IR)
OFFICIAL RESERVES
supply extra currency
–>increase in money supply (QE)= demand pull inflation
M/X POLICY
decrease IR= makes X cheaper and decrease M
–> if promotion of X is unsuccessful= resentment from importing countries–> charges from WTO
INTEREST RATES
keep exchange rate low but not low as it could stimulate AD = demand pull inflation
EXCHANGE CONTROLS
restrict quantity of domestic currency that can be held by foreigners
–> decrease FDI/D: barrier to open new business
CHANGE IN FIXED EXCHANGE RATE
reduce exchange rate by devaluing the currency
THE DEGREE TO WHICH A COUNTRY CAN MANAGE ITS CURRENCY DEPENDS ON
amount of foreign and domestic reserves
relative interest rates
–> the more narrow the band, the more difficult in maintaining the rate
FIXED EXCHANGE RATES
PROS AND CONS
\:) stability inflation control export are price competitive protection against speculation
\:( limitations on domestic policy need to hold foreign reserves setting the rate risk of charges for unfair competition
MANAGED EXCHANGE RATES
“where gov periodically intervenes to keep the rate within a wide band of acceptable values”
when D=S there is a harmonious equilibrium
over-evaluation…
:( black markets provide lower value
:( trade balance deficit
:( domestic industries compete with cheap M
:) dev countries import M at a lower price
under-evaluation
:) cheaper/ more competitive exports
–> increase (X-M)
:) greater access to foreign exchange and econ growth
:( unsustainable + unfair trade promotion and protectionism which could = retaliation
APPRECIATION
PROS
:)
decrease price of M
–> due to increase value of currency
–> increased buying power = help firms import cheaper raw M/ capital goods: lower production costs
–> increase standard of living esp if an economy heavily relies on M
competitive pressures on domestic exporters
decrease inflationary pressure where D for M is in excess–> may help with economic growth
APPRECIATION
CONS
\:( decrease quantity of X --> trade balance deficit --> severe unemployment increase M= hurt domestic producers
SR: decrease in X/GDP= unemployment esp in X firm
DEPRECIATION
PROS
expansion of domestic industries
- -> foreign consumers view exports as relatively cheap
- -> increase in Rev= increase employment?
even domestic firms that don’t export benefit as the increase in the relative price of imports makes their domestic products appear cheaper
DEPRECIATION
CONS
imported inflation
where countries need to import significant levels of raw materials or resources, a decrease in the exchange rate can bring on a certain amount of imported inflation
(because demand of M is inelastic: primary commodities)
APPRECIATION EFFECT ON MAJOR ECONOMIC GOAL
appreciation reduces inflationary pressure where the demand for imports is relatively inelastic (energy sources)–> help with economic growth
more immediate on growth: is reduced exports and decrease GDP–> unemployment esp in X firms
surely since cost of productions have been reduced to due cheaper M then firms can increase their productions= shift of SRAS to the right
–> potential growth!!!
trade balance deficit
DEPRECIATION EFFECT ON MAJOR ECONOMIC GOAL
depreciation increase inflationary pressures when demand for imports is relatively inelastic (energy sources)–> slow down econ growth?
yet decrease X prices= increase rGDP= employment
improve trade balance of X and M
FLOATING EXCHANGE RATE
where the price of a currency is determined by the free market interaction of supply and demand for the currency
FIXED EXCHANGE RATE
through gov action is held to a narrow band of possible prices
locked with another currency
central bank determines
great and constant intervention
if demand for argentine beef decrease then central bank buys pesos or increase IR to increase D of pesos
