Exchange Rates

Question 1

Equivalent to supply of currency

Answer 1

Export of capital

Question 2

Equivalent to demand of currency

Answer 2

Import of capital

Question 3

What creates a supply and demand of currency?

Answer 3

1. Tourism
2. Exporters and Importers of Capital Items
3. Speculators
4. Day traders

Question 4

What is an appreciation of an exchange rate?

Answer 4

An increase in the value of an asset (one currency in terms of another)

Question 5

What happens to the demand curve when there is an appreciation of exchange rate?

Answer 5

It shifts to the right

Question 6

What is a depreciation of an exchange rate?

Answer 6

When market forces in the foreign exchange market lower the value of one currency against another.

Question 7

If you have two exchange rates, what is the relationship between them?

Answer 7

They are reciprocals of each other.

Question 8

Why would there be an appreciation in the exchange rate?

Answer 8

1. An increase in the demand of a country’s exports will cause an appreciation as the demand for the currency will therefore also increase.
2. Foreign direct investment into a country will increase the demand for its currency and thus contribute to an appreciation.
3. Speculation plays a key role. If investors feel a currency is likely to appreciate in the future they will buy it now and actually make this occur.

Question 9

Why would there be a depreciation in the exchange rate?

Answer 9

1. If domestic demand for import increases then the domestic currency is more likely to depreciate as there is a greater relative demand for other currencies.
2. A lower interest rate tends to decrease foreign investment in the country, so more of the domestic currency will be sold and the exchange rate will depreciate.
3. A high domestic inflation rate will usually decrease the demand for exports, as they will become conveniently more expensive, so the exchange rate will fall.

Question 10

What is a fixed exchange rate?

Answer 10

The value of one currency against other currencies remains the same. Maintained by governments.

Question 11

How are fixed exchange rates maintained by the government?

Answer 11

Intervention in the foreign exchange market using foreign exchange reserves. Use the reserves to buy and sell the currency as necessary.

Question 12

What is a floating exchange rate?

Answer 12

Exchange rate is determined by demand and supply in the foreign exchange market. Without government intervention.

Question 13

What happens, in a floating exchange rate, when there is an increase in demand for a currency?

Answer 13

There will be an appreciation of the exchange rate.

Question 14

What happens, in a floating exchange rate, when there is an increase in supply for a currency?

Answer 14

There will be a depreciation of the exchange rate.

Question 15

Advantages of fixed exchange rates

Answer 15

1. Avoids currency fluctuations - these can cause significant problems for firms that are trading.
2. Stability encourages investment
3. Keeps inflation low

Question 16

Disadvantages of fixed exchange rates

Answer 16

1. Less flexibility - harder to respond to temporary shocks
2. Difficult to know what rate to join at
3. Difficulty in keeping the value of the currency

Question 17

Example of a fixed exchange rate

Answer 17

Scotland and the Scottish pound being fixed to the British pound

Question 18

Advantages of floating exchange rates

Answer 18

1. Do not have to hold significant foreign currency reserves
2. Central bank free to pursue domestic monetary policy i.e control interest rates
3. Can act as automatic stabilisers i.e during a recession value of currency may fall and leaf to more exports
4. May insulate economy from imported inflation

Question 19

Disadvantages of floating exchange rates

Answer 19

1. Can be volatile because it is subject to speculation

2. May create uncertainty for firms that rely on international trade

Question 20

Examples of floating exchange rates

Answer 20

No real-world examples of completely floating exchange rates

Question 21

What is a managed float?

Answer 21

An exchange rate with periodic intervention to influence it. If the currency is under or overvalued, the the government will attempt to fix/influence the exchange rate.

Question 22

Effects of overvalued currency

Answer 22

1. Imported goods will be cheaper; exports will be less competitive.
2. More imports can be bought
3. High value of currency forces domestic producers to improve their efficiency to be more competitive
4. Could lead to more unemployment
5. Foreign currency reserves decrease
6. Low inflation

Question 23

Effects of undervalued currency

Answer 23

1. Lead to greater employment in export industries
2. Diversion to domestic goods - can mean that employment in domestic industries will increase
3. Makes imports expensive
4. Leads to imported inflation

Question 24

What is dirty floating?

Answer 24

When the government doesn’t tell you when they fix the exchange rate