Exchange rates Flashcards
What is the exchange rate?
The exchange rate is the rate at which one currency trades against another on the foreign exchange market
If the present exchange rate is £1=$1.42, this means that to go to America you would get $142 for £100. Similarly, if an American came to the UK, he would have to pay $142 to get £100. Although in real life, the dealer would make a profit.
Real Exchange Rate.
This is the exchange rate after being adjusted for the effects of inflation, it, therefore, more accurately reflects the purchasing power of a currency.
Floating exchange rate
When the value of the currency is determined by market forces i.e. the supply and demand for a currency
Fixed exchange rate
where the government seeks to keep the value of a currency at a certain level compared to other currencies
Factors influencing exchange rates
Interest rates – higher interest rates encourage hot money flows and demand for currency. This causes an appreciation.
Economic growth – higher economic growth will tend to cause an appreciation in the currency, this is because markets expect higher interest rates – when growth is rapid.
Inflation – higher inflation makes exports less competitive and reduces demand for currency. This causes a depreciation.
Confidence in the economy/currency.
Current account deficit/surplus. A large current account deficit is more likely to cause a depreciation in the value of the currency because money is leaving the economy to buy imports.
If the Pound Sterling appreciates in value, the effects will include:
UK exports more expensive abroad – leading to lower demand.
Imports into the UK will be cheaper, increasing demand for imports
An appreciation will tend to reduce inflation,
Lower economic growth – due to reduced demand for exports.
Worsening of the current account deficit (because imports are cheaper and quantity of imports rises, but exports are more expensive and quantity falls)
Strong Pound = Imports Cheaper, Exports Dearer. SPICED
If the Pound devalues then we will see:
UK exports become more competitive, increasing demand for exports
Imports become more expensive, leading to lower demand for imports
A depreciation will tend to increase economic growth but also cause inflation.
How does elasticity of demand relate to exchange rates?
If there is a depreciation in the exchange rate, exports are cheaper, but the amount by which quantity increases depends on the elasticity of demand.
If demand is price inelastic, then a depreciation will have a limited impact in increasing demand and improving economic growth. If demand for exports is elastic, then there will be a big boost to exports.
What is purchasing power parity?
It’s a way to compare currencies based on what they can buy rather than the alternative measure, exchange rates = how much one currency is worth in an other currency.
Say I want to know which of us earns more. I earn $100 a day, and you earn €75. How can we tell who earns more? We have to figure out what my Dollar is worth, and what your Euro is worth. One way to do that is to compare things we both need. So if my $100 buys a week’s worth of shopping, but your Euros buy a week and a half, you’re earning more.
Now lets say we’re both earning €75, but I’m in Paris and you’re in Kiev. Our checks look the same, but I live like a pauper in Paris on my €75 while you can live like a Prince in Kiev, because everything in Kiev is cheaper. So while we both earn exactly the same amount, you have more purchasing power.
Basically it’s converting from currency into a defined set of goods.
