Exchange rates Flashcards
Exchange rates
One currency against another
Spot exchange rate
The rate for a currency at today’s market price
Floating exchange rate
When the demand increases, value increases (appreciate) & vice versa
When supply increases, value decreases (depreciate) & vice versa
Forward exchange rate
The delivery of a currency at a specified time in the future at an agreed rate
Companies wanting to reduce risks from exchange rate volatility can buy their currency ‘forward on the market’
Factors influencing exchange rates
Trade balances, FDI, portfolio Investment, interest rate differentials
Arguments for a floating exchange rate
Reduced need for currency reserves
Useful instrument for economic adjustment
Partial automatic correction for trade deficit
Less opportunity for currency speculation
Freedom (autonomy) for domestic monetary policy
Help to prevent imported inflation
Less risk of speculative attacks
Automatic stabilisers
Policies that naturally kick in to stop the economy/ exchange rate going off course
Problems with floating exchange rate
Can be volatile- makes doing business harder
Uncertainty as value changes day to day
Lack of investment- because of the uncertainty
Speculation- fluctuation encourages hot money movement from country to country, so more fluctuation occurs
Arguments for fixed exchange rate
Avoids currency fluctuation
Stability encourages investment
Keep inflation low
Disadvantages of fixed exchange rate
Current account imbalances- over valued exchange rate could cause a currency account deficit
Less flexibility- difficult to respond to temporary shocks
Conflict with other objectives
Managed floating
When the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives
To achieve lower exchange rates (managed floating)
Lower interest rates would cause less investment into banks ; less savings, reducing currency as more supplied
Buy more foreign currency
Taxation of overseas currency deposits & capital controls- cut profit from hot money flows (disincentive to invest)
Why attempt depreciation
Improve the balance of trade in goods ; services/ improve current account position
Reduce risk of deflationary recession by making exports expensive (increase exports & price level)
Rebalance economy away from domestic consumption towards exports & investment
Reduce government debt by selling foreign currencies
Why attempt appreciation
Curb demand pull inflationary pressures
Reduce price of imported capital ; technology
revaluation
increase exchange rate under fixed exchange rate
appreciation
increase in exchange rate under floating exchange rate
devaluation
decrease the exchange rate under fixed
depreciation
decrease the exchange rate under floating
factors influencing floating exchange rate
relative interest rates- if high, more money into banks from elsewhere, increased demand for currency, appreciate
relative inflation rates- higher, purchasing power fall, value fall
current account balances- supply for currency increase with demand, currency depreciate
FDI- high FDI, increased demand, appreciate
speculation- greater levels, lower value
competitive devaluation/ depreciation
a country engineer exchange rate with the aim of improving its net trade balance. if countries follow suit, ‘currency war’ may occur (devalue currency to stimulate economy)
impact of changes in exchange rate: current account of the BofP
devalue/ depreciation- decrease in export price, increase in import price, so increased competitiveness, improve BofP. however, Marshall learner (only lead to improvement if price elasticities is greater than 1), and j curve (worsen before gets better). so only will be long run
impact of changes in exchange rate: economic growth and employment
devalue/ depreciation- increase in AD as net exports rise, rise in output, so increased employment
impact of changes in exchange rate: inflation
increase price of imports of raw materials, increase in cost of production-so cost push inflation. increase AD could also increase rate of inflation
impact of changes in exchange rate: FDI flows
depreciate/ devalue- cheaper for countries with higher value to give money to
