Exchange Rates

Question 1

actors in the foreign exchange market

Answer 1

Question 2

foreign exchange market

Answer 2

market in which currencies are exchanged for other currencies

Question 3

floating exchange rate

Answer 3

market forces alone without any government or central bank intervention determine its value

Question 4

fixed exchange rate

Answer 4

exchange rate is set and maintained at some level by the government

Question 5

managed exchange rate

Answer 5

no announced level or band but either the exchange rate is allowed to float within some implicit upper and lower bound or authorities intervene whenever they consider the direction or speed of adjustment is the currency is undesirable

Question 6

appreciation

Answer 6

price of currency increases within a floating system

Question 7

depreciation

Answer 7

price of currency decreases within a floating system

Question 8

devaluation

Answer 8

official price of currency decreases within a fixed system

Question 9

revaluation

Answer 9

official price of a currency increases within a fixed system

Question 10

causes of change in exchange rate

Answer 10

• change in foreign demand for country’s exports (growing exports - excess currency demand - currency appreciates)
• change in domestic demand for imports (import demand increases - excess currency supply - currency depreciates)
• changes in relative growth rates (high growth rate - incomes increase - import demand increases - currency depreciates)
• changes in relative inflation rates (accelerating inflation - rising prices - export demand decreases - currency depreciates)

Question 11

factors affecting cross-border capital flows

Answer 11

• changes in relative interest rates (IR decrease - domestic bonds less attractive to foreign investors)
• expectations of future growth (economy growth expected - potential business opportunities)
• currency speculation

Question 12

when will an exchange rate appreciate?

Answer 12

1. foreign demand for exports decreases
2. domestic demand for imports decreases
3. domestic interest rates increase
4. expected growth
5. speculators anticipate appreciation

Question 13

when will an exchange rate depreciate?

Answer 13

1. foreign demand for exports decreases
2. domestic demand for imports decreases
3. domestic inflation increases
4. domestic interest rates decrease
5. speculators anticipate depreciation

Question 14

what happens if there is pressure for currency to devalue in a fixed system?

Answer 14

• central bank starts buying currency using foreign exchange reserves
• central bank increases interest rates to attract foreign capital inflows
• official borrowing of foreign exchange
• government restricts imports and access to foreign exchange

Question 15

what happens if there is pressure for the currency to appreciate in a fixed system?

Answer 15

• central bank sells domestic currency to buy foreign currency
• central bank decreases interest rates to create an outflow of foreign capital

Question 16

why might a country keep the currency overvalued?

Answer 16

1. import substitution strategy
2. exports more expensive abroad
3. combat inflation

Question 17

why might a country keep the currency undervalued?

Answer 17

1. cheaper exports for competitive advantage
2. export-led growth
3. creates friction between trading partners
4. inflationary pressure

Question 18

advantages of floating exchange rates

Answer 18

• can use monetary policy to achieve domestic goals
• trade imbalances automatically corrected
• exchange rate adjustments are smooth and continuous
• less speculation
• less need for central bank to keep foreign exchange reserves

Question 19

disadvantages of floating exchange rates

Answer 19

• increased uncertainty hurts trade
• government tends to adopt inflationary policies for short-term gains

Question 20

advantages of fixed exchange rates

Answer 20

• less uncertainty increases trade volume
• policy discipline as inflationary growth not an option
• curbs high inflation

Question 21

disadvantages of fixed exchange rates

Answer 21

• cannot use monetary policy
• gov deprived of exchange rate policy
• restricts use of expansionary fiscal policy because deficit may affect money supply or interest rates
• exchange rate adjustments are abrupt and disruptive
• trade deficits not automatically corrected requiring use of contractionary fiscal policy
• central bank may maintain large foreign exchange reserves

Question 22

purchasing power parity

Answer 22

rate that will equate the cost of purchasing the same basket of goods in two countries

Question 23

balance of payments

Answer 23

record of all transactions of a country with the rest of the world over a period

Question 24

current account

Answer 24

• goods and services (imports and exports)
• primary income (differences between primary income received abroad and payable abroad, includes profits)
• secondary income (donations)

Question 25

current account balance

Answer 25

sum of net exports of goods and services, net income and net current transfers over a period

Question 26

capital account

Answer 26

* receivable and payable capital transfers * acquisition and disposal of patents, copyrights, etc.

Question 27

financial account

Answer 27

FDI porfolio and other investments reserve assets

Question 28

is current account deficit a problem?

Answer 28

* pressure for currency to depreciate * temporary deficits imply improvement in standards of living because nation is consuming more than producing * persistent deficits imply chronic inflation, uncompetitive product markets and rigid labor markets

Question 29

implications of persistent current account deficit

Answer 29

* surplus is required in capital and financial accounts * sale of domestic assets to foreigners (low price, loss of sovereignty) * borrowing from abroad (future repayments and interest) * national income diverted away from domestic development * living standards decrease

Question 30

policies to correct persistent current account deficit

Answer 30

* expenditure-reducing: contractionary fiscal and monetary policies * expenditure-switching: devaluation, trade protection, imports more expensive * supply-side policies: decreasing domestic monopoly power, increasing labor market flexibility

Question 31

why is current account surplus a problem?

Answer 31

* economy consuming inside production possibilities * living standards lower than need be * very reliant on foreign demand for growth * inefficiently employing resources if surplus due to trade barriers * currency appreciates

Question 32

marshall-lerner condition

Answer 32

devaluation will improve trade deficit if PEDX + PEDM \> 1

Question 33

terms of trade

Answer 33

* ratio of average price of exports over the average price of imports * volume of imports attainable by a unit of exports

Question 34

improvement in terms of trade

Answer 34

* terms of trade increase * country can attain greater volume of imports with the same exports

Question 35

worsening in terms of trade

Answer 35

* terms of trade decrease * country can attain smaller volume of imports with same exports

Question 36

causes of improvement in terms of trade

Answer 36

* world demand for country's exports increases * country's supply of exports decreases * appreciation of currency * average domestic prices increasing faster than abroad * imposition of trade barriers

Question 37

what are the consequences of an improvement in terms of trade?

Answer 37

* if due to increase in world demand, export revenues increase * if due to decrease in world supply, depends on PED (price inelastic: export revenues increase) * price elastic: export revenues decrease * if due to appreciation, trade surplus decreases * if due to tariff, trade balance improves