Exchange Rates and Calculations Flashcards
Exchange rates
The value of one currency expressed in terms of another currency
Exchange Rate Index
expresses one currency against a collection/basket of other currencies
Fixed/Pegged Exchange Rate System
- Where the central bank intervenes in the market to ensure the exchange rate is exactly fixed to a predetermined value of currency
TERMINOLOGY USED:
Revaluation (increase in value)
Devaluation (decrease in value)
Floating/Flexible Exchange Rate Systems
- Where the forces of demand and supply determine the price of the currency
TERMINOLOY USED:
Appreciation (increase in value)
Depreciation (decrease in value)
Managed Float Exchange Rate Systems
- Where the currency is able to float within a narrow band of the other currency.
TERMINOLOGY USED:
Appreciation (increase in value)
Depreciation (decrease in value)
Pros of High Exchange Rates
- Downward pressure on inflation
- More imports can be bought
- Forces domestic producers to improve their efficiency because price is high, producer have to focus on quality to compensate for high price
Disadvantages of High Exchange Rates
- Damage to export industries
- Damage to domestic industries who cannot compete with cheaper foreign goods
- Unemployment problems if it continues in the longer term
Pros of Low Exchange Rates
- Greater employment in export industries
- Greater employment in domestic industries
- Improves employment
Cons of Low Exchange Rates
- Inflation
- Competitors may complain
Pros of Flexible Exchange Rates
- Automatic adjustment using forces of demand and supply to return to a stable level
- No large foreign exchange reserves required
- Free to set monetary policy and interest rates for domestic issues
Cons of Flexible Exchange Rates
Uncertainty
- Business planning
- Investment
- Speculation
No discipline required for interest rates
Affected by more than just supply and demanded
- Government Intervention
- World Events
May worsen inflation
Pros of Fixed Exchange Rates
Certainty and stability
- Business planning
- Investment
Provides discipline
- Money supply
- Interest rates
Solves inflationary problems
Reduces speculation in the forex market
Cons of Fixed Exchange Rates
- No automatic adjustment
- Requires large foreign exchange reserves
- Monetary policy may be inappropriate
- Imported inflation
- Setting the level is complex
- If it is too low (e.g. China) there is international disagreement
- Problems with overvaluation and undervaluation
Factors that cause an increase in supply
Increase in Supply:
- Increase in imports
- Foreign country interest rate is high → Increase in domestic investment abroad
- Decrease in foreign inflation rate
- Speculators believe that domestic currency will fall (depreciation)
- Domestic country sells domestic currency (increase in foreign reserves)
- Rise in real income
Factors that cause a decrease in supply
Decrease in Supply:
- Decrease in domestic imports
- Foreign country interest rate is low → Decrease in domestic investment abroad
- Increase in foreign inflation rate
- Falling real income
Factors that cause an increase in demand
Increase in Demand:
- Increase in domestic exports
- Increase in foreign investment abroad
- Domestic country interest rate is high
- Decrease in domestic inflation rate (deflation)
- Speculators believe that domestic currency will rise (appreciation)
- Domestic country buys domestic currency (decrease in foreign reserves)
Factors that cause a decrease in demand
Decrease in Demand:
- Decrease in domestic goods/services exports
- Decrease in foreign investment abroad
- Domestic country interest rate is low
- Increase in domestic inflation rate
Explaining an exchange rate diagram
- State event/situation
- Whose behavior changes
- How/Why the behavior changes
- Identify which curve (supply or demand)
- Shift in curve
Important: What effect whom?
There are 4 groups of people whose behaviour changes:
- People inside the country (consumers, investors) - SUPPLY ↑↓
- People outside the country (consumers, investors) - DEMAND ↑↓
- Central bank/government - SUPPLY ↑ DEMAND↑ (Increases only)
- Speculators - SUPPLY ↑ DEMAND↑ (Increases only)
Inflation and Interest rates impact both people inside and people outside. (DOUBLE SHIFT)
Interest rates impact INVESTORS not BORROWERS (we don’t borrow money across borders typically).
Automatic Adjustment
Flexible exchange rate will automatically adjust to resolve a trade deficit
