Exchange rates + Balance of payments

Question 1

exchange rate

define

Answer 1

the value of one currency expressed in terms of another

Question 2

what is a floating exchange rate system?

Answer 2

exchange rates are determined by market forces, with no govt. or central bank intervention

Question 3

currency appreciation

define

Answer 3

an increase in the value of a currency

Question 4

currency depreciation

define

Answer 4

a fall in the value of a currency

Question 5

causes of appreciation and depreciation

Answer 5

• foreign demand for exports
• domestic demand for exports
• investment (inward and outward)
• speculation
• changes in income of trading partners
• changes in domestic income
• relative inflation rates
• relative interest rates
• central bank intercvention (use of foreign currency reserves)
• remittances

Question 6

consequences of appreciation and depreciation

Answer 6

• currency appreciation can be expected to result in a decrease in net exports
• currency depreciation can be expected to lead to an increase in net exports

Question 7

effect of currency depreciation on the rate of inflation

deamnd-pull AND cost-push

Answer 7

Demand-pull inflation:

• makes exports cheaper and imports more expensive, thus increasing net exports

Cost-push inflation:

• makes imports more expensive, resulting in a leftward shift of the SRAS curve, resulting in cost-push inflation

Question 8

effect of currency appreciation on the rate of inflation

deamnd-pull AND cost-push

Answer 8

Demand-pull inflation:

• reduces demand-pull inflationary pressures due to a decrease in net exports

Cost-push inflation:

• makes imports less expensive, resulting in a rightward shift of the SRAS curve, lowering inflationary pressures

Question 9

effect of depreciation on economic growth

Answer 9

Depreciation increases net exports, increasing AD, thus causing an increase in real GDP.

HOWEVER, depreciation also leads to a leftward shift of the SRAS curve (cost-push inflation), which puts downward pressure on real GDP.

SO, GDP depends on which of the 2 effects is stronger: the upward effect due to AD or the downward effect due to the decrease in SRAS.

Question 10

effect of appreciation on the current account balance

Answer 10

Appreciation will cause imports to increase and exports to fall. If a country has an excess of imports over exports (‘trade deficit’), its deficit is likely to become larger after a period of time. If it has excess of exports over imports to begin with (‘trade surplus’), its trade surplus is likely to become smaller.

Question 11

effect of appreciation on economic growth

Answer 11

Appreciation reduces net exports, reducing growth of real GDP.

Question 12

effect of depreciation on the current account balance

Answer 12

Likely to cause imports to decrease and exports to increase. If a country has an excess of imports over exports (‘trade deficit’), its deficit is likely to become smaller after a period of time. If it has excess of exports over imports to begin with (‘trade surplus’), its trade surplus is likely to become larger

Question 13

effect of depreciation on foreign debt

Answer 13

Depreciation lowers the value of the domestic currency, causing the value of the foreign debt to increase.

Question 14

effect of appreciation on foreign debt

Answer 14

Appreciation causes the value of the foreign debt to fall.

Question 15

effect of depreciation on living standards

Answer 15

Depreciatiopn causes imported goods to become more expensive, so residents become worse off, and travellers abroad find their holidays have been made more expensive.

Question 16

effect of appreciation on living standards

Answer 16

If a currency appreciates, standards of living are likely to increase. Prices of imported goods fall, imports become cheaper, and travellers abroad will find the cost of travelling to decrease.

Question 17

effect of depreciation on unemployment

Answer 17

Depreciation increases net exports and therefore AD, which causes a fall in cyclical unemployment if the economy is in a recessionary gap.

HOWEVER, depreciation may lead to cost-push inflation, which involves lower real GDP due to the decrease in SRAS, hence an increase in unemployment.

SO, the overall effect depends on which of the 2 effects is stronger: the upward effect due to the increase in AD or the downward effect due to the decrease in SRAS.

Question 18

effect of appreciation on unemployment

Answer 18

Appreciation reduces exports and hence AD, creating a recessionary gap and therefore cyclical unemployment.

Question 19

methods the central bank uses to maintain a fixed exchange rate

Answer 19

• using official reserves
• increasing interest rates
• borrowing from abroad
• efforts to limit imports

Question 20

currency devaluation

define

Answer 20

if the currency value is higher than what can be maintained through intervention, the govt. may change it to a new, lower value

Question 21

currency revaluation

define

Answer 21

if the currency value is lower than what can be maintained through intervention, the govt. may change it to a new, higher value

Question 22

Degree of certainty for stakeholders

floating vs fixed exchange rates

Answer 22

Fixed:
High degree of certainty.

Floating:
Uncertainty because stakeholder cannot know what the value of the currency will be in the future.

Question 23

Role of foreign currency reserves

floating vs fixed exchange rates

Answer 23

Fixed:
Central bank intervention to maintain a fixed exchange rate requires sufficient supplies of foreign currency reserves.

Floating:
There is no need for central banks to hold foreign currency reserves since there is no need for intervention in foreign markets.

Question 24

Correction of current account imbalences

floating vs fixed exchange rates

Answer 24

Fixed:
No easy methods to correct imabalances in the balance of payments. External shocks cannot be handled quickly and easily. Persisten current account deficits require large quantities of foreign currency reserves. If these are not readily available, the country must resort to contractionary policies or trade protection. If the current account deficit persists, the country may have to devalue its currency.

Floating:
These can easily adjust automatically to excess demand or supply of the domestic currency, thus bringing about a balance in the balance of payments.

Question 25

Effects of inflation

floating vs fixed exchange rates

Answer 25

Fixed:
If a country has a rate of inflation that is higher than that of its trading partners, the foreign demand for exports falls as these are less competitive, while demand for imports rise, and the country is likely to develop a current account deficit. However, depreciation cannot be used to correct the deficit, so countries must use fiscal policy to maintain a low and stable rate of inflation.

Floating:
If a country has a rate of inflation that is higher than that of its trading partners, so that the country develops a current account deficit, this can be corrected through depreciation. However, depreciation leads to higher costs of imports, which can create cost-push inflation.

Question 26

Flexibility offered to policy-makers

floating vs fixed exchange rates

Answer 26

Fixed:
Do not offer flexibility to policy-makers.

Floating:
Offer greater flexibility to policy-makers.

Question 27

managed exchange rate system

define

Answer 27

exchange rates are supposed to move towards their long-term equilibrium determined by the market; however, central banks periodically intervene to stabilise them over the short term

Question 28

pegged exchange rate

define

Answer 28

one currency is fixed in relation to another currency, and floats in relation to all other currencies

Question 29

overvalued currency

define

Answer 29

A currency that has a value too high relative to its equilibrium free market valu. Its exchange rate has been set at a higher level than the equilibrium market exchange rate.

Question 30

undervalued currency

define

Answer 30

A currency that has a value too low relative to its equilibrium free market value. Its exchange rate is low relative to the one the market would have determined.

Question 31

pros and cons of an overvalued currency

Answer 31

Pros:

• developing countries can import capital goods and materials at a cheaper price

Cons:

• exports become more expensive
• worsening current account balance
• domestic producers have to compete with artificially low-price imports (leading to negative consequences for domestic employment and resource allocation)

Question 32

pros and cons of an undervalued currency

Answer 32

Pros:

• exports become less expensive to foreign buyers; some developing countries have used undervaluation as a method to expand their export industries, dxpand their economies and therefore also increase their employment levels
• country gains access to foreign exchange

Cons:

• imports become more expensive domestically
• can lead to cost-push inflation due to higher price of imports
• deemed unfair and a form of protectionism because it distorts prices: may result in retaliation

Question 33

credits (inflows) represent … for a country’s currency

fill in the blank:
foreign demand OR domestic supply

Answer 33

foreign demand

Question 34

debits (outflows) represent … for a country’s currency

fill in the blank:
foreign demand OR domestic supply

Answer 34

domestic supply

Question 35

surplus

in balance of payments

Answer 35

occurs whenever a baqlance of payments has a positive value, meaning that credits are larger than debits (excess of credits)

Question 36

deficit

in balance of payments

Answer 36

occurs whenever a baqlance of payments has a negative value, meaning that debits are larger than credits (excess of debits)

Question 37

Does a current account surplus causes appreciation or depreciation?

Answer 37

appreciation

Question 38

Does a current account deficit causes appreciation or depreciation?

Answer 38

depreciation

Question 39

implications of a persistent current account deficit

Answer 39

• depreciation exchange rate
• possible need for higher interest rates to attract foreign financial investments, leading to recession
• foreign ownership of domestic assets
• increasing levels of debt
• poor international credit ratings
• painful demand-management policies
• possibility of economic growth

Question 40

methods to correct a persistent current account deficit

Answer 40

• expenditure reducing policies (reduce AD)
• expenditure switching policies (switch consumption away from imported goods towards domestically produced goods)
• supply-side policies (to increase competitiveness)

Question 41

implications of a persistent current account surplus

Answer 41

• low domestic consumption
• insufficient domestic investment
• appreciation of the domestic currency
• inflation
• employment
• reduced export competitiveness

Question 42

What is the Marshall-Lerner condition?

Answer 42

The condition states that a fall in the exchange rate will reduce a current account deficit if the sum of PEDs for exports and imports is greater than 1.