Exchange rates- MM Flashcards

1
Q

What are the 4 functions of money?

A

1)Medium of exchange
2) A store of value
3) A measure of value
4) A standard deferred payment

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2
Q

What is an exchange rate also known as?

A

X-rates

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3
Q

What are X-rates?

A

The price of one currency in terms of another currency

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4
Q

What are the 2 types of X-rates?

A

1) Fixed
2) Floating

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5
Q

When do fixed exchange rates happen?

A

When two currencies will always be exchanged at the same price

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6
Q

What are floating exchange rates determined by?

A

By the private market (FOREX) through supply and demand- where the value of the currency is determined by how much is being supplied & demanded

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7
Q

How do you calculate using an X-rate if the currency is worth more than the original currency?

A

Multiply by X-rate
e.g. £1=$1.20
£300=300x1.2=$360

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8
Q

How do you calculate using an X-rate the currency that is worth more? e.g. £ vs $

A

Divide by x-rate
e.g. £1=$1.20 so
$600=600/1.2=£500

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9
Q

What are 3 strengths of fixed rates?

A

1) Economic stability- less volatile
2) Better at countering domestic inflation
3) Lower opportunity cost for business

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10
Q

Explain why economic stability is a strength of fixed exchange rates

A

Floating x-rates can be volatile & a source of uncertainty for economic agents, which undermines confidence and can decrease investment and growth

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11
Q

Explain lower opportunity cost as a strength of fixed X-rates

A

Owners of small-medium sized businesses don’t have to spend long speculating X-rate movement & can focus on core business work

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12
Q

What are 3 strengths of floating X-rates?

A

1) Flexibility of monetary policy
2) Automatic correction of shocks/trade deficits
3) Central bank doesn’t need to keep purchasing & selling foreign currency

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13
Q

Explain flexibility of monetary policy as a strength of floating X-rates

A

Fixed X-rates becomes whole focus of monetary policy, reducing freedom.
Floating X-rates= cent. bank can change IR to boost growth & control inflation

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14
Q

Explain automatic correction of shocks/trade deficits as a strength of floating X-rates

A

X-rates are a price, so invisible hand acts
e.g. if a country faces a large trade deficit (M>X) so supply (M) exceeds demand (X), causing a fall in X-rate.

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15
Q

Explain central bank not needing to purchase and sell foreign currencies as a strength of floating X-rates

A

They can stock far fewer reserves of foreign currency, so the reserves can be used for promoting economic growth by investing in more profitable assets

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16
Q

What are 6 factors affecting exchange rates?

A

1) interest rates
2) Public debts
3) Political stability & economic performance
4) Terms of trade
5) Current account deficit
6) Inflation

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17
Q

What are 2 ways an increase in interest rates goes about improving exchange rates?

A

1) ↑ IR means hot money wants to get in, so demand for currency ↑
2) Higher IR-↓ inflation, ↑ demand for exports, also ↑ demand for currency
Opposite when IR decreases

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18
Q

What are 2 ways interest rates can affect exchange rates?

A

1) ↑ IR=↑ X-rates
2) ↓ IR=↓ X-rates

19
Q

What are 4 ways public debts affect exchange rates?

A

1) High gvnmt debt= fall in X-rate
2) Big deficit to finance to pay for G spending
3) Less attractive to foreign investors (FDI)
4) Large debt encourages inflation, so real value of currency is lower=less attractive= lower D for currency

20
Q

What are 3 ways political stability & economic performance can affect X-rates?

A

1) FDI wants stable & strong economic performance to invest
2) Less risk
3) Political turmoil= ↓ confidence in currency, movement of capital to more stable countries (capital flight)

21
Q

What is capital flight?

A

Money flowing out of a country- can affect exchange rates

22
Q

What are 2 reasons a change in inflation can affect X-rates?

A

1) Consistent low inflation= rising currency value, ↑ purchasing power vs other countries
2) High inflation= depreciation in their currency about the currencies of trading partners

23
Q

What are 2 reasons current account deficits can affect X-rates?

A

1) High trade surplus (X>M) associated with high demand for currency= strong X-rate
2) High trade deficit (M>X) associated with high supply of currency so weak X-rate

24
Q

What are 2 ways terms of trade can affect X-rates?

A

1) X prices ↑ quicker than M prices, indicating strong demand for currency= strong X-rate
2) X prices ↑ slower than M prices, indicating weaker demand for currency= weak X-rate

25
Q

What are 4 things changes in exchange rates can affect?

A

1) Economic growth
2) Stable prices
3) Employment
4) Balance of payments

26
Q

What impact does a change in X-rates have on economic growth?

A

Devaluation on fixed rates or sustained depreciation of floating rates can drive growth in an economy due to the impact on X & M

27
Q

How does a change in X-rates drive economic growth?

A

Lower X-rate may improve international competitiveness as exports are more attractive compared to imports

28
Q

What does the impact of changing x-rates on economic growth depend on?

A

The type of economy (UK relies on M- so higher M prices would harm growth)

29
Q

How do changes in X-rate impact stable prices?

A

Volatile X-rate=volatile prices=not preferable
Imported inflation with fixed rates- trading countries bring price increases from each country back
Floating rates- can avoid imported inflation by changing X-rate

30
Q

How do changes in X-rate impact employment?

A

Strong currency=X dearer= loss of jobs in export sector
Weak pound= better X= more jobs

31
Q

What does the impact of changing X-rates on employment depend on?

A

The duration of the change-quick change=less likely businesses will change

32
Q

What is the most direct impact of X-rate changes on?

A

Balance of payments

33
Q

What impact does a change in X-rates have on balance of payments?

A

Low currency= drives BoP current account surplus

34
Q

Which country would 1) want to keep balance of payments low and 2) why?

A

1) China
2) Protect huge current account surplus- keep X-rates very low

35
Q

What does the impact of a change in x-rates on the BoP depend on?

A

Which side of BoP is looked at- current vs financial

36
Q

What impact does the strength of a currency have on the financial account?

A

Strong= large surpluses in financial account
weak= large deficits in financial account

37
Q

What 3 factors does the impact of exchange rates depend on?

A

1) Size of change
2) Time
3) PeD of M and X

38
Q

Explain size of change as an evaluation point of exchange rates

A

Minor fluctuations have little effect, big fluctuations have big effects

39
Q

Explain time as an evaluation point of exchange rates

A

How long is the up/downward trend sustained for- longer=bigger effect
Time lag- devaluations no effect short term, big effect on trade defeicit long term

40
Q

Explain PeD of X & M as an evaluation point of exchange rates

A

If combined PeD is less than -1 (inelastic), change in value of x & m will be less than rate change- explained by ST changes not affecting X&M much

41
Q

What are 5 ways countries can increase their international competitiveness?

A

1) Exchange rates
2) Control inflation
3) Strength of institutions
4) Ease of doing business
5) Quality of labour force

42
Q

How do you calculate terms of trade?

A

Index of export prices/ Index of import prices x 100

43
Q

How do you know if terms of trades have improved?

A

Answer to calculation is over 100