Exchange rates- MM

Question 1

What are the 4 functions of money?

Answer 1

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

Question 2

What is an exchange rate also known as?

Answer 2

X-rates

Question 3

What are X-rates?

Answer 3

The price of one currency in terms of another currency

Question 4

What are the 2 types of X-rates?

Answer 4

1) Fixed
2) Floating

Question 5

When do fixed exchange rates happen?

Answer 5

When two currencies will always be exchanged at the same price

Question 6

What are floating exchange rates determined by?

Answer 6

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

Question 7

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

Answer 7

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

Question 8

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

Answer 8

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

Question 9

What are 3 strengths of fixed rates?

Answer 9

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

Question 10

Explain why economic stability is a strength of fixed exchange rates

Answer 10

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

Question 11

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

Answer 11

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

Question 12

What are 3 strengths of floating X-rates?

Answer 12

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

Question 13

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

Answer 13

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

Question 14

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

Answer 14

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.

Question 15

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

Answer 15

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

Question 16

What are 6 factors affecting exchange rates?

Answer 16

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

Question 17

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

Answer 17

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

Question 18

What are 2 ways interest rates can affect exchange rates?

Answer 18

1) ↑ IR=↑ X-rates
2) ↓ IR=↓ X-rates

Question 19

What are 4 ways public debts affect exchange rates?

Answer 19

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

Question 20

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

Answer 20

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)

Question 21

What is capital flight?

Answer 21

Money flowing out of a country- can affect exchange rates

Question 22

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

Answer 22

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

Question 23

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

Answer 23

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

Question 24

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

Answer 24

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

Question 25

What are 4 things changes in exchange rates can affect?

Answer 25

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

Question 26

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

Answer 26

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

Question 27

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

Answer 27

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

Question 28

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

Answer 28

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

Question 29

How do changes in X-rate impact stable prices?

Answer 29

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

Question 30

How do changes in X-rate impact employment?

Answer 30

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

Question 31

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

Answer 31

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

Question 32

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

Answer 32

Balance of payments

Question 33

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

Answer 33

Low currency= drives BoP current account surplus

Question 34

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

Answer 34

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

Question 35

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

Answer 35

Which side of BoP is looked at- current vs financial

Question 36

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

Answer 36

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

Question 37

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

Answer 37

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

Question 38

Explain size of change as an evaluation point of exchange rates

Answer 38

Minor fluctuations have little effect, big fluctuations have big effects

Question 39

Explain time as an evaluation point of exchange rates

Answer 39

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

Question 40

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

Answer 40

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

Question 41

What are 5 ways countries can increase their international competitiveness?

Answer 41

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

Question 42

How do you calculate terms of trade?

Answer 42

Index of export prices/ Index of import prices x 100

Question 43

How do you know if terms of trades have improved?

Answer 43

Answer to calculation is over 100