Exchange rates- MM Flashcards
What are the 4 functions of money?
1)Medium of exchange
2) A store of value
3) A measure of value
4) A standard deferred payment
What is an exchange rate also known as?
X-rates
What are X-rates?
The price of one currency in terms of another currency
What are the 2 types of X-rates?
1) Fixed
2) Floating
When do fixed exchange rates happen?
When two currencies will always be exchanged at the same price
What are floating exchange rates determined by?
By the private market (FOREX) through supply and demand- where the value of the currency is determined by how much is being supplied & demanded
How do you calculate using an X-rate if the currency is worth more than the original currency?
Multiply by X-rate
e.g. £1=$1.20
£300=300x1.2=$360
How do you calculate using an X-rate the currency that is worth more? e.g. £ vs $
Divide by x-rate
e.g. £1=$1.20 so
$600=600/1.2=£500
What are 3 strengths of fixed rates?
1) Economic stability- less volatile
2) Better at countering domestic inflation
3) Lower opportunity cost for business
Explain why economic stability is a strength of fixed exchange rates
Floating x-rates can be volatile & a source of uncertainty for economic agents, which undermines confidence and can decrease investment and growth
Explain lower opportunity cost as a strength of fixed X-rates
Owners of small-medium sized businesses don’t have to spend long speculating X-rate movement & can focus on core business work
What are 3 strengths of floating X-rates?
1) Flexibility of monetary policy
2) Automatic correction of shocks/trade deficits
3) Central bank doesn’t need to keep purchasing & selling foreign currency
Explain flexibility of monetary policy as a strength of floating X-rates
Fixed X-rates becomes whole focus of monetary policy, reducing freedom.
Floating X-rates= cent. bank can change IR to boost growth & control inflation
Explain automatic correction of shocks/trade deficits as a strength of floating X-rates
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.
Explain central bank not needing to purchase and sell foreign currencies as a strength of floating X-rates
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
What are 6 factors affecting exchange rates?
1) interest rates
2) Public debts
3) Political stability & economic performance
4) Terms of trade
5) Current account deficit
6) Inflation
What are 2 ways an increase in interest rates goes about improving exchange rates?
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