Exchange rates pt2 Flashcards
Free floating exchange rates disadvantages - For trade only
Contrary to our assumption, the biggest determinants of exchange rates are not trade but international capital flows so currencies can be under or overvalued due to currency speculation or capital flows not trade so self correcting properties will no longer hold true
Free floating exchange rates disadvantages - Uncertainty
It is less certain than a fixed exchange rate and there is an argument that free floating rates makes firms less confident to plan and invest in future projects
Free floating exchange rates disadvantages-Cost push inflation
High domestic inflation > Exports are uncompetitive > Depreciation of the exchange rate > More expensive imports > Higher costs (cost push inflation)
Free floating exchange rates disadvantages-Demand pull inflation
If supply cannot keep up with the global upsurge for demand and exchange rates are floating, this will result in demand pull inflation.
Fixed exchange rates
This is rare and is usually due to wider political issues e.g. The UAE dirham is fixed to the US dollar as oil exports are traded in dollars which makes it easier for oil transactions.
Managing a fixed exchange rate
The government or central bank has to actively intervene to correct any mismatch between the supply and demand for currency. They cant just say what the currency is worth, they must make the currency worth what they want.
Fixed exchange rate graph
When fixing an exchange rate, the government/central bank decide the rate at which it is to be pegged e.g. central peg. It also sets floor and ceiling values between the rate must remain.
Exchange equalisation
This is where the bank has reserves of its own currency so that it can buy and sell that currency, boosting demand or supply in order to affect the price.
Interest rates
The higher interest rates attracts “hot money” which in turn drives the exchange rate up.
