Exchange rates, Terms of trade, Competitiveness, Monetary union Flashcards
what is exchange rate ?
exchange rate is the price of one currency in relation to another
whats the J curve diagram and explain it
states that a depreciation in currency will lead to a current account surplus because imports become more expensive causing a fall in an expenditure and exports become cheaper and more competitive so more are bought = rise in revenue
Whats the marshall learner condition?
states that depreciation of the exchange rate will lead to an improvement of the current account of the balance of payments if :
- the combined PED for imports and exports are elastic (greater than 1)
whats a free or floating exhange rate system?
value of a currency is determined by free market forces with the value of the currency changing day to day. Gov do not intervene e.g. FOREX (foreign exchange markets)
explain benefits and evaluate floating exchange rate systems
benefits :
- flexible, currency values will adjust to economic changes automatically
- Monetary policy independence: Countries with floating exchange rates can set their interest rates to manage inflation or unemployment without worrying about maintaining a fixed exchange rate.
- no cost to maintain
- correct allocation of resources
.
Evaluation :
- depreciation will not correct a trade deficit unless Marshal learner condition is met (PED of imports and exports is greater than 1)
- Lack of certainty due to fluctuating exchange rate, so firms are hesitant to make investments
- no guarantee that floating exchange rates will be stable
What is a fixed exchange rate system ?
a currency has a fixed value against another currency or commodity. E.g. GOLD standard
explain benefits and evaluate fixed exchange rate systems
Benefits :
- greater certainty - allows the price of exports and imports to be more stable, giving more confidence to overseas businesses leading to higher levels of trade and investment (FDI)
- discipline domestic firms - exchange rate cannot devalue so firms need to match the production improvements of their competitors
- reduced cost of trade - fixed rates reduce the need for hedging and this lowers the cost of international trade = increased trade
.
EVALUATION
- Need to maintain and spend foreign currency reserves to keep the fixed value
- conflits of interest, use of monitary policy (interest rates) to control inflation and encourage AD might influence the exchange rate
- internation retaliation - china fixed thier exchange rate bellow the market rate putting pressure on US and EU, so they imposed tarrifs of some chinese exports
what is a managed exchage rate system?
an exchange rate system where free markets determine the value of a currency but where central banks or government intervene from time to time to change the value of their currency.
what are the 2 most common ways the central banks and government manage their exchange rate?
- adjusting interest rates = increased interest rates = increased value of the pound because the demand would increase and the supply would fall
- buying or selling reserves = the bank of england can increase the value of the pound through buying reserves of the foreign currency and gold and selling the pound on the foreign exchange market. THey can decrease the value of the pound by selling reserves of foreign currecny and gold and buy the poung
Explain the benefits of managed exchange rate and evaluate it
Benefits:
- stable / predictable because central banks can prevent volatility = incentive for investment
- support for acheiving economic goals E.g. govs can us exchange rates to acheive macroeconomic objectives
- flexibility compared to fixed exchange rates
- control over attacks = central banks can control the currency
.
EVALUATION :
- cost of intervention
- inflation due to increased money supply by central banks printing money or buying foreign currency
- can cause market dissortion where the government interveining creates market failures and affects prices. constant intervention goes against natural market forces = imbalances
what is the definition of the terms of trade
the average value of exports relative to the average prices of imports.
- there will be an improvement in the terms of trade if the import prices fall, and the export prices rise.
how do you calculate terms of trade?
the index number of export prices / index number of import prices X 100
what are the factors influencing the terms of trade?
SHORT TERM
- exchange rates
- inflation rate
- demand for a commodity in which the county specialises in
- suppy in commodity which the country specialises in
LONG TERM
- improved productivity rate = more output per units of input
- increasing world incomes
what does an increase in terms of trade imply?
that there is an increase in a countries living standards because less goods have to be exported to buy a given quantity of imports.
what is the definition of International competitivness?
refers to a countries sustained ability to sell goods and services domestically and internationaly whilst making profit, at a price and quality which is attractive.
why is international competitiveness so important ?
lots of exports sold, improving trade balance and increasing AD and economic growth
what are the 2 measures of price competitiveness and what is a measure of NON-price compettiveness?
- relative unit labour costs
- relative export prices
NON-price competitiveness : - quality of good / service
factors influencing international competitiveness are …
- relative labour costs
- productivity (output per unit of input put in) (more efficient)
- inflation (g/s price rise so less competitive)
- regulation (laws limiting pollution) if regulations where removed it could lead to environmental damage, worker exploitation and reduced consumer protection.
- research and development (reinvestment) = new technology advancements push down production price so LRAC FALLS = economies of scale
- Quality
- Taxation, increased tax = increased prices because cost is past on to buyers = less competitive
what is a monetary union?
a group of countries sharing a common currency (Euro)
whats an optimum currency area ?
area that would maximise efficiency if the countries shared a common currency
benefits of a monitary union?
- reduced transaction cost, no currency exchange cost EVALUATION - depends on transaction cost before so may only be a minimal benefit.
- no exchange rate fluctuations (less risk) more stable currency gives businesses confidence to invest
- increased price transparency - easier for countries to compare prices between different countries and buy from the cheapest source = increased competition
- increased trade in the monitary union due to reduced transaction cost and exchange rate risk, this should stimulate competition and further specialisation according to comparitive advantage and improved productivity = economies of scale
- inward investment and FDI
what is foreign direct investment
FDI is inward investment into one country by companies based in another country
negatives of joining a monetary union?
-
intitial transition cost of introducing a new currency for example changing tills, menus and vending machines. EVALUATION: one off cost not long term
-** loss of monitary policy inderpendance** which is bad because some countries may be in a recession and others may be hyperinflating (different business cycles). If all countries are at the same stage of the business cycle this doesnt matter so much. - no exchange rate adjustments possible, if country is uncompetitive a country would normaly drop their interest rates to restore competitiveness but this cannot happen if countries adopt the euro. However that could lead to inflation anyway
- constraints on fiscal policy - all members must follow regulations like keeping their budget deficit below 3%
