Exchange Rates Year 2 Flashcards
What are the 4 types of exchange rate systems
Free Floating System
Managed Floating System
Semi-Fixed System
Fixed Rate System
What is a free floating system
It is when the value of a currency is determined by market forces in the Forex market
Sterling floating since Black Wednesday 1992
What causes the demand for the pound
Demand for visible and invisible exports
Demand to set up business in the UK (FDI)
Demand to buy shares in UK plc’s
Demand to save in UK banks
Speculation that the pound will appreciate
What causes the supply of the pound
Demand for foreign visible and invisible exports
Demand to set up UK businesses overseas
Demand to buy shares in foreign plc’s
Demand to save in foreign banks
Speculation that the pound will fall
What is a managed floating exchange rate
The value of the currency is largely determined by market forces but there is some intervention by the central bank to change the exchange rate
How does the central bank effect the exchange rate
Buying and selling its currency
Altering the rate of interest
How would a central bank depreciate its currency
Sell its currency
Cut the base rate of interest
How would a central bank appreciate its currency
Buy its currency
Raise the interest rate
What is hot money
It is an expression for large sums of footloose, mobile international wealth that is moved at very short notice
Currencies are an asset option and the interest rate is the rate of return
What is a semi-fixed exchange rate
A more formal version of a managed floating system
The currency is given a specific target rate and managed by the central bank
The target is changed by announcing a revaluation or devaluation
What is the Exchange rate Mechanism
Semi-fixed exchange rate system was used to create the euro
It stabilises the currencies before it removes them and replaces it with a single currency
Used for the sterling between 1990-92
What is a fixed exchange rate
Where the exchange rate is fully pegged against another variable
The central bank uses intervention to keep the exchange rate pegged
The pound was on the gold standard and dollar standard
What are the 2 main fixed exchange rates
The sterling system which an English, Welsh, Scottish and Northern Irish pound are all fixed at a 1:1
The Eurozone which all share the euro
What are the rules needed for multiple countries to use the same currency
Each nation must surrender its use of domestic monetary policy - 1 central bank
Each nation will have to coordinate its fiscal policy
Agreement that allow transfers of money between richer and poorer members of the monetary union
What are examples of fixed exchange rate regimes
The Gold Standard - pegged to the value of gold
Currency Unions - Sterling, Euro
What are the reasons for a free floating exchange rate
No need to hold currency reserves for intervention
Freedom to use domestic monetary policy to pursue other wider economic objectives
Automatic self correction of a trade imbalances
How does a country self correct its trade deficit with a floating exchange rate
A trade deficit means that more £’s are being sold by UK consumers for imports than being bought by foreign consumers for UK exports
This causes a surplus of £’s, which causes a currency depreciation
This change in value should make the demand of imports to fall and exports to rise
This shrinks the deficit
What conditions must be met for the self-correction to take place
The Marshall Lerner Rule
What is the Marshall Lerner rule
That a trade balance will be corrected by a currency re-adjustment so long as the combined price elasticity of demand for exports and imports is greater than 1
What does a more elastic price elasticity of demand mean when the exchange rate changes
The greater the response from demand and the greater the change in revenue earned
What factors affect the PED for exports and imports
The degree of competition
Number of substitutes
Type of good - Luxury or Necessity
What is the evaluation of the Marshall Lerner rule
It is more likely to be met in the long run due to the J curve effect
What is the J curve effect
It is the effect of which consumers don’t switch their spending habits to cheaper products because of information failure or inertia or contracts with suppliers
This causes a time lag in the improvement of the trade balance
What does the J curve look like
The Deficit or surplus gets worse in the short run and then improves in the long run
What are the 2 types of J curve effect
The J curve effect - Deficits
The reverse J curve effect - Surpluses
What are the reasons for persistent trade equilibria
Exchange rates aren’t free floating
Financial flows on capital account are over-riding the flows of money on current account
Trade on goods and services is price inelastic and the Marshall Lerner rule isn’t met
What are the reasons for a fixed exchange rate system
The Trade and investment benefits
The reductions in the cost of currency hedging
Disciplines on domestic producers
What are the trade and investment benefits of a fixed exchange rate
The reduced currency risk
Firms have to monitor the change in price of goods but also the exchange rate
Investors may have their profits removed by a bad exchange rate
Consumers and investors can be confident of the future value of their spending and receipt
What is currency hedging
When businesses trade on forward markets at their own risk, which also costs them a percentage of the money
What does a fixed exchange rate do about the disciplines of domestic producers
It forces domestic producers to keep control of their production costs
They can’t rely on a currency depreciation to keep their competitiveness
What is the balance of payments
It is a record of all cross-border flows of money for the purposes of buying goods and services, primary and secondary income flows and all other movements of financial capital
What are the 2 principal sections of the balance of payments
The current account and the financial account
What makes up the current account
Visible and invisible trade
Primary Investment Income
Secondary Transfer Income
What is Visible trade
Goods
e.g. oil, textiles, food
What is invisible trade
Services
(financial, Tourism, shipping, sports)
What is visible and invisible trade equal to
The Balance of Trades
What is Primary Investment Income
‘DRIP’
It is income earnt by UK citizens from their assets overseas in the form of dividends, rent, interest and Profit
What is secondary Transfer Income
It is the transfer of money from UK citizens or the government to people or governments in foreign countries
In the form of aid or money for workers families
What is GNP and what is it made up of
Gross National Product
GDP + DRIP = GNP
Why does the UK have a trade deficit
Because our visible deficit > invisible surplus
What makes up the financial account
Investment and other capital flows:
Direct Investment
Portfolio Investment
Hot Money
What is direct investment
F.D.I
Foreign Direct Investment
What is portfolio investment
Investment in foreign assets
e.g. Bonds/Shares
What is hot money
Bank deposits from foreign savers trying to maximise their interest rate
What does the Balance of Payments always sum to
0
What is the 3rd account on the balance of payments
The capital account
Measures the small and insignificant value of non-monetary assets that cross borders following labour migration
What does a deficit on the current account mean and what happens to the financial account
A deficit is when we consume more than the value of our GDP
This has to be financed by borrowing from overseas which causes a net inflow of funds resulting in a positive financial account
What does a surplus on the current account mean and what happens to the financial account
A surplus is when we consume less than the value of our GDP
This allows us to lend money overseas which is a net outflow of money resulting in a negative financial account
What happens if the balance of payments is not equal to 0
The exchange rate changes
What happens to the exchange rate when the balance of payments is negative
Pound depreciates
What happens to the exchange rate when the balance of payments is positive
Pound appreciates
How does the UK run a financial account surplus
Positive :
F.D.I
Portfolio
Hot money
How does the UK get F.D.I
Rich consumers
Stable democracy/law/economy
Skilled Labour
Low tax/regulations
How does the UK get portfolio investment
Bonds are safe, AAA
Shares of companies are safe and established
How does the UK get Hot Money in
Relatively high rate of interest
Safe Banks
What are the consequences of a current account deficit
Net leakage = Reduced AD
Deflationary
Consume more than we produced so boost in short run living standards
Requires an inflow of currency on the financial account or currency depreciation
What are the consequences of a current account surplus
Net injection = Increased AD
Inflationary
Consume less than we produced so reduction in short run living standards
Surplus of funds will be lent to other nations so outflow of currency on the financial account or currency appreciation
What are the types of current account imbalances
Cyclical or structural
What are cyclical current account imbalances
They are caused by swings in economic activity as the economy moves through the different phases of the trade cycle
What is the current balance likely to be during the up swings of the trade cycle
The current account is likely to deterioate as more imports are sucked in
The more income elastic the demand for imports is, the greater the effect
What is the current account balance likely to be during the down swings of the trade cycle
Current account improves because if the decreased amount of imports
What is assumed when predicting the state of the current account through the trade cycle
Imports are normal goods
GDP level has no impact on the amount of UK goods we sell abroad
What does an enduring imbalance in the current account suggest
If it isn’t explained by the business cycle the it will be due to structural imbalances
What do current account imbalances reflect
Differences in the competitiveness of trading nations
What is international competitiveness
The ability of domestic firms to win international market share on the basis of price and non-price supremacy
What does a countries ability to compete internationally depend on
Relative prices of exports and imports (the terms of trade)
Relative inflation rates ( rate of divergence between exports and import prices)
Relatives production costs per unit
Relative productivity rates
The exchange rate
Relative quality and other non-price factors
What does a country with the greatest competitiveness have when comparing inflation rate and price level
In the short run, it is the one with the lowest price level
In the long run you must consider the inflation rate for the future price level
Whats the difference between price level and inflation
Price level is the average price of goods and inflation rate is the rate of change of the price level
What is the terms of trade
The terms of trade measure the ratio of a country’s export prices to its import prices
What is the equation for the terms of trade
Index of average export prices/Index of average import prices x 100
What happens to the terms of trade if exports are rising faster than import prices
The terms of trade index is said to have improved
Fewer exports have to be given up in exchange for a given volume of imports
What happens to the terms if trade if import prices rise faster than export prices
The terms of trade are said to have deteriorated
A greater volume of exports has to be sold to finance a given amount of imported goods and services
What are the key determinants of the terms of trade
Relative productivity and unit costs
Relative inflation rates
Exchange rates
What is the evaluation of the terms of trade
Rising terms of trade is usually seen as good
If it is due to a rise in demand for exports it is good
If it is due to inflation and a increase in costs then it isn’t good
What are the evaluation points for relative inflation rates
It is only the rate of price increase of the subset of goods and services that effects the current account performance
It is the relative inflation rate against key trading partners
Demand pull inflation is less concerning than cost push
What are the evaluation for productivity rates
It is the relative productivity and the gap between our trading partners
There is a focus on labour productivity when capital productivity is increasingly important
What is the evaluation for exchange rates
Countries are tempted to use the exchange rate but is a form of protectionism that hides the structural inefficiency
Only works in the short run
What is the evaluation for comparative advantage
Countries comparative advantages change over time and leave a mark on the current account
What are the policies to cure or reduce a current account deficit
Policies that switch expenditure
Policies that reduce expenditure
What are the policies that switch expenditure
Depreciation/Devaluation of currency
Protectionism
What is the policy that reduces expenditure
Deflation
What is a devaluation
The deliberate attempt by a country’s central bank to manipulate the value of the currency downwards
What does a depreciation/devaluation of the currency do for a current account deficit
Switch consumer spending away from imports and to exports
What are evaluation points of protectionism
Not allowed in economic unions
Don’t address the cause of lack of competitiveness
Provoke retaliation
Distorts comparative advantage and discourages specialisation
What does deflation do for the current account deficit
Reduce income, so less imports
Fall in price level
Reduce real GDP
Normally done when the economy has a positive output gap
What are the benefits of supply side policies
Likely to yield long run success because they target underlying causes of weak competitiveness
What do supply side policies do
They aim to improve efficiency which product and labour markets operate in
Leading to rightward shift in the LRAS curve
What is globalisation
It is a process through which national economies become increasingly integrated and interdependant
What does the fact that globalisation is a process mean
That it is on-going
There have been waves of globalisation over the centuries temporarily impeded by protectionism and world wars
What are the characteristics of globalisation
Free trade
Free movement of labour, capital, enterprise and technology
How can the extent of globalisation be measured
The increase in the volume and value of world trade
It can also be measured individually as the size of X+M as a % of GDP
What do cross border capital flows mean
Financial flows
FDI
What are financial flows
Hot money flows
What is FDI
Foreign Direct Investment
Expenditure on real physical capital in setting up or expansion of operations and production facilities overseas
What is Offshoring
When work is outsourced to businesses in another country on the basis of lower unit costs (particularity unit labour costs)
What are examples of globalisation
mass economic migration of labour
Nissan in Sunderland
UK retail banks with call centres in India
International supply chains
What is driving greater globalisation
Multilateral trade agreements - reduce tariff barriers
Technological Advances - e.g internet
Collapse of Communism
Export led development strategies
Removal of capital controls
Relaxation of visa controls
What are the pro-globalisation arguments
Increases global allocative efficiency
Countries can consume more than they produce
Developing countries living standards will rise
Help distribute income around the world
Helps investment in developing countries through FDI
FDI can accelerate the transition from a developing to a developed country
FDI countries normally pay a high relative wage
Increased competition will lower prices and give a greater choice
Trade will help developing countries increase living standards and less reliant on aid
What are the anti-globalisation arguements
It doesn’t improve economic development for all citizens
The benefit of trade is unequal between developing and developed countries, making them relatively poorer
Trade leads to greater inequality
Large firms can have more power over the government
Leads to a loss of cultural diversity
Large firms exploit workers by not paying them their fair share
Firms cause large amounts of environmental damage
What policies could be used by a developing country to develop further to an advanced country
Increased Globalisation
Supply-side policies
What is the natural rate of unemployment
The equilibrium rate of unemployment
The rate where real wages have found their free market level and supply of labour is equal to demand for labour
What does it mean for workers if the country is at its natural rate of unemployment
All workers who are willing and able to work at the wage rate found employment
No involuntary unemployment
What unemployment still exits at the natural rate of unemployment
Voluntary or frictional unemployment
Structural unemployment
What is voluntary or frictional unemployment
People who are looking for work with better wages or conditions
Workers between jobs
People leave for personal reasons like illness or retirement
What is structural unemployment
As the economy evolves, there is a mismatch between workers’ job skills and employers needs
Happens when what, where or how goods are being produced
What are the assumptions with the natural rate concept
Markets have the power to clear at an equilibrium an the labour market is like any other market
What are classical economists view of cyclical unemployment
Cyclical unemployment occurs in the short run, but is removed by lower wages in the long run
How does the government reduce the natural rate of unemployment
Focus on improving the efficiency of the labour market by removing what are called ‘labour market imperfections’
What policies can the government do to reduce the natural rate of unemployment
Reform welfare benefits to reduce the unemployment trap where people remain unemployed by choice rather than work
Reforming trade unions to reduce collective bargaining and reduce labour immobility
Reduce income tax to improve incentive to accept work
More relaxed approach to labour migration
Make labour markets more competitive and flexible
No demand side policies
