Exhange Rates And Exchange Rate Policy

Question 1

What is the forex market

Answer 1

A market where investors can buy and sell any currency

Question 2

What factors influence floating ERs

Answer 2

Relative interest rates - impact on hot money
Relative inflation rates - if UK has relatively low inflation, purchasing power of the pound will decrease relative to other countries
Increase in trade surplus on balance of payments - value of £ up, more Q of pound traded so higher demand means ER up. More FDI into UK
Net investment into the UK
Speculation
QE - money supply up, more supply of pounds on FOREX markets, value of pound down

Question 3

Evaluation of factors influencing floating ERs

Answer 3

Depreciation of the currency can lead to economic growth driven by improved trade balance (J curve)

Question 4

What is demand for a currency

Answer 4

Exports plus capital inflows

Question 5

What is supply for a currency

Answer 5

Imports plus capital outflows

Question 6

What is an exchange rate index

Answer 6

A measure of a currency against a trade-weighted basket of currencies. A way of measuring the performance of a currency against a basket of other currencies. The value of the index is 100 in the base year. The weight given to each currency depends on the proportion of transactions done with the country eg pound highest rating given to the Euro

Question 7

Pros and cons of fixed ER

Answer 7

Pros:
Stability for firms - prices are more stable
Predictably and confidence - firms can plan ahead and are likely to invest more.
Discipline - policy makers can’t just devalue their currency to hide inflation or balance of payments deficit
Cons:
May be unable to respond to economic shocks, as you can’t use IRs for this
Problems with reserves - require large foreign exchange reserves
Policy conflicts - fixed ER may not be compatible with other economic targets

Question 8

What is a managed float

Answer 8

When government seeks to keep the value of a currency between a band of the ER. The ER can fluctuate a bit

Question 9

How do governments do managed floats

Answer 9

Buying and selling currency - raise value of its currency by buying its own currency on FOREX markets.
Changing IR
Currency controls - alter supply and demand by limiting the amount of foreign currency that can be bought or sold. This is done by giving licenses to trade currency to certain banks. To increase the value of its currency, it could restrict the number of banks allowed to trade FOREX

Question 10

What impact do ER changes have on terms of trade

Answer 10

ER up - Terms of Trade better, as price of exports up and price of imports down

ER down - Terms of Trade worsens, as price of exports down, imports price up