global economy 4.5 - Exchange rates Flashcards
define an exchange rate
the value of one currency expressed in terms of another currency
what are the 3 types of exchange rate systems?
fixed, floating, managed
define a fixed exchange rate system
a regime where the value of a currency is fixed, or pegged, to the value of another currency, to the average value of a selection of currencies, or to the value of some other commodity, such as gold
who decides and maintains the fixed value of the currency?
the government or central bank
revaluation of the currency
if the value of the currency in a fixed exchange rate system is raised
devaluation of the currency
if the value of the currency in a fixed exchange rate system is lowered
describe the effects of a increase in the supply of Barbadian dollars with a diagram
- supply curve shifts, so there is an excess supply of dollars (Q1Q2)
- without government intervention, the exchange rate will fall
- to maintain its exchange rate, govt buys excess supply of its own currency on the foreign exchange market by using previously amassed reserves of foreign currencies, thus shifting the demand curve from D1 to D2
describe the effects of a increase in the demand of Barbadian dollars with a diagram
- demand curve shifts, so there is an excess demand of dollars (Q1Q2)
- without government intervention, the exchange rate will rise.
- to maintain its fixed exchange rate, govt sells its own currency on the foreign exchange market in order to shift the supply curve from S1 to S2. this will increase US reserves of foreign currencies
define a floating exchange rate system
a regime where the value of a currency is allowed to be determined solely by the demand for, and the supply of, the currency on the foreign exchange market. there is no govt intervention to influence the value of the currency.
describe how a floating exchange rate system operates using a diagram
appreciation of the value of the currency
if the value of the currency in a floating exchange rate system rises
depreciation of the value of the currency
if the value of the currency in a floating exchange rate system falls
when will the demand for the US dollar rise?
- There is an increase in the demand for US goods and services.
- US inflation rates are lower than EU inflation rates, making US goods and services relatively less expensive than EU goods and services
- an increase in incomes in the EU, so people in the EU increase their demand for all things, including US exports
- a change in tastes in the EU in favour of US products - US investment prospects improve due to eg strong economic growth or the implementation of new business-friendly policies
- US interest rates increase, making it more attractive to save there than in EU financial institutions
- speculators in the EU think the value of the US dollar will rise in the future, so they buy it now.
when will there be an increase in the supply of US dollars on the foreign exchange market?
- Americans increase their demand fr EU goods and services, thus exchanging more US dollars for euros.
- US inflations higher than EU inflation rates, and thus US goods and services become relatively more expensive than EU goods and services
- an increase in incomes in the US, so people increase their demand for all things, including imports from the US
- a change in tastes in the US in favour of EU products - EU investment prospects improve
- EU interest rates increase, making it more attractive to save there than in US financial institutions
- speculators in the US think the value of the US dollar will fall in the future, so they sell it now and buy euros.
what is foreign direct investment (FDI) and portfolio investment?
Foreign portfolio investment is the purchase of securities of foreign countries, such as stocks and bonds, on an exchange. Foreign direct investment is building or purchasing businesses and their associated infrastructure in a foreign country.q
describe how a managed exchange rate system works
a regime where the currency is allowed to float, but with some element of interference from the government.
the most common systems are where a central bank will set an upper and lower exchange rate value and then allow the currency to float freely, so long as it does not move out of that band. the upper and lower level values are not public, for fear of speculation
advantages of a high ER
downward pressure on inflation
more imports can be bought
high value of a currency forces domestic producers to improve their efficiency
downward pressure on inflation:
the price of finished imported goods will be relatively low. the price of imported raw materials/components will reduce the costs of production for firms, which could lead to lower prices for consumers. this could also put pressure on domestic producers to be competitive by keeping prices low
more imports can be bought
if the value of the exchange rate is high, then each unit of the currency will buy more foreign currencies, and so more foreign goods and services (this includes visible goods like technology and invisible imports like foreign travel)
forces domestic producers to improve their efficiency
the high er will threaten their international competitiveness so they will be forced to lower costs and become more efficient in order to maintain competitiveness.
possible disadvantages of a high er
damage to export industries
damage to domestic industries
damage to export industries
if the value of the exchange rate is high, then export industries may find it difficult to sell their goods and services abroad, because of their relatively high prices. this could lead to unemployment
damage to domestic industries
with greater levels of imports being purchased, because they are now relatively cheaper, domestic producers may find that the increased competition causes a fall in the demand for their goods and services. this may lead to further unemployment
possible advantages of low exchange rate
greater employment in export industries
greater employment in import industries (opposite of disadvantages of high er)
possible disadvantages of a low exchange rate
inflation: low value of the currency will make imported final goods and services, raw materials and components more expensive. these are needed by firms and costs of production will rise, possibly leading to higher prices.
explain 2 ways that governments can manipulate the er
- using their reserves of foreign currencies to buy, or sell, foreign currencies
- increase of er can be done by buying its own currency on the forex - changing interest rates
- raising interest rates increases exchange rate as it will attract financial investment from abroad
overvalued vs undervalued currency
Undervalued Currency: This refers to a situation where the market value of a currency is considered lower than its intrinsic or fundamental value. An undervalued currency may make a country’s exports more competitive in the international market, potentially boosting its trade balance. However, it can also lead to higher import costs.
Overvalued Currency: Conversely, an overvalued currency is one whose market value is higher than its fundamental value. An overvalued currency can make a country’s exports more expensive for foreign buyers, potentially leading to a trade deficit. On the positive side, it can make imports cheaper for domestic consumers.
