global economy 4.5 - Exchange rates

Question 1

define an exchange rate

Answer 1

the value of one currency expressed in terms of another currency

Question 2

what are the 3 types of exchange rate systems?

Answer 2

fixed, floating, managed

Question 3

define a fixed exchange rate system

Answer 3

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

Question 4

who decides and maintains the fixed value of the currency?

Answer 4

the government or central bank

Question 5

revaluation of the currency

Answer 5

if the value of the currency in a fixed exchange rate system is raised

Question 6

devaluation of the currency

Answer 6

if the value of the currency in a fixed exchange rate system is lowered

Question 7

describe the effects of a increase in the supply of Barbadian dollars with a diagram

Answer 7

1. supply curve shifts, so there is an excess supply of dollars (Q1Q2)
2. without government intervention, the exchange rate will fall
3. 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

Question 8

describe the effects of a increase in the demand of Barbadian dollars with a diagram

Answer 8

1. demand curve shifts, so there is an excess demand of dollars (Q1Q2)
2. without government intervention, the exchange rate will rise.
3. 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

Question 9

define a floating exchange rate system

Answer 9

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.

Question 10

describe how a floating exchange rate system operates using a diagram

Question 11

appreciation of the value of the currency

Answer 11

if the value of the currency in a floating exchange rate system rises

Question 12

depreciation of the value of the currency

Answer 12

if the value of the currency in a floating exchange rate system falls

Question 13

when will the demand for the US dollar rise?

Answer 13

1. 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
2. US investment prospects improve due to eg strong economic growth or the implementation of new business-friendly policies
3. US interest rates increase, making it more attractive to save there than in EU financial institutions
4. speculators in the EU think the value of the US dollar will rise in the future, so they buy it now.

Question 14

when will there be an increase in the supply of US dollars on the foreign exchange market?

Answer 14

1. 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
2. EU investment prospects improve
3. EU interest rates increase, making it more attractive to save there than in US financial institutions
4. speculators in the US think the value of the US dollar will fall in the future, so they sell it now and buy euros.

Question 15

what is foreign direct investment (FDI) and portfolio investment?

Answer 15

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

Question 16

describe how a managed exchange rate system works

Answer 16

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

Question 17

advantages of a high ER

Answer 17

downward pressure on inflation
more imports can be bought
high value of a currency forces domestic producers to improve their efficiency

Question 18

downward pressure on inflation:

Answer 18

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

Question 19

more imports can be bought

Answer 19

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)

Question 20

forces domestic producers to improve their efficiency

Answer 20

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.

Question 21

possible disadvantages of a high er

Answer 21

damage to export industries
damage to domestic industries

Question 22

damage to export industries

Answer 22

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

Question 23

damage to domestic industries

Answer 23

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

Question 24

possible advantages of low exchange rate

Answer 24

greater employment in export industries
greater employment in import industries (opposite of disadvantages of high er)

Question 25

possible disadvantages of a low exchange rate

Answer 25

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.

Question 26

explain 2 ways that governments can manipulate the er

Answer 26

1. 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
2. changing interest rates
   - raising interest rates increases exchange rate as it will attract financial investment from abroad

Question 27

overvalued vs undervalued currency

Answer 27

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.