HSC Year 12 Topic 2 Exchange rates Flashcards
What are exchange rates?
The price of Australia’s currency in terms of another country’s currency or a basket of currencies. The equilibrium price.
What are the different systems for determining the exchange rate?
The floating system (clean or dirty), fixed rate system and flexible peg. Or a monetary union.
What are bilateral exchange rates?
The measurement of the value of a currency against a single other currency.
What is the difference between the direct and indirect method of quotation?
Indirect refers to how much one unit of domestic currency can purchase in a foreign currency.
Direct refers to how much domestic currency is required to purchase one unit of foreign.
What is the trade weighted index (TWI)?
A measure of the value of the AUD against a basket of currencies of Australia’s major trading partners.
Benefits of using the TWI?
It is less subject to pronounced changes and more stable compared to bilateral exchange rates.
What is a floating exchange rate system?
This is determined by market forces which can be broken up into two categories. Where supply and demand intersect.
Clean - there is no government intervention.
Dirty - government intervention if deemed necessary (short term).
What is the fixed/pegged exchange rate system?
The government wants to fix the price of the currency at a certain price, this requires continual government intervention.
What is the managed flexible peg system?
Government intervention if the currency moves outside the target band.
Why is the AUD supplied in forex markets?
To buy imports of goods and services.
To send income out of Australia.
To invest overseas, capital outflow.
Why is the AUD demanded in forex markets
Buy Australian exports of goods and services.
Send income into Australia.
Invest in Australia, capital inflow.
What is an appreciation?
Increase in value of a currency in a floating exchange rate system.
What is a depreciation?
A fall in the value of a currency in a floating exchange rate system. This makes the currency more internationally competitive. Increases price of imports and increases imported inflation.
Advantages of floating exchange rates.
Reduces need for large foreign currency reserves.
Insulation for the economy after external shock.
Flexibility in determining interest rates.
Reduces speculation over future values of currency.
Pursue independent monetary policy.
Disadvantages of floating exchange rates.
Increased volatility.
Subject to sudden shifts in sentiment.
Speculative bubbles.
What are fixed exchange rates?
When a currency is fixed/pegged to another country’s currency.
What is revaluation?
Where the central bank increases the value of it’s currency which operates under the fixed exchange rate system.
What is devaluation?
When the central bank fixes the price of it’s currency below the market equilibrium.
Why do countries fix there currencies? (advantages)
Avoids currency fluctuations.
Certainty of currency value encouraging firms to invest since it is stable.
Reduces speculation if the central bank is credible.
Reduces costs of currency hedging for businesses.
Keeps inflation low since there is now imported inflation.
Disadvantages of fixed exchange rates.
Imposes responsibility on central banks.
Conflicts with other economic objectives. Increases speculation if overvalued or undervalued.
Decreases ability to respond quickly to external shocks.
Requires large foreign currency reserves.
What is a managed exchange rate?
Where the central sets the value of the exchange rate within a target band.
How does a the central bank manage exchange rates?
It usually sets the band daily. It does this buy intervening in the forex market to keep it within its target band.
Advantages of managed exchange rates.
Less fluctuations.
Increased stability for businesses and investors.
Reduces speculation.
Disadvantages of managed exchange rates.
Fluctuations are not eliminated.
Implications for central banks, since they need foreign reserves to intervene.
Uncertainty regarding central bank decisions.
