Introduction to Exchange Rates

Question 1

What is an exchange rate?

Answer 1

An exchange rate is the price of one currency in terms of another

Question 2

When does a fixed exchange rate occur?

Answer 2

This occurs when the government seeks to keep the value of a currency fixed against another currency

Question 3

what must the government need to do to maintain a fixed exchange rate?

Answer 3

the government/central bank need to maintain a large amount of currency reserves (domestic/foreign reserves) in order to manipulate supply and demand in terms of currency

Question 4

The demand for currencies is based upon….?

Answer 4

1) Demand for exports in G&S
2) Inflows of investment
3) Speculative buying (hot money)
4) Central bank buying up their own currency

Question 5

The supply of currencies is based upon…?

Answer 5

1) Demand for imports in G&S
2) Outflows of investment
3) Speculative selling
4) Central bank selling their own currency

Question 6

What does hot money flows refer to?

Answer 6

capital flows moving to countries with higher interest rates and/or expected change in exchange rate

Question 7

What is a bilateral exchange rate?

Answer 7

measuring one currency against another

Question 8

What is a nominal exchange rate?

Answer 8

the physics figures of the exchange rate ie £1;$1.50

Question 9

What is an effective exchange rate?

Answer 9

Describes the strength of a currency relative to a basket of other currencies

Question 10

What is a real exchange rate?

Answer 10

The exchange rate when adjusted for inflation (nominal - inflation)

Question 11

What is purchasing power parity?

Answer 11

A theory which looks at how much an exchange rate needs to be adjusted so that the real price level goods cost the same in two countries

Question 12

What are the pros and cons of fixed exchange rates?

Answer 12

Pros-

• they offer greater certainty due to the lack of speculation about their fluctuations
• allow firms to keep costs under control
• help govt maintain low inflation, Bring down interest rates and encourage investment

cons

• can be fragile/ prone to attacks
• makes it harder to achieve some economic targets

Question 13

What are the pros and cons of a floating exchange rate?

Answer 13

Pros-

• they are an automatic stabiliser for helping CA deficits ie if theres a large deficit a country sees a big outflow of money, reducing the demand for the domestic currency and lowering the value. this increases competitiveness and increases x relative to m
• more flexibility to change interest rates than a fixed rate as they are not targeting a specific number

cons

• uncertainty about how it might change
• speculation
• lack of economic discipline
• may be inflationary

Question 14

What is there a balance/ trade off between for a country determining exchange rates?

Answer 14

-rates need to be high to reduce inflationary pressure
but low to stimulate exports
(low rate makes imports more expensive, cost push inflation)

Question 15

Advantages of manipulating exchange rates:

Answer 15

• raise AD
• Increased GDP
• create jobs
• improve balance of payments