Macro 15 - Exchange rates

Question 1

What are the three different exchange rate systems?

Answer 1

• Floating exchange rate
• Fixed exchange rate
• Managed exchange rate

Question 2

What is a floating exchange rate?

Answer 2

A floating exchange rate is a system where the price of one currency expressed in terms of another is determined by the forces of demand for and supply of the currency in the foreign exchange market

Question 3

How is an exchange rate determined in a floating exchange rate system?

Answer 3

The exchange rate is determined by the supply and demand of that currency against another currency or basket of currencies

Question 4

Draw a diagram to show floating exchange rate determination

Answer 4

See page 7 in pack 15

Question 5

Explain the causes of exchange rate fluctuations

Answer 5

• Exchange rate fluctuations are caused by changes in the supply and demand for a currency.
• When the demand for a currency exceeds its supply the exchange rate will increase in value known as an appreciation.
• When its supply exceeds demand it will fall in value known as a depreciation

Question 6

What are the factors which affect supply and demand of a currency in a floating exchange rate?

Answer 6

• Speculation
• The official buying and selling of the currency by the government or central bank
• Relative inflation rates
• Relative interest rates
• Confidence in the state of the economy
• The balance on the current account

Question 7

What is speculation?

Answer 7

Currency speculation involves buying currency without the intention of using it to buy foreign goods or services but to re-sell it when the value is higher

Question 8

What are the factors influencing the supply of a currency?
(Why would people be selling a currency?)

Answer 8

• To buy foreign currency to import foreign goods
• To buy foreign currency to save in foreign banks
• To speculate
• Quantitative easing

Question 9

What is a fixed exchange rate?

Answer 9

A fixed exchange rate is where the government or its central bank sets the exchange rate. This often involves maintaining the exchange rate at a target rate

Question 10

What are some the wats a government or central bank can manipulate the exchange rate in a fixed exchange rate system?

Answer 10

• Buy its own currency on foreign exchange markets increasing its value
• Sell its own currency of foreign exchange markets decreasing its value
• Change interest rates - hot money inflows
• Limit the currency leaving the country reducing its supply

Question 11

What is a managed exchange rate?

Answer 11

In a managed exchange rate system both free market forces of supply and demand and the government are responsible for determining the exchange rate of the currency. The currency’s value is allowed to fluctuate within a permitted band but there is central bank intervention to avoid large fluctuations in the rate.

Question 12

What are the different ways in which a country can manage or fix its exchange rate?

Answer 12

• Capital controls
• Buying and selling currency
• Changing the interest rate

Question 13

What are capital controls?

Answer 13

Capital controls are limits on the amount of foreign currency that can be bought

Question 14

What are some drawbacks of using capital controls to fix or manage exchange rates?

Answer 14

They can lead to black markets developing and are open to corruption

Question 15

What are some drawbacks of buying and selling currency to fix or manage exchange rates?

Answer 15

-Buying currency costs money creating an opportunity cost
- The country could run out of foreign exchange reserves to sell
- Printing money or selling currency could be inflationary

Question 16

Define the term appreciation

Answer 16

An appreciation occurs under a system of floating exchange rates when the value of a currency increases against another currency as a result of the operation of market forces

Question 17

Define the term revaluation

Answer 17

A revaluation occurs under a system of fixed exchange rates when the government decides to increase the value of its currency against other currencies

Question 18

Define the term depreciation

Answer 18

A depreciation occurs under a system of floating exchange rates when the value of a currency decreases against another currency as a result of the operation of market forces

Question 19

Define the term devaluation

Answer 19

A devaluation occurs under a system of fixed exchange rates when the government decides to decrease the value of its currency against other currencies

Question 20

Define the term competitive devaluation

Answer 20

Competitive devaluations are sometimes referred to as currency wars because a devaluation/depreciation by one country results in other countries also taking measures to reduce the value of their currencies

Question 21

What are the advantages of a floating exchange rate system?

Answer 21

• A floating exchange rate will reduce the need for currency reserves
• A floating exchange rate can help to reduce a current account deficit
• A floating exchange rate means that a government doesn’t need to use monetary policy to help maintain the exchange rate so it can use it for other objectives

Question 22

What are the disadvantages of a floating exchange rate system?

Answer 22

• Floating exchange rates can fluctuate widely which makes business planning difficult
• Speculation can artificially strengthen an exchange rate which could cause a country to lose competitiveness
• Falls in exchange rates can lead to inflationary pressures

Question 23

What are the advantages of a fixed exchange rate system?

Answer 23

• Speculation may be reduced
• Competitive pressures are placed on firms
• Fixed exchange rates create certainty which encourages FDI

Question 24

What are the disadvantages of a fixed exchange rate system?

Answer 24

• The country loses control of interest rates as they need to be used to keep the exchange rate at the desired level
• Fixed exchange rates are difficult to maintain
• If speculators feel a fixed exchange rate isn’t sustainable they might take advantage of this by selling the currency

Question 25

What is a nominal exchange rate?

Answer 25

The number of units of the domestic currency that can purchase a unit of a given foreign currency

Question 26

What is a real exchange rate?

Answer 26

A real exchange rate is the nominal exchange rate adjusted to reflect the different inflation rates in the countries of the two currencies concerned

Question 27

What is a bilateral exchange rate?

Answer 27

The value of one country’s currency against another country

Question 28

What is and effective exchange rate index?

Answer 28

An effective exchange rate is a country’s currency compared to a basket of currencies, its a weighted average. It gives a summary of the overall value of a currency compared to several others