Macro A2 - Exchange Rate

Question 1

Floating exchange rates

Answer 1

an exchange rate system where a country’s currency price is determined by the foreign exchange market, depending on the relative supply and demand of other currencies

Question 2

Fixed exchange rate

Answer 2

a regime applied by a government or central bank that ties the country’s official currency exchange rate to another country’s currency or the price of gold.

Question 3

Managed exchange rate

Answer 3

an exchange rate system that allows a nation’s central bank to intervene regularly in foreign exchange markets to change the direction of the currency’s float and/or reduce the amount of currency volatility.

Question 4

Revaluation of a currency

Answer 4

A revaluation is a calculated upward adjustment to a country’s official exchange rate relative to a chosen baseline

Question 5

Appreciation of a currency

Answer 5

an increase in the value of one currency in relation to another currency.

Question 6

Devaluation of a currency

Answer 6

when a government makes monetary policy to reduce a currency’s value

Question 7

Depreciation of a currency

Answer 7

Currency depreciation is a fall in the value of a currency in terms of its exchange rate versus other currencies.

Question 8

Factors that affect floating exchange rates:

Answer 8

Inflation rate.
Interest rate.
Where the domestic county is in a recession.
Current account/balance of payments.
Terms of trade.
Government debt.
Political stability/performance.

Question 9

Ways the government may influence exchange rates.

Answer 9

Reserves and Borrowing - If the value of an exchange rate is falling and the government wants to maintain its original value it can use its foreign exchange reserves – e.g. selling its dollars reserves and purchase pounds. This purchase of Pound sterling should increase its value.

Borrow - The government can also borrow foreign currency from abroad to be able to buy sterling.

Changing interest rates - higher interest rates will cause hot money flows and increase demand for sterling. Higher interest rates make it relatively more attractive to save in the UK. If investors wish to save in the UK, then there will be more demand for Pound Sterling and the exchange rate will appreciate.

Reduce inflation -

• Through either tight fiscal or Monetary policy, the government can reduce Aggregate Demand and hence inflation can be reduced.
• By decreasing, AD consumers will spend less and purchase fewer imports and so will supply fewer pounds. This will increase the value of the Exchange Rate.
• The lower inflation rate will also help because British goods will become more competitive. Thus, over time, the demand for Sterling will rise.

Question 10

Competitive devaluation

Answer 10

Competitive devaluation consists of a series of sudden depreciation in currency of two national currencies due to both the countries taking tit-for-tat actions with a purpose to gain mileage in international exports.

Question 11

Consequences of competitive devaluation/depreciation

Answer 11

The result of competitive devaluation can lead to trade wars or negatively impact trading partners that are not directly involved in the tit-for-tat devaluations. Devaluation can have a positive effect on domestic inflation and exports.

Question 12

Marshall-learner condition

Answer 12

This refers to the proposition that the devaluation of a country’s currency will lead to an improvement in its balance of trade with the rest of the world only if the sum of the price elasticities of its exports and imports is greater than one.

Question 13

J curve affect

Answer 13

The J Curve effect says a trade deficit can worsen after depreciation, but improve if the Marshall-Lerner condition holds. The J-curve effect refers to the phenomenon in which a country’s balance of trade initially worsens after it devalues its currency or otherwise reduces its trade barriers.

Question 14

Impact of exchange rates on the current account of balance of payments

Answer 14

The appreciation in the exchange rate would make exports less competitive and imports more competitive therefore with fewer exports and more imports there would be a deficit on the current account, and visa versa.

Question 15

Impact on of exchange rates on economic growth

Answer 15

A strong exchange rate can depress economic growth because: Exports more expensive, therefore less demand for exports. Imports cheaper, therefore more demand for imported goods (and therefore less demand for domestically produced goods) and visa versa.

Question 16

Impact on of exchange rates on employment/unemployment

Answer 16

Currency appreciation makes imports cheaper, and exports become less competitive, so the domestic demand falls. Local companies try to reduce costs and might cut jobs, causing unemployment to rise.

Question 17

Impact on of exchange rates on the rate of inflation

Answer 17

A good general rule is that if inflation affects the foreign exchange rate, the effect is usually negative rather than positive. An inflation rate that is very high is extremely likely to negatively impact the country’s exchange rates with other countries, and visa versa.