MACRO - exchange rates ✅

Question 1

what is the exchange rate

Answer 1

The exchange rate of a currency is the weight of one currency relative to another

Question 2

what is a floating exchange rate

Answer 2

The value of the exchange rate in a floating system is determined by the forces of supply and demand.

Question 3

how do floating exchange rates work on a diagram

Answer 3

• In a floating exchange rate system, the market equilibrium price is at P1. When demand increases from D1 to D2, the exchange rate appreciates to P2.
• The demand for a currency is equal to exports plus capital inflows. The supply of a currency is equal to imports plus capital outflows.

Question 4

what are causes of changes in the currency in a floating system

Answer 4

1. Trade balances – countries with strong trade/current account surplus see currencies appreciate as money flows into circular flow for X of goods/services and investment income
2. Foreign direct investment – attracts high net inflows of capital investment = increase in currency demand and rising exchange rate
3. Portfolio investment – strong inflows of portfolio investment into equities/bonds from overseas = currency appreciation
4. Interest rate differentials – high interest rate = ‘hot money’ flows coming in = appreciation
5. Speculation – responsible for day-to-day volatility

Question 5

what is a fixed exchange rate

Answer 5

• A fixed exchange rate has a value determined by the government compared to other currencies.
• In a fixed exchange rate system, the supply of the currency can be manipulated by the central bank, which can buy or sell the currency to change the price to where they want.

Question 6

how can fixed exchange rates be demonstrated on a diagram

Answer 6

In the diagram, the supply has been increased (S1 to S2) by selling the currency so more is on the market (Q1 to Q3). The currency depreciates as a result (P2 -> P3), which makes exports more competitive.

Question 7

what is a managed exchange rate system

Answer 7

• managed exchange rate systems combine the characteristics of fixed and floating exchange rate systems.
• The currency fluctuates, but it doesn’t float on a fully free market.
• This is when the exchange rate floats on the market, but the central bank of the country buys and sells currencies to try and influence their exchange rate.

Question 8

examples of managed exchange rate systems

Answer 8

• The Japanese central bank has also attempted to make exports more competitive by manipulating the Yen, even though the Yen floats on the market.
• The Indian rupee fluctuates on the market, but the central bank intervenes when it falls outside a set range.

Question 9

how do interest rates affect exchange rates

Answer 9

• An increase in interest rates, relative to other countries, makes it more attractive to invest funds in the country because the rate of return on investment is higher.
• This increases demand for the currency, causing an appreciation. This is known as hot money.

Question 10

how can quantitative easing affect the money supply

Answer 10

• This is used by banks to help to stimulate the economy when standard monetary policy is no longer effective.
• This has inflationary effects since it increases the money supply, and it can reduce the value of the currency. QE is usually used where inflation is low and it is not possible to lower interest rates further.

Question 11

what are foreign currency transactions

Answer 11

• The Bank of England uses this to manage the UK’s gold and foreign currency reserves, as well as managing the MPC’s pool of foreign currency reserves.
• It involves buying and selling foreign currency to manipulate the domestic currency.
• EG// China kept large reserves of the US Dollar by purchasing government bonds, in order to undervalue the Yuan.

Question 12

what are changes in the exchange rate classified as and in which exchange rate system do they occur in

Answer 12

Depreciation is a fall in the value of a currency in a floating exchange rate system

Devaluation is a fall in the value of a currency in a fixed exchange rate system

Appreciation is a rise in the value of a currency in a floating exchange rate system

Revaluation is a rise in the value of a currency in a fixed exchange rate system

Question 13

what is competitive devaluations/dirty floating and why is it used

Answer 13

• When country deliberately drives down value of currency to give competitive lift to demand, output, jobs in export industries
• Used in deflationary recession or to attract extra FDI
• Attractive for countries in trade deficit/rising unemployment
• Can be seen as form of trade protectionism inviting retaliatory action, eg import tariff
• Cutting exchange rate = harder for other countries to export negatively = affects growth rate = damages volume of trade taking place between nations

Question 14

how do exchange rates affect business activity

Answer 14

1. Price of X in international markets
2. Overseas goods costs
3. Overseas profits/revenues
4. Converting cash receipts from customers overseas

Question 15

impact of currency depreciation on macroeconomic objectives and wider objectives

Answer 15

INFLATION = high import prices = increased consumer prices. Helps country avoid deflation and lowers real interest rates
ECONOMIC GROWTH = weaker currency = stimulates GDP growth. But, depends upon PED for exports. Many exports require imported components = more expensive from depreciation
UNEMPLOYMENT = competitive currency = increase domestic production = positive export multiplier = stimulate AD and jobs
BALANCE OF TRADE = dependent upon PED for X/M, J Curve effect. Impact on X = dependent on strength of GDP in key export markets
BUSINESS INVESTMENT = help improve profitability
WIDER EFFECTS = similar to interest rate cut. Risks of higher costs of importing components/materials/prices of capital technologies
FDI = makes country’s FDI assets appear more valuable and FDI liabilities less valuable to overseas investors = reduce inwards FDI

Question 16

who benefits and loses from a lower exchange rate

Answer 16

WINNERS = businesses exporting into international markets, businesses earning substantial profits in overseas currencies
LOSERS = overseas businesses trying to compete in the domestic market, businesses importing goods and services

Question 17

what does currency depreciation AD stimulation depend on

Answer 17

1. Length of time lag
2. Scale of change in exchange rate
3. If change is temporary/long lasting
4. Coefficients of PED for X/M (Marshall Lerner condition)
5. Size of multiplier/accelerator effects
6. Which stage of economic cycle it takes place
7. Type of economy – small developing vs large advanced
8. Degree of openness to international trade

Question 18

what are the risks of internal devaluation

Answer 18

1. Loss of output/rising unemployment
2. Fall in nominal wages = reduce living standards
3. Risks from sustained deflation
4. Real value of debt increases
5. Danger of permanent loss of output (hysteria)

Question 19

what are the drawbacks of external devaluation

Answer 19

1. Increase in cost-push inflation = higher import prices
2. Rise in inflation = reduces real incomes
3. No guarantee trade deficit will improve (j curve)
4. Foreign creditors demand higher interest rates on government/corporate debt
5. Currency uncertainty = country less attractive to inward FDI

Question 20

advantages of floating exchange rates

Answer 20

• reduces need for central bank to hold large currency reserves
• freedom to set interest rates to meet objectives
• help prevent imported inflation
• insulation for economy after external shock, especially export dependent countries
• partial automatic correction for current account deficit
• less risk of currency becoming over/undervalued
• automatically adjusts to economic shocks

Question 21

evaluation of floating exchange rates

Answer 21

• no guarantee that floating exchange will be stable
• volatility in floating exchange detrimental to attracting inward investment
• lower exchange rate doesn’t always correct persistent balance of payments deficit

Question 22

problems using exchange rates to measure GDP

Answer 22

• Exchange rates volatile from month to month and year to year
• Exchange rates more relevant to products traded between countries than non-traded products
• Calculations of GDP based on market exchange rates over-estimate cost of living in poorer developing countries (Balassa-Samuelson effect)

Question 23

what is PPP

Answer 23

purchasing power parity theory

• PPP adjustment – basket of comparable goods/services and the price of these in different countries
• PPP is the exchange rate needed to buy the same quantity of products in each country

Question 24

advantages of fixed exchange rate

Answer 24

Allows for firms to plan investment, because they know that they will not be affected by harsh fluctuations in the exchange rate.
It gives the monetary policy a focused target to work towards.

Question 25

disadvantages of fixed exchange rate

Answer 25

The government and the central bank do not necessarily know better than the market where the currency should be.
The balance of payments doesn’t automatically adjust to economic shocks.
It can be costly and difficult for the government to hold large reserves of foreign currencies

Question 26

disadvantages of fixed exchange rate

Answer 26

The government and the central bank do not necessarily know better than the market where the currency should be.
The balance of payments doesn’t automatically adjust to economic shocks.
It can be costly and difficult for the government to hold large reserves of foreign currencies

Question 27

disadvantages of floating exchange rate

Answer 27

The fluctuations in the price of the exchange rate can be unpredictable, which can make investment planning difficult.
It can also affect the exports and imports of a country, which could cause a lot of unemployment if an industry is affected in particular.
It could make the exchange rate vulnerable to speculative shocks.

Question 28

what is a currency union

Answer 28

Members of a monetary union share the same currency. This is more economically integrated than a customs union and free trade area. The Eurozone is an example of this.

A common central monetary policy is established when a monetary union is formed. The single European currency, the Euro, was implemented in 1999 to form the Eurozone.

Question 29

what are convergence criteria of the euro

Answer 29

• Gross National Debt has to be below 6% of GDP
• Inflation has to be below 1.5% of the three lowest inflation countries
• The average government bond yield has to be below 2% of the yield of the countries with the lowest interest rates. This ensures there can be exchange rate stability.
• required to control government finances so budget deficits cant exceed 3%

Question 30

what is the optimal currency zone

Answer 30

The optimal currency zone is created when countries achieve real convergence.

Member countries have to respond similarly to external shocks or policy changes.

There has to be flexibility in product markets and labour markets to deal with shocks.

This could be through the geographical and occupational mobility of labour, and wage and price flexibility in labour markets.

Fiscal transfers could be used to even out some regional economic imbalances.

Question 31

advantages of a currency union

Answer 31

• The participating countries have more currency stability, and the currency is less prone to speculative shocks.
• This gives future markets more certainty, so there is more investment and growth potential.
• There are fewer admin fees and less red tape when travelling abroad or exchanging money.
• This also benefits firms which trade with the different member states. It is especially beneficial to small firms, who benefit from the time and money saving of a common currency.
• The German monetary credibility might result in all member states having a lower interest rate. This might encourage more investment and spending, which might create more jobs.

Question 32

disadvantages of a currency union

Answer 32

• Labour mobility is limited across Europe due to language barriers.
• Moreover, the differences in economic performance between member countries means a common monetary policy might not be effective.
• The exchange rate is not flexible to meet each country’s need, such as if they need a boost in exports.
• Member nations lose sovereignty when there is a common monetary union.
• This means that countries with a strong economy have to cooperate with countries that have weaker economies. - They cannot adapt their policies to meet each individual requirement.
• The one-off cost of joining a currency union of changing labels and prices can be significant.

Question 33

when does the optimal currency area work best

Answer 33

1. Integration between countries
2. Flexible labour markets to cope with external shocks
3. Wage/salary flexibility in economic cycle
4. Adaptable labour (skills) = reduce risk of structural unemployment
5. Labour mobility
6. Flexible employment contracts including short term contracts
7. Effects of interest/exchange rate changes have the same effect on businesses/households
8. Member nations willing to make fiscal transfers between each other