Macroeconomics: exchange rates

Question 1

What are the main features of a free-floating exchange rate?

Answer 1

Currency value is set purely by market forces.
Strength of currency supply and demand drives the external value of currency in the markets.
Currency can either appreciate or depreciate.

Question 2

What are managed-floating exchange rates?

Answer 2

The central bank gives freedom for market exchange rates on a day-to-day basis, supply and demand factors drive the currency’s value.
However, the central bank may intervene occasionally -
buying to support a currency (selling their FX reserves).
selling to weaken a currency (adding to their FX reserves)

Question 3

What are the factors that will impact the demand of the £? (overseas)

Answer 3

Interest rates in the UK relative to other countries - greater rate of return in savings.
Attraction to tourism
Price/quality of UK exports relative to other countries (more competitive)
State of the economy e.g. if the economy is booming the country may want to buy from the UK.
Increase in FDI - foreign firms in the UK must pay for factories, workers, and machinery in £s.

Question 4

What are the factors that will impact he supply of the £? (people at the UK)

Answer 4

Interest rates in other countries relative to the UK - if interest rates are high relative to the UK - residents of the UK will save in those countries.
State of the economy in the UK - if the economy is booming - imports will rise - supply more.
Policies/quality of imports relative to the UK.
Protectionist policies/trade agreements impacting prices.

Question 5

What are the impacts on exporters and importers when the exchange rate falls?

Answer 5

Exporters benefit - more goods sold abroad.
Possibility of business expansion, increased sales, more employment, and rising profits.
Importers have problems due to rising prices of imported goods measured in £s because it becomes more expensive to buy goods and services priced in foreign currencies. As a result, sales fall, workers may be made redundant and the business might close.

Question 6

What are the impacts on exporters and importers when the exchange rate rises?

Answer 6

Exporters have problems with the effect of price rising in other countries. Possibility of sales falling, redundancies, and business closure if problems persist.
Importers benefit - the cost of imports falls as fewer £s are needed to pay for them. Sales and profits might rise, and more jobs may be created as the business expands.

Question 7

What is a fixed exchange rate?

Answer 7

The exchange rate fluctuates in a narrow range (or not at all) against a base currency over a sustained time.
Government action is needed to maintain the exchange rate.
Exchange rate is pegged.

Question 8

What is meant by exchange rates?

Answer 8

The price of one currency in another currency.

Question 9

What is a floating exchange rate?

Answer 9

Exchange rate fluctuates in a wider range.
No government intervention to fix the exchange rate against a base currency.
Appreciation/depreciation can occur frequently.

Question 10

What is a free-floating currency?

Answer 10

Where the external value of a currency depends wholly on market forces of supply and demand.

Question 11

What is a managed floating currency?

Answer 11

When the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macro objectives.

Question 12

What factors determine a currency’s value?

Answer 12

Trade balances - countries that have strong trade and current account surpluses tend to see their currencies appreciate as money flows into the circular flow from exports of goods and services and from investment income.
FDI - an economy that attracts high net inflows of capital investment from overseas will see an increase in currency demand and a rising exchange rate.
Interest rate differentials - countries with relatively high interest rates can expect to see “hot money” flowing across the currency markets and causing an appreciation of the exchange rate.

Question 13

What are the benefits of a depreciating currency?

Answer 13

If an economy’s currency depreciates in value, that country should benefit from cheaper exports.
This will mean more demand for that country’s exports and therefore inflows of cash from abroad.
This can help reduce the current account deficit on the BoP and may even result in a trade surplus.

Question 14

What is a currency union?

Answer 14

2 or more states/countries share the same currency without them necessarily having any further integration. e.g. Eurozone

Question 15

What are the advantages of currency unions?

Answer 15

Consumers would not have to change money when traveling and would encounter less red tape when transferring large sums of money across borders. (transaction pass smoothly).
Businesses would no longer have to pay hedging costs which they do today in order to enable themselves against the threat of currency fluctuations. Businesses, involved in commercial transactions in different member states, would no longer have to face administrative costs for accounting for the changes of currencies, plus time involved.
Single currency should result in lower interest rates - reduced risk, increased stability, greater integration.

Question 16

What are the disadvantages of currency unions?

Answer 16

Loss of independent monetary policy- in the Euro, interest rates are set by the ECB but may be inappropriate for the UK economy.
Loss of ability to depreciate economy in recession - in the Euro, there is no possibility to devalue. If you have higher inflation than other European countries, you will soon become uncompetitive. This has been a major problem for European countries like Greece, Spain, and Portugal. Their decline in competitiveness has led to a decline in exports and a fall in economic growth, contributing to their decline in tax revenues.

Question 17

What are the pros of a floating exchange rate system?

Answer 17

Reduced need for currency reserves as there is no exchange rate target so there is little requirement for a central bank to hold foreign currency reserves to use during intervention.
Automatic adjustment mechanism - a floating exchange rate adjusts naturally in response to changes in economic conditions. For example, if a country’s trade deficit grows, its currency may depreciate, making exports cheaper and imports, more expensive, which helps correct the imbalance.
Monetary policy independence - countries with floating exchange rates have greater flexibility to set monetary policies tailored to their domestic economic needs without maintaining a fixed exchange rate. This means central banks can focus on controlling inflation, unemployment, or economic growth rather than defending a currency peg.

Question 18

What are the cons of a floating exchange rate?

Answer 18

Impact on inflation: Currency depreciation in a floating system can lead to imported inflation, as the cost of imported goods and services rises.
Adverse effects on trade and investment: Volatile exchange rates can discourage international trade and investment, as businesses face higher risks and costs related to currency fluctuations. Hedging against this risk can be expensive and complex for small and medium-sized enterprises.
Potential for economic instability - sudden and significant appreciation or depreciation of a currency can disrupt economic activity e.g. a strong currency may hurt export industries, while a weak currency may increase the cost of servicing foreign debt.

Question 19

What are the pros of fixed exchange rates?

Answer 19

Promotes trade and investment – stability in exchange rates encourages cross-border trade and investment by providing a predictable environment for businesses and investors. This is especially beneficial for countries reliant on exports or foreign investment.
Keep inflation low – firms have an incentive to keep cutting costs to remain competitive.
Confidence – a stable currency can enhance consumer and business confidence, as people perceive the economy as stable and well-managed.

Question 20

What are the cons of fixed exchange rates?

Answer 20

Conflict with other macro objectives – to maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives. If a currency is under pressure and falling – the most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures. However, higher interest rates will cause lower AD and lower economic growth, if the economy is growing slowly this may cause a recession and rising unemployment.
Less flexibility – in a fixed exchange rate, it is difficult to respond to temporary shocks. E.g. if the price of oil increases, a country that is a net oil importer will see a deterioration in the current account balance of payments. But in a fixed exchange rate, there is no ability to devalue and reduce current account deficit.