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Economics (Macro) > Open economy (exchange rates) > Flashcards

Open economy (exchange rates) Flashcards

1
Q

What are exchange rates

A

One currency expressed in terms of another

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2
Q

What is an effective exchange rate

A

The pound compared to a basket of currencies made up of our main trading partners, weighted according to the amount of trade with the UK

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3
Q

Who supplies pounds to the foreign exchange market

A

The UK

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4
Q

Why does the UK supply pounds to the foreign exchange market

A

To buy foreign goods, services and assets

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5
Q

Explain how supplying pounds to the foreign exchange market is an import

A

It is an outflow of money to buy foreign goods and services to bring into the UK

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6
Q

Who demands pounds

A

Other countries

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7
Q

Why do other countries demand pounds

A

To buy British goods, services and assets

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8
Q

Explain how the inflow of money into the UK is an export

A

Money is coming into the UK so other countries can purchase British goods services and assets

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9
Q

What is a floating exchange rate system

A

Where a government only allows market forces to affect the exchange rate

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10
Q

What is a fixed exchange rate

A

Where a government chooses to fix its exchange rate against another currency

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11
Q

Give an example of a fixed exchange rate

A

Cambodian Riel: 4,100 - 1 dollar

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12
Q

What must a government do if it has a fixed exchange rate and the demand for its currency rises

A

It must prevent the currency from getting stronger

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13
Q

If the UK becomes more competitive relative to the USA, what does this mean in terms of supply and demand for the pound and why

A

Demand for the pound rises as there is greater demand for British goods and services

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14
Q

Why does the government use foreign currency reserves

A

To supply pounds to the foreign exchange market or other currencies to the FEM

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15
Q

If demand for the pound decreases, what can the UK do to balance it

A

Uses FCR to demand pounds to the FWM

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16
Q

What is devaluation/revaluation

A

Changing a fixed rate

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17
Q

What is depreciation/appreciation

A

The value of a currency changing over time

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18
Q

What is a managed float

A

Officially having a floating exchange rate but the government may intervene behind the scenes of the FEM

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19
Q

How does the value of the pound affect the macro economy (3)

A
  • Weaker pound is inflationary
  • Weaker pound increases exports
  • Increases the price of imports
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20
Q

How does a weaker pound increase exports

A

British goods and services are relatively cheaper to other countries

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21
Q

How does elasticity determine the effects of a weaker pound on import spending

A

May not affect spending if specific imports are elastic such as gas and electricity

22
Q

Give an example of inelastic imports

A

Gas and electricity

23
Q

What determines the value of a currency in the long run

A

Macroeconomic performance relative to other countries

24
Q

How does a lack of competitiveness from the UK lead to a fall in the exchange rate

A

There will be less demand for pounds (to buy UK G&S), and it will supply more pounds (to import G&S due to better quality)

25
Q

How may a fall in the exchange rate cancel out a lack of UK competitiveness

A

The exchange rate falling means UK G&S are cheaper relatively, therefore increasing demand for pounds to purchase them

26
Q

What is Purchasing Power Parity theory (PPP)

A

The path of the nominal exchange rate that keeps the real exchange rate constant over time

27
Q

In the short run, what causes exchange rates to deviate from their long run path

A

The effects of interest rates

28
Q

Explain the effects of rising interest rates on the movement hot money

A

Provides the incentive for hot money to enter a country to take advantage of the higher returns on offer

29
Q

How does entrance of hot money into the UK affect the exchange rate

A

Increased demand for pounds as in order to enter the country, the hot money must demand pounds. Therefore causes a temporary spike in the value of the pound

30
Q

What is the balance of payments

A

A record of one country’s transactions with the rest of the world

31
Q

What is a current account

A

A recordof all payments for trade in goods and services plus income flow

32
Q

What 4 parts make up a current account

A

Balance of trade in goods (visibles)
Balance of trade in services (invisibles)
Net income flows (Primary income flows
Net current transfers (secondary income flows)

33
Q

Give an example of a primary income flow

A

Wages and investment income

34
Q

Give an example of secondary income flows

A

Government transfers to the EU or UN

35
Q

What is a financial account

A

A record of all transactions for financial investment

36
Q

What does the financial account include

A

FDI
Portfolio investment

37
Q

What is portfolio investment

A

Financial flows such as the purchase of bonds or savings in banks (including hot money)

38
Q

What is a capital account

A

Purchase and selling of land

39
Q

What is the balancing item

A

The balancing item allows for statistical discrepancies

40
Q

What are 4 causes of a current account deficit

A

The rate of consumer spending on imports
International competitiveness (Less competitive exports due to higher inflation)
Overvalued exchange rate
Structure of the economy

41
Q

How does an overvalued exchange rate lead to a current account deficit

A

It makes exports relatively more expensive

42
Q

How can the structure of the economy lead to a current account deficit

A

Deindustrialisation can harm the export sector

43
Q

What 4 factors determine how impactful a current account deficit is

A

How the deficit is financed (capital flows or borrowing
Causes of the deficit (Increased growth or being uncompetitive)
Can the country devalue the currency
Quantity of foreign assets

44
Q

What are 5 effects of a current account deficit

A

Leakage from circular flow
Depreciation of exchange rate
Sign of uncompetitive exports
Increased levels of consumption
Foreigners own more domestic assets (to finance debt through FDI)

45
Q

When is a current account deficit seen as problematic

A

Over 5% of GDP

46
Q

Give 3 advantages of a floating exchange rate

A

May help to automatically adjust current account deficit
Can be a useful macro absorber when there is an external shock
The central bank doesn’t need to hold large F.E.R

47
Q

How does a floating exchange rate automatically adjust a current account deficit

A

Trade leads to the value of the currency decreasing which leads to expenditure switching effects

48
Q

Give an example of how floating exchange rates be a useful macroeconomic absorber when there is a shock

A

e.g. Currency decreases in a recession leading to a lift to export industries

49
Q

Give 3 disadvantages of a floating exchange rate

A

Removes the option for a government to use the currency to achieve a competitive devaluation to improve international competitiveness
Free floating currency may be volatile which may inhibit trade and long run FDI
Floating exchange rates may invite more currency speculation from traders - currency may then move away from a suitable value for the domestic economy

50
Q

Look at evaluation points in notes

A

Economics (Macro) (10 decks)

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