Open economy (exchange rates) Flashcards
What are exchange rates
One currency expressed in terms of another
What is an effective exchange rate
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
Who supplies pounds to the foreign exchange market
The UK
Why does the UK supply pounds to the foreign exchange market
To buy foreign goods, services and assets
Explain how supplying pounds to the foreign exchange market is an import
It is an outflow of money to buy foreign goods and services to bring into the UK
Who demands pounds
Other countries
Why do other countries demand pounds
To buy British goods, services and assets
Explain how the inflow of money into the UK is an export
Money is coming into the UK so other countries can purchase British goods services and assets
What is a floating exchange rate system
Where a government only allows market forces to affect the exchange rate
What is a fixed exchange rate
Where a government chooses to fix its exchange rate against another currency, guaranteeing convertibility against a set exchange rate
Give an example of a fixed exchange rate
Cambodian Riel: 4,100 - 1 dollar
What must a government do if it has a fixed exchange rate and the demand for its currency rises
It must prevent the currency from getting stronger
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
Demand for the pound rises as there is greater demand for British goods and services
Why does the government use foreign currency reserves
To supply pounds to the foreign exchange market or other currencies to the FEM
If demand for the pound decreases, what can the UK do to balance it
Uses FCR to demand pounds to the FEM
What is devaluation/revaluation
Changing a fixed rate
What is depreciation/appreciation
The value of a currency changing over time
What is a managed float
Officially having a floating exchange rate but the government may intervene behind the scenes of the FEM
How does a weaker pound affect the macro economy (3)
- Weaker pound is inflationary
- Weaker pound increases exports
- Increases the price of imports
How does a weaker pound increase exports
British goods and services are relatively cheaper to other countries
How does elasticity determine the effects of a weaker pound on import spending
May not affect spending if specific imports are inelastic such as gas and electricity
Give an example of inelastic imports
Gas and electricity
What determines the value of a currency in the long run
Macroeconomic performance relative to other countries
How does a lack of competitiveness from the UK lead to a fall in the exchange rate
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)
How may a fall in the exchange rate cancel out a lack of UK competitiveness
The exchange rate falling means UK G&S are cheaper relatively, therefore increasing demand for pounds to purchase them
What is Purchasing Power Parity theory (PPP)
The path of the nominal exchange rate that keeps the real exchange rate constant over time
In practice this means:
However uncompetitive goods are due to poor macro performance, the fall in the exchange rate can cancel out the effects of high inflation and poor SSP’s which makes the goods seem competitive and restores macroeconomic equilibrium which allows 2 way trade to continue
In the short run, what causes exchange rates to deviate from their long run path
The effects of interest rates
Explain the effects of rising interest rates on the movement hot money
Provides the incentive for hot money to enter a country to take advantage of the higher returns on offer
How does entrance of hot money into the UK affect the exchange rate
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
What is the balance of payments
A record of one country’s transactions with the rest of the world
What is a current account
A record of all payments for trade in goods and services plus income flows
What 4 parts make up a current account
Balance of trade in goods (visibles)
Balance of trade in services (invisibles)
Net income flows (Primary income flows)
Net current transfers (secondary income flows)
Give an example of a primary income flow
Wages and investment income (FDI is in financial account, but the money generated from FDI in the country is investment income)
Give an example of secondary income flows
Government transfers to the EU or UN
Payment for membership to the IMF
What is a financial account
A record of all transactions for financial investment
What does the financial account include
FDI
Portfolio investment
What is portfolio investment
Financial flows such as the purchase of bonds or savings in banks (including hot money)
What is a capital account
Purchase and selling of land
What is the balancing item
The balancing item allows for statistical discrepancies
What are 5 causes of a current account deficit
Low investment and productivity
High production costs
Depletion of resources
Strong domestic growth
Strong exchange rate
How does an overvalued exchange rate lead to a current account deficit
It makes exports relatively more expensive
Give an example of how the structure of the economy may lead to a current account deficit
Deindustrialisation can harm the export sector
What 4 factors determine how impactful a current account deficit is
- How the deficit is financed (inflows on financial account or borrowing)
- Causes of the deficit (Increased growth or being uncompetitive e.g. UK poor SSPs & productivity gap)
- Effects of depreciation in the value of currency (more exports but also is inflationary)
- Proportion of GDP
- Whether money is coming in on the financial account (if we also have a financial account deficit then very bad, but in the uk we tend to have a financial account surplus)
What are 5 effects of a current account deficit
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)
When is a current account deficit seen as problematic
Over 5% of GDP
Give 3 advantages of a floating exchange rate
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.C.R
How does a floating exchange rate automatically adjust a current account deficit
Trade leads to the value of the currency decreasing which leads to expenditure switching effects
In a CAD, Imports are greater than exports which means we supply more £ to FEM than other countries demanding £, which means supply is greater than demand. When S greater than D, price falls which means UK goods and servcices are relatively cheaper
Give an example of how floating exchange rates be a useful macroeconomic absorber when there is a shock
e.g. Currency decreases in a recession leading to a lift to export industries
Give 3 disadvantages of a floating exchange rate
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
Look at evaluation points in notes
Draw the diagram for a fixed change rate
E & D are the free market equilibrium points (depending on which way D shifts)
C to A and A to B show the extent to which the government must intervene (depending on which way D shifts) - the government must use FCR
If there is too much demand, the government supplies AB pounds
If there is too little demand, the government demands CA pounds
What 2 things determine macroeconomic performance in an economy which means the value of a currency changes. Give an example of this
Level of Inflation
Effectiveness of supply side policies
Poor UK SSPs means our currency has fell against our main trading partners
Give the 2 main disadvantages of a fixed exchange rate
No monetary policy autonomy
Have to hold large FCR
What are expenditure switching effects
Where domestic prices decrease which means consumers spend on domestic goods than they do imports. Lower prices also mean an increase in demand for export
Give 3 advantages of a fixed rate
Price stability - provides a predictable environment for businesses and consumers (which may increase FDI)
Discipline on monetary policy - constrains a country’s central bank from perusing an independent monetary policy
Most nations which have a fixed rate heavily rely on trade as a main proportion of GDP, therefore there is certainty between trading due to the fixed rate. So a fixed rate maintains this high prop of GDP
Also can lead to lower borrowing costs due to a fixed rate being a good indicator of macroeconomic performance relative to the nation of the currency it is fixed against (lower yield on bonds)
Give 3 disadvantages of a fixed rate
Lack of flexibility in responding to external economic shocks - country may be forced to adopt monetary policies that are not best suited to a specific circumstance (no monetary policy autonomy)
Speculative attacks may occur if investors believe the currency is overvalued or if there are concerns about the countries ability to maintain the peg
Dependence on FCR
What 2 things make up a financial account
FDI
Portfolio investment (bonds etc)
What 5 things determine an exchange rate
RICCC
Relative inflation
Current account deficit
Interest rates
Competitiveness
Confidence/speculation
Explain how inflation may determine an exchange rate
If inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive, and there will be an increase in demand for Pound Sterling to buy UK goods. Also, foreign goods will be less competitive and so UK citizens will buy fewer imports.
Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency
Give a real world example of a country with a lower inflation rate seeing an appreciation in their currency
The long-term appreciation in the German D-Mark in the post-war period was related to the relatively lower inflation rate
Explain how interest rates may determine an exchange rate in the short run
Higher interest rates cause an appreciation
If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK (Hot money inflows). You will get a better rate of return from saving in UK banks. Therefore demand for Sterling will rise and value will rise
Explain how speculation may determine an exchange rate
If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise
Why do exchange rates not always reflect economic fundamentals
Due to speculation
Movements in the exchange rate do not always reflect economic fundamentals but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of the pound will probably rise in anticipation.
Give an example of speculation affecting the value of the pound
The fall in the value of the Pound post-Brexit was partly related to the concerns that the UK would no longer attract as many capital flows outside the Single Currency.
Explain how competitiveness may determine an exchange rate
If British goods become more attractive and competitive this will cause the value of the exchange rate to rise. For example, if the UK has long-term improvements in labour market relations and higher productivity, good will become more internationally competitive and in long-run cause an appreciation in the Pound.
Explain how a current account deficit may determine an exchange rate
A deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial account, then this is OK. But a country which struggles to attract enough capital inflows to finance a current account deficit will see a depreciation in the currency
