Theme 4 - Exchange Rates Flashcards
Define exchange rate
The value of one currency in terms of another
Define the spot exchange rate
The price of currency at todays’s market price
Define forward exchange rate
The price is agreed at a fixed rate to be delivered in the future. This is called hedging
Define fixed exchange rate
The price of a currency is pegged and fixed against another
What are the main arguments for adopting a fixed exchange rate?
Increased trade and investment due to increased certainty
There is still some flexibility
Reduction in the cost of hedging
Incentivises domestic firm to keep costs low to remain competitive
Reinforces gains in competitive advantage
Define floating exchange rate
The value of the currency is determined by interactions of market demand and supply
What are the main arguments for a floating exchange rate?
Reduced need for currency reserves
Useful instrument of economic adjustment during recession
Partial automatic correction
Less opportunity for currency speculation
Freedom to pursue other objectives
Define managed floating
The Bank of England can and may intervene in the currency market
What are the two main methods of exchange rate manipulation?
Buying and selling currency and interest rate manipulation
How are interest rates used to manipulate the exchange rate?
To appreciate the currency - increase the interest rate to increase FDI and consumption
To depreciate the currency - Reduce the interest rates to discourage spending
What does the Marshall lerner condition state?
That the sum of the price elasticities of demand for imports and exports must be higher than one to devalue the currency
What does the J-curve show?
That a deficit can worsen after a depreciation, but improve in the long term, there is a time lag.
What is inflation likely to occur after a depreciation?
Imports are more expensive, causing cost push inflation. Aggregate demand is increasing casing demand pull inflation
