Topic 4.2 - Exchange Rates (incomplete) Flashcards
Explain Exchange Rates
The value of one currency compared to another currency.
Define Nominal Exchange Rates
The value of one currency compared to another currency without being adjusted for inflation.
Gives an inaccurate representation of purchasing power
Define Real Exchange Rates
The value of one currency compared to another currency, adjusted for inflation.
Gives an accurate representation of purchasing power
Define Trade-Weighted Exchange Rate
The weighted average of the exchange rate,
Where the weight of each currency is equal to the share in trade.
The more the domestic country trades with a foreign country, the greater the weight of the currency.
Explain how floating exchange rates are determined
Through supply and demand for the currency.
A simple supply and demand diagram
Demand for UK currency increases when the demand for UK goods increases from non-dom consumers.
Supply of UK currency increases when UK consumers want to import foreign goods
Explain how fixed exchange rates are determined
The value of a currency in comparison to another currency
What does a Depreciation of a Currency mean
When the value of one currency falls in comparison to another currency,
Only in a floating exchange rate system
What does an Appreciation of a Currency mean
When the value of one currency rises in comparison to another currency.
Only in floating system
What does a Revaluation of a Currency mean
When the Central Bank raise the value of the currency, usually by decreasing the supply of the currency.
What does a Devaluation of a Currency mean
When the central bank lower the value of the currency, usually by increasing the supply of the currency.
List the causes of the Floating Exchange Rate changing.
Inflation
Interest Rates
Speculation / Confidence
Other currencies
International Trade
BOP / Trade Balance
How does inflation cause the Floating Exchange Rate to change
High Inflation Rates,
High Prices,
Low demand for exports,
Therefore low demand for the currency.
Currency depreciates
How do interest rates cause the Floating Exchange Rate to change
High Interest Rates,
High Return on Investment,
Therefore High Investment,
So high demand for currency,
Currency Appreciates
How does Speculation cause the Floating Exchange Rate to change
If investors and speculators believe the currency will appreciate in the future,
Demand for currency increases, since they think they will make a profit,
Currency appreciates
How do other currencies cause the Floating Exchange Rate to change
Acts as a substitute good,
Increase in demand for other currency
Lower value of domestic currency
How does the BOP or Trade Balance cause the Floating Exchange Rate to change
If a country has a net trade surplus in their current account,
Value of currency increases,
Since foreign buyers need to purchase the currency more than domestic citizens buy a foreign currency.
How does International Trade affect the Floating Exchange Rate
Increase in international demand (exports),
Increase in demand for the currency as they need the currency to purchase the good,
So value of currency increases
Explain the effect of Exchange Rates on Net Exports and how that will affect the Domestic Economy
SPICED
WPIDEC
Stronger (expensive) pound
Cheaper to buy foreign goods,
More expensive for foreign markets to buy domestic goods,
So increase in imports and decrease in exports,
So Lower AD,
So Lower GDP & Lower Current Account,
But Lower Demand-Pull Inflation
Explain how a depreciation of the Pound will affect UK Firms’ Supply & Demand
DEMAND:
Lower Pound Value,
Cheaper for foreign consumers to purchase pound,
So UK goods are cheaper for foreign consumers.
So will lead to an increase in exports,
Increases AD
Increase Revenue & Profit
SUPPLY:
Lower Pound Value,
More expensive to purchase foreign currencies,
Imports more expensive,
Increase in cost of raw materials,
Decrease in AS
Explain what is meant by a Hybrid Exchange Rate System
AKA a Managed Float System
Combines the characteristics of fixed and floating systems,
Currency fluctuates but is not solely determined by supply and demand,
There is some degree of government and monetary intervention.
For example:
The Central Bank of the country will still buy and sell currency in order to lower and increase the value of the currency
What is a Developing Economy most likely to use as its Exchange Rate System and why.
A Fixed Exchange Rate.
Lower inflation risks,
So promotes investment & trade
Examples: UAE, Vietnam, Egypt & India
What is an Emerging Economy most likely to use as its Exchange Rate System and why.
A Hybrid Exchange Rate.
Since it can adapt to limit volatility and inflation which will promote investment and trade.
Examples: China, Brazil & Russia
What is a Developed Economy most likely to use as its Exchange Rate System and why.
A Floating Exchange Rate.
Low risk of currency crisis so no need for intervention.
Less risk of shocks since they trade with so many industries
Don’t need foreign reserves
