Topic 5-Exchange rates

Question 1

Exchange rate

Answer 1

The value of one currency in terms of another

Question 2

Factors influencing exchange rate (6 factors)

Answer 2

• Relative interest rates
• Relative inflation rates
• Current account balance
• Foreign Direct Investment (FDI)
• Speculation

Question 3

Factors influencing exchange rate (explanation) -Relative interest rates

• Relative inflation rates
• Current account balance
• Foreign Direct Investment (FDI)
• Speculation

Answer 3

• higher interests rates>attracts money into its banks from abroad ( cuz of prospect of gaining a higher return). This creates an increased demand for the currency>value^
• higher inflation rates>purchasing power will fall relative to competitors and in LR>Exchange rate decreases
• Deficit=supply for its currency is higher than demand
• High level of FDI will experience an increased demand for currency>appreciate
• Speculation: e.g expected state of the economy, expected change in interest or fear of rising rate of inflation

Question 4

Effects of a depreciation in the value of a currency

Effects of BOP

Answer 4

• A decrease in the foreign currency price of a countries exports (exports are cheaper&imports more expensive)
• Cheaper exports&more expensive imports>increase competitiveness of countries g&s> improve the current account of the countries BOP

Question 5

Effects of a depreciation in the value of a currency

Effects on economy

Answer 5

• Lead to an increase in AD>rise in real output and an ^price level
• increased price of imported commodities&raw materials would cause an increase in costs of production>cost-push inflation&demand-pull
• Rise in real output should help reduce unemployment as jobs in export sector^

Question 6

Evaluation of devaluation (explanation)
The effect of a devaluation will depend on:
1. The elasticity of demand for exports and imports:
2.State of the global
3.Inflation
4. why the currency is being devaluated

Answer 6

1. PED=Inelastic fall in price of export>to only a small rise in quantity>value of exports may fall.
   Eval: Marshall Lerner condition: If PED>1 then a devaluation will improve the current account
2. If global economy=in recession>devaluation may not work by boosting demand for exports. If growth is strong>^demand. In boom=likely to worsen inflation
3. Effect on inflation will depend on:
   -spare capacity in the economy e.g in recession devaluation is unlikely to cause inflation
   -Firms may not pass increased import costs onto consumers and would reduce their profit margins in the short-run
   4.if due to competitiveness>can restore competitiveness &lead to economic growth. If it is aiming to meet a certain exchange rate>may be inappropriate for economy

Question 7

Evaluation of devaluation (4 evaluations)

Answer 7

1. The elasticity of demand for exports and imports:
2. State of the global
3. Inflation
4. why the currency is being devaluated

Question 8

Fixed exchange rate

Answer 8

When exchange rates have been set at a particular level in terms of other currencies

Question 9

Floating exchange rate

Answer 9

The value of a countries currency/ the exchange rate is able to fluctuate freely and is determined by market forces

Question 10

Devaluation

Answer 10

A process whereby the gov deliberately lower the value of the countries currency relative to another country

Question 11

Revaluation

Answer 11

A process whereby the gov deliberately raise the value of the countries currency relative to another country