Topic 6 - International Sector & Policy

Question 1

6.01 - What is the exchange rate?

Answer 1

It is the price of a unit of one currency expressed in the units of another currency.

Question 2

6.02 - Under a floating exchange rate, how is the equilibrium exchange rate determined?

Answer 2

By forces of supply and demand for a country’s currency

Question 3

6.03 - What does depreciation mean in relation to the foreign exchange market? And what is the opposite?

Answer 3

It means that it takes more units of a country’s currency to buy a single unit of foreign currency. The opposite is Appreciation.

Question 4

6.04 - What does the supply and demand of a foreign currency reflect?

Answer 4

The demand by foreigners for domestic goods, services and assets.

Question 5

6.05 - How are foreign currency demand and supply represented on a graph and why?

Answer 5

Demand is down sloping because as the foreign currency becomes less expensive, demand for foreign goods increases. Supply is up sloping because as the foreign currency rises, demand for foreign goods will fall.

Question 6

6.06 - How is the Australian dollar price of the foreign currency found on a graph?

Answer 6

It is the intersection of the demand and supply curves.

Question 7

6.07 - What are the determinants of exchange rates?

Answer 7

• Changes in tastes
• Relative income changes
• Relative price changes (inflation)
• Relative real interest rates
• Speculation

Question 8

6.08 - What are the two polar options for an exchange rate system?

Answer 8

• Flexible or floating exchange rates

* Fixed exchange rate

Question 9

6.09 - What are flexible or floating exchange rates?

Answer 9

These are exchange rates for which the values are determined by the unimpeded forces of supply and demand.

Question 10

6.10 - What are fixed exchange rates?

Answer 10

Government intervention in the foreign exchange market offsets the changes in exchange rates caused by the demand and supply factors.

Question 11

6.11 - What is the benefit of a freely floating exchange rate system?

Answer 11

It is that a deficit/surplus on the current account will be offset by a surplus/deficit on the capital account - a truism.

Question 12

6.12 - Does a freely floating exchange rate system ensure external balance occurs?

Answer 12

No, because external balance requires a sustainable balance on the current account.

Question 13

6.13 - What is a gold standard system?

Answer 13

A system under wich the value of a nation’s monetary unit was backed by gold rather than fiat.

Question 14

6.14 - How would a deficit affect the demand for foreign currency in a gold standard system?

Answer 14

A deficit would cause changes in domestic prices and incomes shifting the demand for foreign currency down so that it intersects lower on the supply curve.

Question 15

6.15 - How would a deficit affect the demand for foreign currency in a system under exchange controls?

Answer 15

The Government would ration the foreign currency amongst those demanding it.

Question 16

6.16 - What are the disadvantages of floating exchange rates?

Answer 16

• uncertainty and diminished trade
• terms of trade
• instability in the macroeconomic environment

Question 17

6.17 - What is meant by ‘uncertainty and diminished trade’ when talking about the disadvantages of floating exchange rates?

Answer 17

That uncertainty on prices due to movements in the exchange rate will discourage the flow of trade.

Question 18

6.18 - What is meant by ‘terms of trade’ when talking about the disadvantages of floating exchange rates?

Answer 18

That a decline in the international value of a country’s currency will result in worsening terms of trade.

Question 19

6.19 - What are the two types of ‘instability in the macroeconomic environment’ when talking about the disadvantages of floating exchange rates?

Answer 19

• Destabilising effects on the domestic economy arising from shifts in net exports brought about by changes in the exchange rate
• Complicates the use of domestic monetary and fiscal policies.

Question 20

6.20 - What is the other name for fixed exchange rates? and why would a country choose to have a fixed exchange rate?

Answer 20

Pegged exchange rates. A country may do this to overcome the disadvantages of floating exchange rates.

Question 21

6.21 - What does the maintenance of fixed exchange rates require?

Answer 21

Adequate reserves to accomodate periodic payment deficits. The government must intervene in the market to ensure that the total demand for and supply of currency are such that the target exchange rate level is maintained.

Question 22

6.22 - What is a supposed advantage and disadvantage of fixed exchange rates?

Answer 22

Advantage - is they provide stability in which to conduct international trade
Disadvantage - is that if foreign exchange reserves are inadequate, nations must enact activist economic policies to maintain the exchange rate.

Question 23

6.23 - What are the policies a country could enact to manage inadequate foreign exchange reserves where they have fixed exchange rates?

Answer 23

• protectionist trade policies - to increase net exports
• exchange controls - so imports may only be financed through the proceeds of exports
• fiscal and monetary policy - to adjust the equilibrium level of real domestic income so that it is consistent with exchange rate equilibrium at the target exchange rate level.