Unit 4: Exchange Rate

Question 1

What is the Exchange Rate?

Answer 1

The rate at which one currency can be exchanged for another.

Question 2

What is meant by the Nominal Exchange Rate?

Answer 2

The number of units of the domestic currency that can purchase a unit of a given foreign currency

Question 3

What is meant by the Effective Exchange Rate?

Answer 3

Measures the value of a currency against a basket of other currencies
These currencies refer to the countries they trade the most with

Question 4

What do exchange rates Depend on?

Answer 4

Supply & Demand

Question 5

What is a Floating Exchange Rate?

Answer 5

Under floating exchange rates, the exchange rate is determined by supply and demand. There is no government/central bank intervention.

The UK uses this.

Question 6

What is a Fixed Exchange Rate?

Answer 6

A currency’s value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value (e.g. gold)

The value is determined by the government or central bank

Question 7

What is a Managed Exchange Rate?

Answer 7

The exchange rate is allowed to float usually within a range, and the central bank intervenes by buying & selling the currency, in order to influence the exchange rate.

Chine & India uses this.

Question 8

What is Revaluation?

Answer 8

When the exchange rate goes up.

This only occurs in a Fixed exchange rate, where the government/central bank determines this

Question 9

What is Devaluation?

Answer 9

When the exchange rate goes down.

This only occurs in a Fixed exchange rate, where the government/central bank determines this

Question 10

What is Appreciation?

Answer 10

When the exchange rate goes up.

This only occurs in a Floating exchange rate, where market forces (supply/demand) determines this

Question 11

What is Depreciation?

Answer 11

When the exchange rate goes down.

This only occurs in a Floating exchange rate, where market forces (supply/demand) determines this

Question 12

What Factors influence Exchange Rates?

Answer 12

Relative interest rates (hot money flows)
Relative inflation rates
International trade performance
Government finances (budget deficits/surpluses)
State of the economy
Inflows & Outflows of foreign investment (FDI)
Speculation
Quantitative Reasoning

Question 13

How can the Exchange Rate be Managed/Influenced by the Central Bank?

Answer 13

Changing Interest Rates:
Raising interest rates will increase the value of the currency

Intervention on the Foreign Exchange Market
Making the demand curve shift right will increase the currency’s value

Question 14

What effect will a Depreciation of the exchange rate have on the Current Account?

Answer 14

Weak pound - Imports dear & exports cheap - Increase in exports - Current account Improves

Question 15

What effect will a Depreciation of the exchange rate have on Economic Growth & Employment?

Answer 15

Weak pound - Current account improves - (X-M) is higher - Right shift in AD

Question 16

What effect will a Depreciation of the exchange rate have on the Inflation Rate?

Answer 16

Weak pound - Current account improves - Right shift in AD - Higher price level - More Inflation

Question 17

What effect will a Depreciation of the exchange rate have on FDI?

Answer 17

Depreciation - Country is more Attractive for foreign countries to invest (as resources are cheaper) - FDI Increases

Question 18

What is the Marshall-Lerner Condition?

Answer 18

There will only be an improvement in the current account if the sum of the PEDs for imports & exports is More Than 1.

Question 19

What is the J-Curve Effect?

Answer 19

In the short run there might be a deterioration in the
current account of the balance of payments because the demand for imports might be price inelastic if firms have stocks or if they are tied into contracts; and the demand for exports might be price inelastic because consumers take time to adjust to the new, lower, prices.

However, in the long run demand for exports and imports is likely to become more price elastic so the significance of the above factors disappears.

Question 20

What does an Improvement in the Current Account Depend On?

Answer 20

The Marshall-Lerner Condition

The J Curve Effect