Week 3 - Exchange Rate System and Gov. Influences Flashcards
What is the role of the central bank in modern economies? (3)
- Monitor inflation and employment
- Manage monetary policy
- Sometimes act as last resort lenders
What are the three main types of exchange rate systems (3)
- Freely floating exchange rate system
- Fixed exchange rate system
- Managed float exchange rate system
What is a freely floating exchange rate system? (2)
- Exchange rates are determined by market forces without government intervention
- Offers greater insulation from foreign economic problems
What are the advantages of a freely floating exchange rate system? (4)
Market-driven flexibility: The exchange rate adjusts based on market forces, reflecting changes in economic conditions without government intervention.
No need for reserves: Since the central bank doesn’t need to hold large reserves of foreign currency, the system is less costly.
Policy independence: Governments and central banks are free to set domestic monetary policies without worrying about maintaining a fixed exchange rate.
Automatic stabilization: Fluctuations in the exchange rate can help stabilize the economy by balancing trade deficits or surpluses through adjustments in the currency value.
What are the disadvantages of a freely floating exchange rate system? (4)
Increased volatility: Exchange rates can fluctuate significantly, leading to uncertainty for international trade and investment.
Currency speculation risk: Frequent fluctuations may encourage speculative activities that can destabilize markets.
Negative impact on businesses: Multinational corporations (MNCs) may face increased risks and costs related to exchange rate fluctuations, requiring them to manage currency risk actively.
Possible misalignment: Exchange rates may not always reflect the true underlying economic conditions, leading to an overvalued or undervalued currency.
How does a fixed exchange rate system operate? (2)
- Holds the currency’s value constant or within narrow bands
- The central bank must buy and sell foreign currency to maintain this rate
What are the benefits of a fixed exchange rate system? (4)
Exchange rate stability: Fixed rates reduce exchange rate volatility, providing more predictable conditions for international trade and investment.
Lower inflation risk: By pegging the currency to a stable foreign currency (e.g., the USD), inflation can be kept low, as the central bank is required to maintain the fixed rate.
Attracts foreign investment: Predictability and low volatility in exchange rates can attract foreign investors, as it reduces currency risk.
Discipline in fiscal and monetary policies: Governments are constrained in their ability to print money or run excessive deficits, which can lead to better long-term economic stability.
What are the drawbacks of a fixed exchange rate system? (4)
Loss of monetary policy control: The central bank may lose the ability to implement independent monetary policies, as they must focus on maintaining the fixed exchange rate.
High reserves needed: The central bank must maintain large foreign exchange reserves to defend the fixed exchange rate, which can be costly and impractical.
Vulnerability to external shocks: If the fixed exchange rate is not aligned with market conditions, external shocks (e.g., changes in interest rates or inflation in the anchor country) can cause economic instability.
Risk of currency crises: If market expectations diverge from the fixed rate (e.g., if there are doubts about the country’s ability to maintain the peg), speculative attacks can deplete reserves, leading to a currency crisis.
What is a managed float exchange rate system? (2)
- Central bank sets a target range for the exchange rate
- The currency is allowed to float in this range, and the central bank intervenes where necessary to keep the exchange rate within the limits
What are the advantages of a managed float exchange rate system?
- Flexibility - exchange rate can respond to market conditions while still being managed by the central bank
- Stability - it allows for some stability in the currency exchange rate while still accommodating market forces
- Controlled interventions - The central bank can intervene selectively, reducing the need for constant market management while preventing extreme volatility
What are the drawbacks of a managed float exchange rate system?
- Market distortions - frequent intervention can lead to market distortions and mispricing of the currency
- Central bank dependency - the system relies on the central bank’s ability and willingness to intervene when needed, which may not always be effective
- Uncertainty - if interventions aren’t predictable then uncertainty arises which leads to investor concerns about currency risk
What is a currency board? (2)
- A system where the supply of domestic currency is directly tied to foreign currency reserves
- there is no discretion in monetary policy
What is the policy trilemma in exchange rate systems? (2)
- States that nations cannot simultaneously have free capital movement, a fixed exchange rate and an independent monetary policy
- A country can only have 2 of these 3
What happens when international interest rates increase under a fixed exchange rate system? (2)
- If the central bank does not match the interest rate increase, capital outflows occur
- The currency then becomes undervalued and speculation against the fixed rate occurs
What is a currency crisis? (2)
- occurs when a central bank runs out foreign currency reserves - leading to the devaluation of a currency
- results from economic mismanagement or speculative attacks
What is the risk of a fixed exchange rate in terms of speculative attacks?
A divergence between the true equilibrium exchange rate and the fixed rate can create profit opportunities for speculators - leading to a currency crisis
How can devaluation affect a country with a fixed exchange rate? (2)
- Devaluation can occur if the fixed rate is unsustainable due to economic imbalances
- This can lead to a currency crisis and a shift to a floating rate system
Why might a smaller or developing country prefer a fixed exchange rate system? (2)
- Provide transparency, monetary policy anchors and stability for countries with weaker economic institutions
- This helps to attract inward foreign investment
How does government intervention affect exchange rates in a managed float system?
The central bank intervenes to stabilise the currency when it outside the target range by either buying or selling foreign currency in the market
What is direct intervention by a central bank?
The central bank exchanging its own currency for foreign currencies in the market to stabilise or influence the exchange rate
What is indirect intervention by a central bank?
The central bank influencing factors that determine currency value, such as fluctuating the interest rates or altering the money supply
What is sterilised intervention?
The central bank intervenes in the foreign exchange market while offsetting the effects on the money supply by buying or selling treasury securities
What is a non-sterilised intervention?
When a central bank intervenes in the exchange market without taking action to offset changes in the money supply - affecting inflation and interest rates
What is the Economic and Monetary Union (EMU) in the EU?
Involves the coordination of fiscal policies, a common monetary policy and the adoption of the euro as a common currency amongst EU member states
What are the pros of the EMU and the Euro? (4)
- Enhanced price transparency - Use of a single currency removes exchange rate differences - making it easier to compare pruces across countries
- Lower transaction costs - no need to exchange currency which reduces the costs associated with currency conversion for businesses and travellers
- Encourages competition - businesses can more easily compare prices and suppliers across different member states
Boosts International trade - common currency encourages removes the threat of exchange rate volatility between eurozone countreis - encourages international investment into the Eurozone
What are the cons of the EMU and the Euro? (4)
- Loss of Independent Monetary Policy - member countries lose control as decisions are made by ECB, limiting their ability to address country specific challenges
- Inability to devalue currency - decreased flexibility to respond to economic shocks
- Limited fiscal policy flexibility - Stability and Growth pact limits ability to use government spending to stimulate the economy during times of crisis
- Risk of financial instability - the EMU ties multiple countries together, meaning that financial problems in one country can affect the stability of other countries in the eurozone
What are asymmetric economic shocks?
Economic disruptions that affect one country more than others within a currency union - making it harder for that country to adjust through monetary policy
