Exchange Rates

What is an exchange rate?

The price of one currency in terms of another.

What are the 3 exchange-rate systems?

Freely floating, managed floating and fixed exchange rates.

What is a freely floating exchange rate?

Determined by demand and supply, with no government intervention.

What is a managed floating exchange rate?

Market-determined, but the central bank intervenes when necessary.

What is a fixed exchange rate?

The central bank maintains the currency at a set value.

What is a currency board?

Domestic currency is backed by foreign currency reserves.

What causes demand for a currency?

Exports, inward investment, hot money and speculation.

What causes supply of a currency?

Imports, outward investment, hot money outflows and speculation.

What is appreciation vs depreciation?

Appreciation = currency rises in value.
Depreciation = currency falls in value.

What is revaluation vs devaluation?

Revaluation = official rise under a fixed rate.
Devaluation = official fall under a fixed rate.

What causes currency appreciation?

Demand ↑ or supply ↓ → currency appreciates.

What causes currency depreciation?

Demand ↓ or supply ↑ → currency depreciates.

What happens when exports increase?

Demand for currency ↑ → appreciation → exports become less competitive.

What happens when imports increase?

Supply of currency ↑ → depreciation → imports become more expensive.

What are the main advantages of floating rates?

Automatic adjustment, monetary-policy independence and fewer reserves needed.

What are the main disadvantages of floating rates?

Volatility, uncertainty, imported inflation and speculative attacks.

What are the main advantages of fixed rates?

Price stability, greater certainty, encourages trade and FDI.

What are the main disadvantages of fixed rates?

Less monetary-policy freedom, costly to maintain and vulnerable to speculation.