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Appreciation
A rise in the value of the currency due to market forces
Depreciation
A fall in the value of the currency due to market forces
Revaluation
A rise in the value of the currency due to deliberate government policy
Devaluation
A fall in the value of the currency due to a deliberate government policy
Effective exchange rate
An index number of the value of a country’s currency relative to a weighted basket of other currencies
Floating exchange rate
Market supply and demand of the currency are the sole determinants of its value
Semi fixed exchange rate
The currency has a floor and ceiling but can move between permitted bands of fluctuation
Fixed exchange rate
An exchange rate which doesn’t change and is permanently fixed
Managed exchange rate
The government will intervene to influence the market demand and supply of the currency (dirty exchange rate)
Why would governments manipulate the exchange rate?
To boost trade, to improve the balance of payments, to create economic stability
What are some benefits of floating exchange rate systems?
Freedom for domestic monetary policy
Useful investment for macroeconomic adjustment
Partial automatic correction for a trade deficit
Reduced risk of currency speculation
What are some disadvantages of floating exchange rate systems?
Volatile so there’s no certainty for trade an investment
Self correction of trade deficits is unlikely
A dirty floating exchange rate means you still have to keep some currency reserves for emergencies
Gold standard
An example of a fixed exchange rate system
What are the benefits of a currency board fixed exchange rate?
Interest rates are automatically adjusted
It’s predictable and rule-based which promotes investment
What are some potential disadvantages of a currency board fixed exchange rate?
Prevents governments from selling their interest rates so that if their inflation is high it’ll be even higher than the country it’s pegged to
Disequilibrium
Benefits of fixed exchange rate systems
Stable
Some flexibility permitted
Reduces cost of trade by reducing uncertainty
Encourages FDI, increased confidence in the market which raises animal spirits
Drawbacks of fixed exchange rate systems
The most expensive type of system, large currency reserves are needed
Independent monetary policy isn’t possible if interest rates are used to determine the value of the currency
No partial correction of a balance of payments deficit as with a floating system
Ways the government plays a part in determining the exchange rate
Buying and selling currency using the gold and foreign currency reserves
Raising or lowering interests, influencing free market demand and supply
Borrowing from the International Monetary Fund (IMF) which can be used to buy domestic currency and hold up the exchange rate. This is a last resort.
Adjustable peg system
An exchange rate system where currencies are fixed in value in the short term but can be devalued/revalued in the long term. This is done if economic circumstances change, Bretton Woods
The Bretton Woods agreement
Established in 1944, created a system of international monetary management, setting up institutions like the IMF and World Bank to promote economic stability and reconstruction after World War II until the early 1970s.
Why did the pound devalue in 1967?
Persistent balance of payments crisis, high inflation, and a weakening economy, which led to a loss of confidence in the pound and pressure on the British government to take action to stabilize the currency. This culminated in Prime Minister Harold Wilson's decision to devalue the pound by 14.3%
Benefits of a managed exchange rate
Attempts to have the benefits of both fixed and floating exchange rate systems and minimise both of their disadvantages
Cheaper than a fixed rate system
More stable than a floating system
Allows for a limited reduction in BoP when the currency depreciates within ceiling and floor
Disadvantages of managed exchange rate systems
May still have disadvantages of fixed and floating systems
More expensive than a floating exchange rate system but not as stable as a fixed rate system
Currency may head to the floor in the LR, causing pressure for realignment
Imperfect information means the currency may initially be set at the wrong value
Open target for speculators who can force down the value of the currency causing it to devalued or ejected from the semi fixed system (UK out of ERM black wednesday 1992)
Index of terms of trade formulae
(Index of export prices / index of import prices) x 100
Terms of trade
The ratio of export prices to import prices
When will there be an improvement in terms of trade
If export prices rise relative to import prices
If export prices fall by relatively less than import prices
When will there be a deterioration in the terms of trade
If import prices rise significantly that export prices or if import prices fall by relatively less than export prices.
Factors which lead to an improvement in the terms of trade
An increase in the exchange rate
High relative inflation rate
Increase in global demand for a commodity in which the country specialises
Factors which lead to a depreciation in the terms of trade
Increase in global supply of a commodity in which the country specialises
Improved relative productivity rate
Falling prices of a good a country sells
International competitiveness
A country’s sustained ability to sell it’s goods and services in domestic and international markets profitably, at a price and quality that is attractive in those markets
Why is competitiveness important?
It is the key to economic growth, which leads to a lower unemployment rate
Measures of price competitiveness
Relative unit labour costs (measurement of labour costs in one country relative to those in another), the figures are converted into a single currency and shown as an index number
Relative export prices
Measures of non-price competitiveness
Quality of goods and services (design, reliability, performance, marketing, branding ect.
Factors influencing international competitiveness
Wage and non-wage labour costs
Productivity
The exchange rate
Inflation
Regulation (implementing more costs to business which could reduce competitiveness)
R&D
Quality
Taxation
Monetary/currency union
A group of countries which share a common currency, e.g the euro
Fiscal union
A group of countries where a central body has some powers over gov borrowing, spending and setting uniform rates of tax across all member countries
Benefits of Monetary union
Reduced transaction costs
No exchange rate fluctuations
Increased price transparency
Increased trade between eurozone nations
Drawbacks of monetary union or joining the euro
Currency fluctuations can still be a problem when trade with the rest of the world
Transition costs
Loss of monetary independence
No exchange rate adjustment possible
Constraints on fiscal policy
Optimum currency area
A group of countries where efficiency would be maximised by sharing a common currency
Features needed to achieve the optimal currency zone
Member countries must have sufficient structural economic convergence (similar trade patterns, business cycles, housing markets)
Sufficient labour market flexibility to absorb unexpected economic events
Fiscal union
