4.1.8 Exchange Rates (copy)

Define exchange rate

The value of one currency against another

What is real exchange rate?

Nominal exchange rate + relative cost of living between two countries

What is trade weighted index? (2)

- Value one currency has against a weighted basket of other currencies.

- Weights are calculated relative to the amount of trade that takes place in these currencies.

What is spot price?

Agree an exchange rate today - deliver £ for $ today

What is forward price?

Agree on a future exchange rate today - deliver £ for $ in the future

What are floating exchange rates? (3)

1. Determined by supply and demand that allow currency values to float against one another (trade, investment, speculation).

2. e.g. £ and $

3. Appreciate and depreciate.

What are managed exchange rates? (3)

1. Determined by free market with occasional Central Bank intervention.

2. e.g. RMB and Venezuelan Bolivar.

3. Revaluate and devaluate.

What are fixed exchange rates? (3)

1. Determined by the government to keep it at a specific level (Central Bank buys/sells currency reserves, Monetary policy).

2. e.g. Saudi riyal fixed to the $

3. Revaluate and devaluate.

What is the difference between revaluation and appreciation of a currency?

Revaluation = Currency's value is adjusted relative to a baseline, such as the price of gold, another currency or wage rates.

Appreciation = Value of a currency increases. e.g. each £ will buy more $.

What is the difference between devaluation and depreciation of a currency?

Devaluation = Value of a currency is officially lowered in a fixed exchange rate system.

Depreciation = Value of a currency falls relative to another currency. e.g. each £ will buy less $.

What are 2 advantages of floating exchange rate regimes?

1. Robustness → Efficient price mechanism.

2. Economic Costs → Depreciation means UK becomes more X-competitive so unemployment falls.

What are 2 disadvantages of floating exchange rate regimes?

1. Volatility → Constantly changing and subject to speculation.

2. Economic Costs → If M>X = £ depreciates. → Import-led cost-push inflation.

What is 1 advantage of managed/fixed exchange rate regimes?

Volatility → Reduces business uncertainty. → Importers, Exporters, Investors gain confidence.

What are 2 disadvantages of managed/fixed exchange rate regimes?

1. Robustness → Scope for govt intervention = scope for govt failure.

2. Economic Costs → If M>X = RMB remains constant. → Foreign currency gap. → Can't afford future iMports. → Growth slowdown.

What are 5 exchange rate policies?

1. Buying & Selling currency → If you want to decrease value, sell. If you want to increase value, buy.

2. Monetary policy → Higher interest rate attracts hot money.

3. Currency controls → Limits sale/purchase of foreign currency.

4. Borrowing from IMF → Last resort - sign of economic failure.

5. Devaluation & Revaluation → Only if currency is fixed against another currency.

How do governments influence ER through buying and selling of currencies? (2)

Buy currency to increase value (revaluation)

Sell currency to decrease value (devaluation)

What are 3 factors influencing exchange rates?

1. Interest rates → (high interest rate = appreciation as more demand for currency).

2. Inflation → (high inflation = depreciation).

3. Terms of trade → (ToT improve = appreciation, because can buy more M with same amount of X).

What are the impacts of a depreciation in the value of the £? (3)

1. Make X look. more attractive. → Higher volume of X (less expensive to consumers in other countries).

2. Makes M look less attractive. → Lower volume of M.

3. Overall effect = Improvement in the trade position (assuming the Marshall Lerner position holds → PED of X and M are elastic).

What is the Marshall Lerner condition?

If M and X are inelastic, currency depreciation won’t improve the trade position.

• Firms are locked into LTM contracts.

• Consumers are habitual and addicted.

• Our exchange rate mechanism inverts.

Explain the J-Curve (2)

1. In STM. following depreciation, trade position may worsen. → e.g. Firms are locked into contracts.

2. In LTM, if M-L condition holds, trade position will improve in the LR. → Once iMporters and eXporters have had time to adjust to exchange rate shock.