Exchange rate systems

How will quantitative easing affect the exchange rate of a currency?

Quantitative easing involves the central bank creating new money. This will increase the supply of the currency and cause a depreciation of its exchange rate.

What are the three exchange rate systems?

• fixed exchange rates

• managed exchange rates

• floating exchange rates

What is a fixed exchange rate?

Fixed exchange rates fix the value of one currency (like the Argentinian peso) to the value of another (like the Dollar).

So 1 dollar= 1 Peso

How can the central bank manage the exchange rate of a currency in two ways?

1. change the interest rate to shift the supply and demand of the currency, OR

2. they can use foreign currency transactions

The Central Bank of Argentina uses foreign currency transactions to sell their own currency on the currency market. What is a diagram to show this?

If the Central Bank of Argentina sells Argentine pesos on the currency market, the supply of pesos will increase. This will shift the supply curve to the right and cause a decrease (a depreciation) in the exchange rate.

The Central Bank of Argentina increases its interest rate. What is a diagram to show this?

If the Central Bank of Argentina increases its interest rate, the demand for Argentine pesos will increase.This is because hot money investors searching for a high interest rate will be incentivised to save in Argentina. To do so they must purchase pesos and this will shift demand for the peso to the right and cause an increase (an appreciation) in the exchange rate.

How can a country change the value of their fixed exchange rates?

Revaluing or devaluing the currency

What is revalutation?

When a country raises their fixed exchange rate

What is devalutation?

When a country lowers their fixed exchange rate. 

When will the government or central bank onlyintervene in a managed exchange rate system?

to keep the exchange rate in a certain range

How does a reduction in imports affect the value of the UK’s exchange rate?

In order to buy imports, consumers must purchase foreign currency. To do so they must sell (or supply) pounds. This means that a decrease in imports will lead to a decrease in the supply of pounds which in turn will lead to an appreciation of the pound.

What is a floating exchange rate?

With a floating exchange rate, the government or central bank does not intervene to manage their exchange rate at all. The exchange rate is simply determined by the supply and demand for the domestic currency.

What are the two types of exchange rates?

Nominal and real

What is a nominal exchange rate?

The nominal exchange rate tells us the price of one currency in terms of another.

What is a real exchange rate?

the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries.

How can you calculate the real exchange rate?

Real ER = (Nominal ER x Domestic Price)/Foreign Price

What does a price level tell us?

A price level tells us the average price of a basket of goods and services in an economy.