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Questions and Answers
What happens in a floating exchange rate system when there is excess demand for a currency?
What happens in a floating exchange rate system when there is excess demand for a currency?
In a fixed exchange rate system, the Central Bank does not negotiate with the IMF.
In a fixed exchange rate system, the Central Bank does not negotiate with the IMF.
False
What is the term used for the decrease in the value of a currency in a floating exchange rate system?
What is the term used for the decrease in the value of a currency in a floating exchange rate system?
depreciation
The price of one currency in terms of another is known as an __________.
The price of one currency in terms of another is known as an __________.
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Match the following exchange rate systems with their descriptions:
Match the following exchange rate systems with their descriptions:
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What is the current peg rate of the Hong Kong dollar to the US dollar?
What is the current peg rate of the Hong Kong dollar to the US dollar?
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A revaluation occurs when the Central Bank decreases the strength of its currency.
A revaluation occurs when the Central Bank decreases the strength of its currency.
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What is the primary function of a Central Bank in a managed exchange rate system?
What is the primary function of a Central Bank in a managed exchange rate system?
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If the Central Bank wants to increase the strength of the currency, it would ______ its interest rates.
If the Central Bank wants to increase the strength of the currency, it would ______ its interest rates.
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Which of the following factors does NOT influence floating exchange rates?
Which of the following factors does NOT influence floating exchange rates?
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Quantitative easing is a method used to decrease the money supply.
Quantitative easing is a method used to decrease the money supply.
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What happens to a currency when it is subject to competitive devaluation?
What happens to a currency when it is subject to competitive devaluation?
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If a country has an increasing trade surplus, it will likely result in a(n) ______ of its currency.
If a country has an increasing trade surplus, it will likely result in a(n) ______ of its currency.
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Match the following terms with their definitions:
Match the following terms with their definitions:
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What is the impact of foreign direct investment (FDI) on a country's currency?
What is the impact of foreign direct investment (FDI) on a country's currency?
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What is a potential consequence of intentional currency depreciation?
What is a potential consequence of intentional currency depreciation?
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Countries that appreciate their currency will generally see an increase in unemployment.
Countries that appreciate their currency will generally see an increase in unemployment.
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What is the Marshall-Lerner condition?
What is the Marshall-Lerner condition?
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Depreciation of a currency can lead to __________ inflation due to higher costs of imported raw materials.
Depreciation of a currency can lead to __________ inflation due to higher costs of imported raw materials.
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Match the economic indicators with their respective impacts of currency depreciation:
Match the economic indicators with their respective impacts of currency depreciation:
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What happens to foreign direct investment (FDI) when a currency depreciates?
What happens to foreign direct investment (FDI) when a currency depreciates?
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A depreciation in currency will lead to an immediate increase in exports.
A depreciation in currency will lead to an immediate increase in exports.
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What is the J-Curve effect?
What is the J-Curve effect?
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An appreciation of a country's currency leads to a decrease in __________ due to a higher cost of exports.
An appreciation of a country's currency leads to a decrease in __________ due to a higher cost of exports.
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If the combined elasticity of exports and imports is less than 1, what is the likely result of currency depreciation?
If the combined elasticity of exports and imports is less than 1, what is the likely result of currency depreciation?
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Study Notes
Exchange Rate Systems
- An exchange rate is the price of one currency in terms of another (e.g., £1 = €1.18)
- International currencies are traded on the foreign exchange market (forex).
- Central banks control the exchange rate system, determining a nation's currency value.
- Three exchange rate systems exist: floating, fixed, and managed.
Floating Exchange Rate
- Determined by market forces (supply and demand).
- Appreciation (currency worth more) occurs with excess demand.
- Depreciation (currency worth less) occurs with excess supply.
Fixed Exchange Rate
- Central banks negotiate with the IMF to peg their currency to another.
- Pegging can be at parity (e.g., 1 Brunei Dollar = 1 Singapore Dollar) or not (e.g., HK$ 7.75 = US$ 1).
- Revaluation increases currency strength; devaluation decreases it.
Managed Exchange Rate
- Combines fixed and floating elements.
- Central banks set a preferred currency value with a fluctuation band (e.g., 0.75%).
- Market intervention (buying/selling currency) occurs to maintain this band.
- Interest rates can influence currency values.
- Higher interest rates attract foreign investment, increasing demand and appreciation.
- Lower interest rates decrease attractiveness, decreasing demand and causing depreciation.
Factors Influencing Floating Exchange Rates
- Relative interest rates: Higher UK interest rates attract foreign investment, increasing £ demand and appreciation. Conversely, lower interest rates result in £ depreciation.
- Relative inflation rates: Higher UK inflation makes UK exports more expensive, decreasing demand and depreciating the £.
- Net investment (Foreign Direct Investment): FDI into the UK increases £ demand, causing appreciation. UK FDI abroad supplies £, causing depreciation.
- Current account: A trade surplus leads to £ appreciation; a deficit leads to depreciation.
- Speculation: Traders buy/sell currencies based on short-term/medium-term value expectations.
- Quantitative easing (QE): Increasing the money supply (used for gilt buybacks) causes a supply of £s, resulting in depreciation.
Intervention in Markets
- Using fx transactions & interest rates:
- Interest rate adjustments—increasing rates appreciate the currency, lowering them depreciate.
- Central bank buying/selling currency—buying to bolster the currency's value, selling to depreciate it.
Consequences of Competitive Devaluation/Depreciation
- Makes exports cheaper, potentially leading to increased export volumes and higher export revenue (if demand is price elastic).
- Anti-competitive; larger economies manipulate markets, gaining unfair advantages.
- Other countries may retaliate, reducing effectiveness.
- Costs of imports increase, often offsetting gains, resulting in lower profits.
Impacts of Changes in Exchange Rates
-
Current account: Currency depreciation makes exports cheaper and imports more expensive, affecting current account balance. This depends on the Marshall-Lerner condition (combined elasticity of exports/imports):
- If < 1 (inelastic), depreciation worsens the current account (time lag "J-Curve").
- If > 1 (elastic), depreciation improves the current account; firms/consumers react to price changes over time.
-
Economic growth: Increased net exports (due to depreciation) lead to economic growth.
- Increase in aggregate demand leads to potential demand-pull inflation.
- Inflation: Imported raw material costs increase with currency depreciation (cost-push inflation).
- Unemployment: Increased exports (due to depreciation) lead to job creation, decreasing unemployment.
- Living standards: Depreciation increases import costs, impacting households; however, increased exports can lead to wage increases and higher living standards.
- Foreign Direct Investment (FDI): Currency depreciation makes investment cheaper, increasing FDI.
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Description
Explore the various types of exchange rate systems including floating, fixed, and managed rates. Understand how currencies are valued and the role of central banks in setting these rates. Test your knowledge on international currency trading and exchange mechanisms.
