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Questions and Answers
What happens to a country's exports when it has high inflation relative to other countries?
What is a potential consequence of setting a fixed exchange rate at an artificially low level?
What is a benefit of a fixed exchange rate in terms of speculation?
What is a requirement for a country with a fixed exchange rate to instil confidence in the foreign exchange markets?
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Why might setting the level of a fixed exchange rate be difficult?
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What is a benefit of a fixed exchange rate in terms of government policies?
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What is the effect of a high exchange rate on domestic producers?
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What happens to the demand for domestic goods and services when the exchange rate is high?
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What is the effect of a low exchange rate on export industries?
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What is the effect of a high exchange rate on the purchasing power of a currency?
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Why may a high exchange rate lead to a decrease in employment in export industries?
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What is the effect of a low exchange rate on the competitiveness of domestic producers?
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What is a potential disadvantage of a managed float exchange rate system?
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What is a benefit of an undervalued currency, like China's RMB?
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What is a potential consequence of a floating exchange rate on a country's economy?
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Why might a country like China intervene in its currency market?
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In a free floating exchange rate system, what is the primary factor that affects the value of the currency?
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What is a potential advantage of a free floating exchange rate system?
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Study Notes
Fixed Exchange Rates
- A country with high inflation relative to other countries will make its exports less competitive and its imports relatively less expensive.
- Fixed exchange rates reduce uncertainty for economic agents, ensure sensible government policies on inflation, and reduce speculation in foreign exchange markets.
- However, maintaining high levels of foreign reserves is necessary to defend the currency, and setting the fixed exchange rate can be challenging.
- A country that fixes its exchange rate at an artificially low level may create international disagreement.
Effects of High Exchange Rates
- Downward pressure on inflation due to lower prices of imported goods.
- More imports can be bought with each unit of currency.
- High exchange rate forces domestic producers to improve efficiency to maintain competitiveness.
- Possible disadvantages include damage to export industries and domestic industries due to increased competition from imports.
Effects of Low Exchange Rates
- Greater employment in export industries due to increased competitiveness.
- Greater employment in domestic industries as imports become more expensive.
- Possible disadvantages include an undervalued currency and potential inflation.
Undervalued Currencies
- China has operated a fixed exchange rate and has adjusted it when needed to stimulate its markets.
Free Floating Exchange Rates
- Advantages: self-adjusting, no need to maintain high levels of foreign reserves.
- Disadvantages: create uncertainty, affected by government intervention, world events, and speculation, and may worsen existing levels of inflation.
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Description
Test your understanding of fixed exchange rates, including their effects on inflation, exports, and imports, as well as their advantages and disadvantages in terms of economic uncertainty and government policies.
