6.4 Exchange Rate Systems Flashcards

1
Q

Exchange rate definition

A

The price of one currency expressed in terms of another currency

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2
Q

What does a higher exchange rate for pounds mean?

A

That £1 will buy more foreign currency = more foreign goods for cheaper cost

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3
Q

Floating exchange rate definition

A

When the exchange rate is determined by supply and demand and governments make no attempt to influence the value of the currency

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4
Q

What are the factors that affect a floating exchange rate?

A
  • interest rates
  • foreign trade
  • relative inflation
  • FDI
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5
Q

How do interest rates effect a floating exchange rate?

A

If interest rates increase relative to those in other economies, there will be an inflow of ‘hot money’ into the UK = increased demand for the pound = rise in value of the currency

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6
Q

How does foreign trade effect a floating exchange rate?

A
  • Increased demand for imports would mean an outflow of pounds in order to buy the foreign currency needed to purchase the imports
  • increased supply of pounds = fall in exchange rate
    Or
  • higher demand for Uk exports = more demand for pound = rise in currency
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7
Q

How does relative inflation effect a floating exchange rate?

A

If UK inflation is higher than other economies = exports less price competitive = reduce demand for exports = lower exchange rate
- (greater supply of pounds and reduced demand for pounds)

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8
Q

How does FDI effect a floating exchange rate?

A

Increasing FDI to the UK will increase demand for the currency = rise in exchange rate

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9
Q

Advantages of a floating exchange rate

A
  • gives the monetary policy more freedom to focus on other macroeconomic objectives
  • the exchange rate automatically adjusts to economic shocks
  • no need for governments to hold extensive stocks of foreign currency for open market operations to influence the currency value
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10
Q

Disadvantages of floating exchange rates

A
  • fluctuations in the price of the exchange rate makes investment planning hard
  • affects unemployment in a country as exports and imports can change
  • speculators may buy or sell currency’s which impact domestic businesses or create cost-push inflation
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11
Q

Open market operations

A

Direct intervention into the foreign currency market to influence the demand for and supply of that currency

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12
Q

Fixed exchange rate definition

A

Where the government intervenes in the foreign exchange market to stabilise a currency’s value against one or more other currencies

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13
Q

What are the ways the government can intervene in exchange rates?

A
  • monetary policy
  • open market operations
  • capital controls
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14
Q

What are capital controls?

A

Restrictions on the quantity of currency that can leave or enter an economy
(Mostly hot money)

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15
Q

Advantages of fixed exchange rate

A
  • allows firms to plan investment, as no fluctuations in the exchange rate
  • it gives the monetary policy a focused target to work towards
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16
Q

Disadvantages of fixed exchange rates

A
  • interest rates cannot be used for domestic purposes = must be kept in line with the economy which their exchange rate is fixed against
  • large reserves of foreign currency may be needed for government intervention
  • lack of adjustments to current account imbalances
17
Q

Eurozone definition

A

Those countries using the euro as their currency

18
Q

Currency union definition

A

A group of countries which share a common currency

19
Q

Arguments in favour of joining a currency union

A
  • no costs involved in converting currencies between members
  • no worries about the exchange rate being over-valued or under-valued against others members
  • greater price transparency for consumers
  • currency is less prone to speculative shocks
20
Q

Arguments against joining a currency union

A
  • monetary policy has to be conducted for the currency union as a whole = may not be in each countries best interest
  • businesses may not be able to compete with lower-cost producers that are members of the union and cannot benefit from a falling exchange rate
  • one off cost of joining a currency union of changing labels and prices + changing people’s perceptions of cost can be significant