Exchange Rates

Question 1

What determines value of a currency in a free floating exchange rate

Answer 1

Supply and demand

Question 2

Factors increasing demand for £

Answer 2

High relative interest rates (causing hot money inflows)
Low relative inflation
Increase in exports
Increase in confidence
Increase in FDI
Speculators purchase more £s

Question 3

Factors increasing supply for £

Answer 3

Low relative interest rates
High relative inflation
Increase in imports
Decrease in confidence
Outward FDI
Speculators sell £s for other currencies

Question 4

Benefits of a strong currency

Answer 4

Costs less to import for consumers so SRAS shifts right so more growth so lower cost push inflation
Higher living conditions for population due to increased purchasing power of currency

Question 5

Benefits of a weak currency

Answer 5

Exports increase so X-M increases so AD increases so real GDP increases so economic growth occurs

Question 6

Policies to strengthen / weaken the value of a currency (freely floating)

Answer 6

Strengthen: increase IRs to encourage hot money inflows and increase demand for currency
Weaken: increase QE to increase money supply or decrease IRs to encourage hot money outflows

Question 7

Impact of a depreciation in ER on economic growth

Answer 7

WPIDEC: exports more price competitive, imports less price competitive so assuming Marshal Lerner Condition is fulfilled then X-M improves
C also increases as consumers consume domestic goods so AD rises, increasing RY
Eval: CoP increases as SRAS shifts left

Question 8

Impact of a depreciation in ER on inflation

Answer 8

Demand pull inflation as X-M increases
Cost push inflation as CoP rises

Question 9

Impact of a depreciation in ER on balance of payments

Answer 9

Income tax revenue increases as real GDP increases following AD increase as a result of higher X-M so deficit is reduced
Eval: J curve, time lag, raw materials becoming expensive makes manufacturing sector less competitive

Question 10

Marshall Lerner Condition

Answer 10

States that the balance of trade will only improve over time after depreciation of the domestic currency if the combined elasticity if demand for exports and imports is greater than 1

Question 11

J curve

Answer 11

In the short run, trade balance worsens as PED is inelastic so demand for goods and services is unchanged, but in the long run, trade balance improved as PED is more elastic and so consumers will import less

Question 12

Consequences of a depreciation in ER

Answer 12

Price level increases so inflation
A depreciation in £ causes a rise in cost of imported goods and services causing an increase in CPI
Commodity prices (in $) become higher so increased cost of resources results in cost-push inflation
Export led growth of output causes an increase in real GDP resulting in demand-pull inflation
Employment increases
Increase in output causes derived demand for labour so higher employment
Import penetration is less severe so increased competition for domestic firms so protection of domestic jobs
Highest growth of employment in exporting sectors of economy

Question 13

Knock on effects of a depreciation in ER

Answer 13

In medium to long term the balance of payments current account will improve
Depreciation of £ causes the value of exports to ride and value of imports to fall

Question 14

Fixed exchange rate

Answer 14

Currency has a target value but can often move between permitted bands of fluctuation

Question 15

Floating exchange rate

Answer 15

Market supply and demand of the currency are the sole determinants of its value

Question 16

Managed exchange rate

Answer 16

Government intervenes to influence market supply and demand of the currency

Question 17

Why the £ may be demanded by foreigners

Answer 17

To buy UK exports of goods and services e.g. an Italian consumer buys a UK car in Milan so UK company exchanges euros given to demand pounds when profits are repatriated to UK
To save their money in UK accounts - increased IRs encourage foreign investors to move money into UK banks to take advantage of higher return rate so they supply another currency to demand £
To invest in UK firms - for FDI to take place, foreign companies need to supply their currency to demand pound in order to purchase UK capital assets
To make money by speculating £ - to make a gain from future higher value of currency, foreigners supply money to demand pound to purchase UK currency

Question 18

Why the £ may be supplied to foreigners

Answer 18

UK households want overseas imports of goods and services
UK households want to save their money in overseas bank accounts
UK companies or households want to invest in overseas firms (outward FDI)
To make money by speculating another currency

Question 19

Hot money inflow CoR

Answer 19

If UK IRs rise, UK banks give greater returns
Investors then exchange their foreign currency on forex markets and purchase £s
This increases demand for the pound, appreciating it

Question 20

Currency speculation

Answer 20

Practice of buying or selling a currency with the expectation that its value will change, allowing the speculator to profit from the difference in exchange rates

Question 21

Speculators CoRs

Answer 21

Believes a currency will depreciate so sells it, increasing supply, depreciating currency
Believes a currency will appreciate so buys it, decreasing supply, appreciating currency

Question 22

Evaluating effects of a currency depreciation

Answer 22

Time lag
Openness of economy - what % of GDP is trade
Scale of change in ER
Duration
PED
Stage of business cycle