Economics- Edexcel 4.1.8
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| exchange rate | the rate or price at which one country’s currency can be exchanged for other currencies in the foreign exchange market
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| effective exchange rate | a weighted index of sterling’s value against a basket of currencies where the weights are based on the importance / share of trade between the UK and each country
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| main exchange rate systems | free-floating currency/managed-floating currency/fixed exchange rate system
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| free-floating currency | where the external value of a currency depends wholly on market forces of supply and demand (there is no central bank intervention to influence a currency’s price)
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| managed-floating currency | when the central bank may choose occasionally to intervene in foreign exchange markets to influence/move the value of a currency to meet specific macroeconomic objectives
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| fixed exchange rate system | opposite of a floating currency where currencies trade at an officially announced level and market forces don’t move the value of a currency from day to day
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| depreciation | a fall in the value of a currency in a floating exchange rate system
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| devaluation | a fall in the value of a currency in a fixed exchange rate system
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| appreciation | a rise in the value of a currency in a floating exchange rate system
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| revaluation | a rise in the value of a currency in a fixed exchange rate system
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| demand for a currency | an inflow of money into an economy
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| demand for a currency in the foreign exchange market is derived from | demand for a country’s exports of goods and services and from speculators looking to profit from changes in currency values and from currency volatility
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| investors tend to demand which currencies | currencies whose value is expected to rise and where relative interest rates on money deposited into a country are high
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| supply of a currency | an outflow of money from an economy
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| supply of a currency determined | by level of domestic demand for / expenditure on imported goods and services from aboard or speculative outflows of a country’s currencies on the FX markets
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| free-floating currency system | external value of currency is set by market forces/no intervention in the currency market by the nation’s central bank/no official target value for the exchange rate
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| how is the external value of the currency set by market forces? | the strength of currency S & D drives the external value of a currency in the markets and the currency appreciates or depreciates
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| what factors cause changes in the currency in a floating system? | trade or current account balances/FDI/portfolio investment/interest rate differentials
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| trade/current account balances in a floating system | countries that have strong trade and current account surpluses tend to see their currencies appreciate as money flows into the circular flow from exports of goods and services and from inflows of investment income
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| portfolio investment in a floating system | strong inflows of portfolio investment into equites and bonds from overseas can cause a currency to appreciate
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| FDI in a floating system | an economy that attracts high net inflows of capital investment from overseas will see an increase in currency demand and a rising exchange rate
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| interest rate differentials in a floating system | countries with relatively high interest rates can expect to see ‘hot money’ flowing coming in and causing an appreciation of the exchange rate
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| managed exchange rate | an exchange rate regime in which the exchange rate is neither entirely free (or floating) nor fixed
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| banks intervene to influence the price by | buying to support a currency or selling to weaken a currency
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| monetary policy in a country with a managed floating system | currency is a key target
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| main tools for managing floating exchange rates | changes in monetary policy interest rates/quantitative easing/direct buying or selling in the currency market (intervention)/taxation of overseas currency deposits and capital controls
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| competitive devaluations | occur when a government deliberately intervenes to drive down the value of their currency to provide a lift to AD, output and jobs in export industries
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| when do governments attempt competitive devaluations | when faced with a deflationary recession or to attract FDI
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| competitive devaluations other name | dirty floating
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| risks involved with competitive devaluations | seen as a form of trade protectionism that invites retaliatory action and go against principles of trade based on comparative advantage
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| fixed exchange rate system | government or central bank fixes the currency value/pegged exchange rate becomes the official rate/adjustable currency peg system
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| anchor currency | a foreign currency that is held in significant quantities by central banks or other monetary authorities as part of their foreign exchange reserves
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| ways exchange rates impact business activity | prices of exports in international markets, costs fo goods bought from overseas, revenues and profits earned from overseas, converting cash receipts from customers overseas
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| SPICED | strong pound imports cheaper exports dearer
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| evaluating effects of a currency depreciation | length of time lags/scale of change/temporary or long lasting change/coefficients of price elasticity of demand for X&M/size of multiplier & accelerator effects/when currency movement takes place/type & degree of openness of economy
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| advantages of floating exchange rates | reduces need for central bank to hold large amounts of currency reserves/freedom to set monetary policy interest rates/insulation after an external shock/offers partial automatic correction for trade deficit/less risk of becoming undervalued
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| disadvantages of floating exchange rates | no guarantee that floating exchange rates will be stable/volatility may be detrimental to attracting FDI/lower exchange rates don’t correct a persistent current account deficit
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| advantages of fixed exchange rates | certainty of currency values gives confidence for FDI/reduced need to engage in ‘currency hedging’/controls inflation/leads to lower borrowing costs/imposes more responsibility on gov macro policies/less speculation in currency markets
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| disadvantages of fixed exchange rates | reduced freedom to use interest rates/developing countries don’t have large foreign currency reserves/difficult to use competitive devaluation/devaluation can lead to cost-push inflation which has regressive effects
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