4.1.8 Exchange rates

• What are exchange rates?

  The price of one currency in terms of another
• What are foreign exchange reserves?

  Cash and other reserve assets held by a central bank 
• What are the key reasons for the large volume of currency trades?

  • Impact of globalisation
  • Speculation
  • Hedging behaviour 
• What are the exchange rate systems?

  • Floating exchange rate
  • Fixed exchange rate
  • Managed exchange rate
• What is a floating exchange rate?

  Value of currency is determined by market forces
• What are floating exchange rates influenced by?

  • Relative inflation rates
  • Relative interest rates
  • Current account balance 
  • Foreign direct investment
  • Speculation
• What are fixed exchange rates?

  Government sets a specific value for its currency
• What are managed exchange rates?

  Value of currency is determined by market forces but is subject to intervention by the Central Bank in the foreign exchange market in order to influence to exchange rate
• What are advantages to a floating exchange rate?

  • Reduced need for currency reserves
  • Freedom for domestic monetary policy
  • Useful instrument for macroeconomic adjustment
  • Partial automatic correction for a trade deficit
  • Reduced risk of currency speculation
• What are disadvantages to a floating exchange rate?

  • Volatility - reduce incentive for foreign investment and trade
  • Self-correction of trade deceit is unlikely
• What are advantages to a fixed exchange rate?

  • Decrease exchange rate uncertainty
  • Some flexibility permitted
  • Reduction in the cost of trade (reduced hedging)
  • Discipline on domestic products
• What are disadvantages to a fixed exchange rate?

  • Interest rate effects 
  • Large level of foreign currency reserves needed
  • Speculative attacks in exchange rate is set too high or too low
• What is currency revaluation?

  When a country decides to increase the exchange rate of its currency under a system of fixed exchange rates
• What is currency devaluation?


  When a country decides to decrease the exchange rate of its currency under a system of fixed exchange rates
• What is currency depreciation?

  Decrease in the external value of one currency in relation to another currency.
• What exchange rate system does depreciation happen within?

  Floating
• What are advantages to currency depreciation?

  • Increase in employment in exporting and domestic industries
• What are disadvantages in currency depreciation?

  • Higher inflation
• What is currency appreciation?

  Increase in the external value of one currency in relation to another currency
• What exchange rate system does appreciation happen within?

  Floating
• What are advantages to currency appreciation?

  • Lower inflation 
  • Cheaper imports - increase in living standards
  • Potential efficiency gains for domestic products
• What are disadvantages to currency appreciation?

  • Lower growth - potential current account deficit
  • Higher unemployment in exporting industries and domestic industries