Exchange rate systems

• What is the exchange rate of a currency?

  Weight of one currency relative to another
• How is the value of the exchange rate determined in a floating system?

  By the forces of supply and demand
• What happens to the exchange rate when demand increases in a floating exchange rate system?

  The exchange rate appreciates
• What is the demand for a currency equal to?

  Exports plus capital inflows
• What is the supply of a currency equal to?

  Imports plus capital outflows
• What defines a fixed exchange rate?

  Value determined by the government
• How can a central bank manipulate the supply of currency in a fixed exchange rate system?

  By buying or selling the currency
• What happens to the currency when the supply is increased in a fixed exchange rate system?

  The currency depreciates
• What is a managed exchange rate system?

  Combines fixed and floating exchange rate characteristics
• What does the Japanese central bank do to influence the Yen?

  Manipulates the Yen to make exports competitive
• How does the Indian rupee behave in the market?

  Fluctuates but is managed by the central bank
• Why might governments want to influence their currency?

  To maintain a fixed exchange rate
• What does an increase in interest rates relative to other countries do?

  Makes investment more attractive, increasing demand
• What is hot money?

  Investment attracted by higher interest rates
• What is quantitative easing (QE)?

  Stimulates the economy by increasing money supply
• What are the inflationary effects of quantitative easing?

  Increases the money supply, reducing currency value
• What does the Bank of England use foreign currency transactions for?

  To manage gold and foreign currency reserves
• How did China keep the Yuan undervalued?

  By purchasing US dollar assets
• What are the advantages of fixed exchange rate systems?

  • Allows firms to plan investments
  • Provides a focused target for monetary policy
• What are the disadvantages of fixed exchange rate systems?

  • Government may not know market needs
  • Balance of payments does not adjust automatically
  • Costly to hold large reserves of foreign currencies
• What are the advantages of floating exchange rate systems?

  • Automatically adjusts to economic shocks
  • Monetary policy can focus on other objectives
• What are the disadvantages of floating exchange rate systems?

  • Unpredictable fluctuations complicate investment planning
  • Can affect exports and imports, causing unemployment
  • Vulnerable to speculative shocks
• What are the advantages of joining a currency union?

  • More currency stability and less prone to shocks
  • Fewer admin fees and less red tape
  • Lower interest rates due to shared credibility
• What are the disadvantages of joining a currency union?

  • Limited labour mobility due to language barriers
  • Common monetary policy may not suit all members
  • Loss of sovereignty for member nations
  • Significant one-off costs of joining
• What is the Eurozone?

  A monetary union sharing the Euro currency
• What is required for countries to join the Euro?

  Meet four convergence criteria
• What is one of the convergence criteria for joining the Euro?

  Budget deficits cannot exceed 3% of GDP
• What is another convergence criterion for joining the Euro?

  Gross National Debt must be below 6% of GDP
• What is the inflation criterion for joining the Euro?

  Inflation must be below 1.5% of the three lowest countries
• What is the average government bond yield criterion for joining the Euro?

  Must be below 2% of the lowest interest rates
• What creates an optimal currency zone?

  Real convergence among member countries
• What is required for member countries to respond to external shocks?

  Flexibility in product and labor markets
• What can be used to even out regional economic imbalances?

  Fiscal transfers