Exchange rate

• Define bilateral exchange rates

  The value of one currency expressed in another currency.
• Define effective exchange rates

  Describes the strength of one currency to a basket of other currencies using an index.
• Define exchange rates

  The purchasing power of a currency in terms of what it can buy of other currencies.
• Define fixed exchange rate

  The value of the currency is set against the value of another and that exchange rate does not change.
• Define floating exchange rate

  The value of the currency is determined purely by market demand and supply of the currency.
• Define hybrid exchange rate system

  A combination of the characteristics of fixed and floating exchange rates; the currency fluctuates but it doesn't float on a fully free market. e.g managed float
• Define nominal exchange rates

  The weight of one currency relative to another, without being adjusted for inflation.
• Define real exchange rates

  When the exchange rate is adjusted for inflation to give a more accurate reflection of purchasing power.
• Define trade-weighted exchange rate

  Measures how the exchange rate is changing against other currencies in general, rather than a single currency.
• Floating exchange rate system: diagram

  The market equilibrium is at P1. When demand increases from D1 to D2, the exchange rate appreciates to P2.

  
• Fixed exchange rate system: diagram

  The supply of the currency can be manipulated by the central bank, which can buy or sell the currency to change the price to where they want.In the diagram, the supply has been increased from S1 to S2 by selling the currency so more is on the market (Q1 to Q3).The currency depreciates from P2 to P3 whcih makes exports more competitive.

  
• Bilateral exchange rates

  The market exchange rate is bilateral since the value of two currencies is compared to each other. It is the value of one currency expressed in another currency. It doesn't compare living standards between countries, but I can help holidaymakers see how far their currency goes in their destination country.
• Define depreciation

  When the value of a currency falls relative to another currency in a floating exchange rate system.
• Define appreciation

  When the value of a currency increases .E.g each pound will buy more dollars
• Define devaluation

  When the value of a currency is officially lowered in a fixed exchanged rated system.
• Define revaluation

  When the currency's value is adjusted relative to a baseline, such as the price of gold, another currency or wage rates.
• Causes of exchange rate changes: (1. inflation)

  A lower inflation rate means exports are relatively more competitive. This increases demand for the currency, causing the currency to appreciate.
• Causes of exchange rate changes: (2. interest rates)

  An increase in interest rates, relative to other countries, makes it more attractive to invest funds in the country because the rate of return on investment is higher. This increases demand for the currency, causing an appreciation, which is known as hot money.
• Causes of exchange rate changes: (3. speculation)

  If speculators think a currency will appreciate in the future, demand will increase in the present, since they believe a profit can be made by selling the currency in the future. This can cause an increase in the value of the currency.
• Causes of exchange rate changes: (4. other currencies)

  If markets are concerned about major economies, such as the EU, the currency might rise. This happened with the Swiss Franc in 2010 when markets were worried about the EU economy.
• Causes of exchange rate changes: (5. government finance)

  A government with a high level of debt is at risk of defaulting, which could cause the currency to depreciate. This is since investors start to lose confidence in the economy, so they sell their holdings of bonds.
• Causes of exchange rate changes: (6. Balance of payments)

  When the value of imports exceeds exports, there is a current account deficit. Countries which struggle to finance this, such as through attracting capital inflows, have currencies which depreciate as a result.
• Causes of exchange rate changes: (7. international competitiveness )

  An increase in competitiveness increases demand for exports, which increases demand for the currency. This causes an appreciation of the currency.
• Causes of exchange rate changes: (8. government intervention)

  Governments might try and influence their currency, such as by maintaining a fixed exchange rate. E.g China has previously kept the Yuan undervalued by buying US dollar assets to make their exports seem relatively cheaper.
• Effect of exchange rates on: AD

  It affects the price of exports and imports.If the exchnage rate appreciates, AD is likely to fall since imports become cheaper and exports become more expensive.
• Effect of exchange rates on: Businesses- exports

  As the value of the pound falls, UK exports become more competitive. Firms may then lower the price of the item in the export market to boost sales, or they could keep it the same to boost profit margins.
• Effect of exchange rates on: Businesses- price inelastic goods


  If UK goods are relatively price inelastic, a depreciation in the pound will not result in a significant boost in export sales. It is depends on the export market's rate of economic growth. The more consumer and firm confidence they have, as well as their disposable income, the more inclined they are to buy UK exports.
• Effect of exchange rates on: Businesses- raw material importers

  As imports are more expensive when the pound is lower, production costs will rise. This could make the firm less competitive globally, resulting in lower profits. Changes in the exchange rate, on the other hand, will have no effect on the amount purchased or the price paid if firms have fixed contracts for how long they would import materials from another country. This reduces uncertainty of production costs for firms.
• Effect of exchange rates on: Businesses- profit margins

  If the £ depreciates, firms might think that they can increase their profit margins by keeping the price the same, without having to increase efficiency or productivity to lower their average costs.
• What is a managed float?

  When the exchange rate floats on the market, but the central bank of the country buys and sells currencies to try and influence their exchange rate. E.g The Brazilian currency floated freely with some government intervention prior to Jan 1999.
• Fixed exchange rate system: benefit- investment

  Allows for firms to plan investment, because they know that they will not be affected by harsh fluctuations in the exchange rate.
• Fixed exchange rate system: disadvantage- knowledge

  The government and the central bank don't necessarily know better than the market where the currency should be.
• Fixed exchange rate system: benefit- target


  It gives the monetary policy a focused target to work towards.
• Fixed exchange rate system: disadvantage- BOP

  The BOP doesn't automatically adjust to economic shocks.
• Fixed exchange rate system: drawback - costs

  It can be costly and difficult for the government to hold large reserves of foreign currencies.
• Floating exchange rate system: benefit - economic shocks

  The exchange rate automatically adjusts to economic shocks.
• Floating exchange rate system: benefit - freedom

  It gives the monetary policy more freedom to focus on other macroeconomic objectives.
• Floating exchange rate system: drawbacks - predictability

  The fluctuations in the price of the exchange rate can be unpredictable, which can make investment planning difficult.
• Floating exchange rate system: drawbacks - unemployment

  It can also affect the exports and imports of a country, which could cause a lot of unemployment if an industry is affected in particular.
• Floating exchange rate system: drawbacks - vulnerability

  It could make the exchange rate vulnerable to speculative shocks.