1.9 exchange rates

• define exchange rate

  the cost of one currency in terms of another currency e.g. £1.00 = $1.56
• how is demand for a currency determined?

  exports + capital inflows (inflows of foreign money)
• state 4 things that could make demand increase for a particular currency?

  • interest rates
  • demand for exports (tourism)
  • speculation
  • confidence
• explain how demand for exports increases the demand for a curency

  • if demand for british exports increases consumers abroad will sell their currency to purchase £
  • this increases demand for £ and causes an apprecation of the exchange rate
• explain how demand for exports increases the demand for a curency

  • if demand for british exports increases consumers abroad will sell their currency to purchase £
  • this increases demand for £ and causes an apprecation of the exchange rate
• explain how interest rates increases the demand for a currency

  • if interest rates rise in the Uk it will become a more attractive place to deposit money in banks (as the reward for saving is higher)
  • this will see a rise in hot money flows into the Uk so demand for £ will increase and the exchange rate appreciates
• explain how speculation increases the demand for a currency

  • if foreign currency dealers expect Uk interest rates to rise they will expect demand for £ to increase and so the £ to appreciate
  • as a result speculators try to buy £ in advance causing the value of £ to increase further
• explain how speculation increases the demand for a currency

  • if foreign currency dealers expect Uk interest rates to rise they will expect demand for £ to increase and so the £ to appreciate
  • as a result speculators try to buy £ in advance causing the value of £ to increase further
• explain how confidence increases the demand for a currency

  • if confidence in the Uk increases flows of FDI (foreign direct investment) into the Uk should increase
  • this increases the amount of capital flowing into the Uk and so the demand for £ increases and the value of the currency would appreciate
• result of an increase in demand of £ on exchange rates (£ v $)

  • increase in exports to the US increases demand for £ as Americans have to pay in £
  • this increases the demand of £ from D to D1
  • the price of £ rises from £1= $1.50 to £1=$1.60, this is called an appreciation of the £

  
• how is supply for a currency determined

  imports + capital outflows (money flowing out of the economy)
• state 4 things that could make you want less of a particular currency

  • interest rates
  • demand for imports
  • speculation
  • confidence
• explain how quantitative easing would make you want less of a currency

  • gov increases money supply so more £ is available
  • supply increases but the value of £ decreases
  • quantitative easing involves buying up bonds which act as an injection of extra £s into the economy and increasing the supply of £s
• result of an increase in supply of £ on exchange rates (£ v $)

  • increase in supply of a currency will cause it to depreciate
  • a depreciation in the exchange rate will make exports cheaper so, over time there should be an increase in exports

  
• what is the impact of increased Uk interest rates on the exchange rate?


  the value of £ increases as there is a higher return on investment and demand increases due to hot money inflows
• what is the impact of increased UK imports on the exchange rate

  increased supply of currency as imports increase, increased supply means the value of £ decrases
• what is the impact of speculation that the Uk is likely to enter a recession on the exchange rate

  supply increases as confidence falls, more people sell their £, the value of the £ will therefore fall
• what is the impact of the government starting a process of quantitative easing on the exchange rate

  increased supply as more money available, supply increases, the value of £ decreases
• how does a strong £ affect economic growth

  • exports more expensive for foreign buyers
  • less demand for Uk exports
  • less GDP, less growth
• how does a strong £ affect unemployment

  • fewer exports
  • higher unemployment as labour is a derived demand
• how does a strong £ affect price stability

  • less demand for exports
  • AD falls
  • low inflation
• how does a strong £ affect trade balance

  • price of imports fall, demand for imports rises
  • price of exports rise, demand for exports falls
  • this worsens the trade balance
• give 2 effects of an appreciation of currency on households and firms

  households

  • unemployment (less demand for exports)
  • improvement in living standards (cheaper imports)

  firms

  • less profit (less demand for exports)
• what is an exchange rate index

  shows the percentage change in the value of the currency against its main competitors. It sets the index to 100 for a particular base year, which enables users to make percentage comparisons
• define free floating system

  this is where the exchange rate is determined solely by the market forces of demand and supply
• give 2 advantages of a free floating system

  • flexibility- government isn't tied into maintaining an exchange rate
  • freedom for gov to pursue other macro objectives
• give 2 disadvantages of a free floating system

  • uncertainty (of the exact price of a currency on a daily basis)
  • damage to investment (due to uncertainty, inflation etc)
• what are currency reserves

  amount of currency reserves that are held by the central bank of a country
• define fixed exchange rates

  when the government maintains its exchange rate, often used to promote trade and exports used by countries with high inflation. The exchange rate is usually fixed against the US $
• give 2 advantages of fixed exchange rates

  • reduces uncertainty
  • economic growth (greater certainty=greater investment, spending etc)
• give 2 disadvantages of fixed exchange rates

  • maintenance (fixed exchange rate systems are expensive to sustain in the long term)
  • speculation (investors may sell extra currency to make short term profit as the gov might intervene to buy back currency to maintain its level)
• define the hybrid system

  • central bank of gov set upper and lower limits for their currency value
  • ER determined by demand and supply