4.5 Exchange Rates (DP IB Economics: SL): Flashcards
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Define exchange rate.
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Define exchange rate.
An exchange rate is the price of one currency in terms of another, for example £1 = €1.18.
What determines a currency's value under a floating exchange rate system?
Under a floating exchange rate system, a currency's value is determined by the forces of demand and supply on the foreign exchange market.
Define appreciation of a currency.
An appreciation is a rise in the value of a currency, caused under a floating system by excess demand for it on the forex market.
True or False?
Under a floating exchange rate system, an excess supply of a currency on the forex market causes it to appreciate.
False.
An excess supply causes the currency to depreciate; it is excess demand that causes it to appreciate.
Define fixed exchange rate system.
A fixed exchange rate system is one in which the central bank intervenes in the currency market to fix (peg) the exchange rate against another currency.
Under a fixed exchange rate system, how does a central bank make its currency appreciate?
It buys its own currency on the forex market using its foreign reserves, thereby increasing demand for it.
Under a fixed exchange rate system the peg is sometimes set at , for example 1 Brunei Dollar = 1 Singapore Dollar.
Under a fixed exchange rate system the peg is sometimes set at parity, for example 1 Brunei Dollar = 1 Singapore Dollar.
Define revaluation.
A revaluation occurs when the central bank changes the peg in order to increase the strength of its currency.
Define devaluation.
A devaluation occurs when the central bank changes the peg in order to decrease the strength of its currency.
Define managed exchange rate system.
A managed exchange rate system is one in which the exchange rate is allowed to fluctuate within a specified band around a desired value, with the central bank intervening if it moves outside that band.
Under a managed system, what does a central bank do when its currency approaches the top of the band?
It sells its own currency (buying foreign reserves) to increase supply and depreciate the currency back within the band.
Under a managed exchange rate system, the exchange rate is allowed to fluctuate within a specified around a desired value.
Under a managed exchange rate system, the exchange rate is allowed to fluctuate within a specified band around a desired value.
True or False?
The currency bands used in a managed exchange rate system are published by the central bank.
False.
The bands are not published, as knowing them would allow currency speculators to predict interventions and profit from them.
How does a rise in a country's relative interest rates affect its currency?
A rise in relative interest rates attracts hot money inflows, increasing demand for the currency and causing it to appreciate.
Define hot money.
Hot money is short-term financial capital that flows between countries in response to relative interest rates.
How does a rise in a country's relative inflation rate affect its currency?
Higher relative inflation makes exports more expensive, reducing foreign demand for them, so the currency depreciates.
Define speculation in the foreign exchange market.
Speculation occurs when traders buy a currency in the expectation that it will be worth more in the short to medium term, then sell it to realise a profit.
Foreign direct investment into a country creates a demand for its currency, causing it to .
Foreign direct investment into a country creates a demand for its currency, causing it to appreciate.
How do high levels of remittances affect a country's currency?
High remittances help to keep demand for the currency strong, as seen in the Philippines.
True or False?
A rise in a country's relative inflation rate causes its currency to appreciate.
False.
Higher relative inflation makes exports dearer and reduces demand for the currency, causing it to depreciate.
What happens to imports and exports when a currency depreciates?
A depreciation makes imports more expensive and exports cheaper.
Why can a currency depreciation cause cost-push inflation?
A depreciation raises the price of imported raw materials, increasing firms' costs and causing cost-push inflation.
A depreciation makes exports cheaper and imports dearer, so net exports should rise, increasing demand.
A depreciation makes exports cheaper and imports dearer, so net exports should rise, increasing aggregate demand.
What determines the extent to which a depreciation improves the current account balance?
It depends on the price elasticity of demand for exports and imports.
True or False?
A currency appreciation tends to increase aggregate demand.
False.
An appreciation makes exports dearer and imports cheaper, so net exports and aggregate demand tend to fall.
How is unemployment likely to change if a depreciation increases exports?
Unemployment is likely to fall, as more workers are needed to produce the additional exports demanded.
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