Exchange Rates

Question 1

What is the Exchange Rate?

Answer 1

• Is the rate at which one currency trades against another on the foreign exchange market

Question 2

Where are currencies traded?

Answer 2

Foreign Exchange markets

Question 3

Why in mid 2008 was there a sharp depreciation of the Pound?

Answer 3

• Hit by the Credit Crunch

Question 4

Why was the a sharp drop in 2016?

Answer 4

• Because markets were less optimistic about the long-term fortunes of the UK economy outside the EU.

Question 5

Define the Exchange Rate Index.

Answer 5

This gives a measure of a currency against a trade-weighted basket of currencies.

Question 6

Define Real Exchange Rate.

Answer 6

• This is the exchange rate after being adjusted for the effects of inflation, it, therefore, more accurately reflects the purchasing power of a currency.

Question 7

Define the Floating Exchange Rate.

Answer 7

• When the value of the currency is determined by market forces – supply and demand for currency

Question 8

Define Fixed Exchange Rate.

Answer 8

• Where the government seeks to keep the value of a currency at a certain level compared to other currencies.

Question 9

Diagram that calculates exchange rates using supply and demand diagram.

Answer 9

Question 10

Factors influencing Exchange Rates.

Answer 10

• Interest rates
• Economic growth
• Inflation
• Confidence in the economy/currency.
• Current account deficit/surplus.

Question 11

How do Interest Rates affect Inflation?

Answer 11

• higher interest rates encourage hot money flows and demand for currency. This causes an appreciation.

Question 12

What are Hot Money Flows?

Answer 12

Hot money flows refer to capital flows moving to countries with higher interest rates.

Question 13

How does Economic Growth affect exchange rates?

Answer 13

• Higher economic growth will tend to cause an appreciation in the currency, this is because markets expect higher interest rates – when growth is rapid.

Question 14

How does Inflation affect Exchange Rates?

Answer 14

• Higher inflation makes exports less competitive and reduces demand for currency. This causes a depreciation.

Question 15

How does the Current Account Deficit/Surplus affect Exchange Rate?

Answer 15

• A large current account deficit is more likely to cause a depreciation in the value of the currency because money is leaving the economy to buy imports.

Question 16

What factors will happen if the Pound appreciates in value?

Answer 16

• UK exports more expensive abroad – leading to lower demand.
• Imports into the UK will be cheaper, increasing demand for imports
• An appreciation will tend to reduce inflation,
• Lower economic growth – due to reduced demand for exports.
• Worsening of the current account deficit (because imports are cheaper and quantity of imports rises, but exports are more expensive and quantity falls)
• Strong Pound = Imports Cheaper, Exports Dearer. SPICED

Question 17

What does SPICED stand for?

Answer 17

• Strong
• Pound
• Imports
• Cheap
• Exports
• Dear (Expensive)

Question 18

What will happen if the Pound depreciates in value?

Answer 18

• UK exports become more competitive, increasing demand for exports
• Imports become more expensive, leading to lower demand for imports
• A depreciation will tend to increase economic growth but also cause inflation.

Question 19

Evaluative points on Exchange Rates - Elasticity of Demand.

Answer 19

If there is a depreciation in the exchange rate, exports are cheaper, but the amount quantity increases depend on the elasticity of demand. If demand is price inelastic, then a depreciation will have a limited impact in increasing demand and improving economic growth. If demand for exports is elastic, then there will be a big boost to exports.

Question 20

Evaluative points on Exchange Rates - Time Lag

Answer 20

In the short term, demand for exports is often inelastic but becomes more price elastic over time.

Question 21

Evaluative points on Exchange Rates - Reasons for Appreciation/Depreciation.

Answer 21

Often it is most successful economies who see appreciation. The currency appreciates because there is more demand for their exports. Therefore, in this case, a depreciation won’t cause a fall in economic growth – only limit the growth rate. If the currency appreciates due to speculation, during a period of weak economic growth, then the negative effect on growth may be more pronounced.