Economics Test – Chapter 26: Exchange rates
Exchange rates = the price of one currency expressed in the terms of other
currency
Exchange rate system = the way that a country manages its exchange rate
(exchange-rate regime)
1. Define, explain, and give examples of a fixed and a floating
exchange rate system.
Fixed exchange rate:
o An exchange-rate regime where the value of a currency is fixed, or
pegged, to the value of another currency
o To the average value of selection of currencies, or to the value of some
other commodity
Floating exchange rate:
o An exchange-rate regime where the value of a currency is allowed to be
determined solely by the demand for, and supply of, the currency on the
foreign exchange market
2. Distinguish between a devaluation and a revaluation of a currency.
(only in the fixed exchange rate system)
Revaluation = if the value of the currency is raised
Devaluation = if the value of the currency is lowered
3. Distinguish between depreciation and appreciation of currency.
(only in the floating exchange rate system)
Appreciation = if the value of the currency increases
Depreciation = if the value of the currency falls
4. Calculate exchange rates and changes in exchange rates.
PAST PAPER QUESTION
May 2015 paper 3 Q3 (page 133 - 135)
5. Describe factors leading to changes in the demand for, and supply
of, a currency.
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6. Define, explain, and give examples of a managed exchange rate
system.
Exchange-rate regimes where the currency is allowed to float but with some
element of interference from the government
The government usually sets a range between which the exchange rate should
remain
Intervention may involve the interest rate being manipulated or the currency
being bought or sold
7. Evaluate the advantages and disadvantages of high and low
exchange rates.
High exchange rates:
Advantages:
o Downward pressure on inflation: price of finished goods will be relatively
low, price of imported raw materials will reduce costs of production
lower prices for consumers + puts pressure on domestic products to
be competitive
o More imports can be bought: each unit of the currency will buy more
foreign currencies and so more foreign goods and services
o A high value of currency forces domestic producers to improve their
efficiency: can threaten the international competitiveness so they will be
forced to lower costs and become more efficient greater economic
productivity
Disadvantages:
o Damage to export industries: export industries may find it difficult to sell
their goods and services abroad because of their relatively high prices
lead to unemployment
o Damage to domestic industries: greater levels of imports being
purchased – domestic producers may find that increased competition
causes a fall in demand
Low exchange rates:
Advantages:
o Greater employment in export industries: exports from the country will
be relatively less expensive and so more competitive more
employment
o Greater employment in domestic industries: make imports more
expensive encourage domestic consumers to buy domestically
produced goods
8. Explain government measures to intervene in the foreign exchange
market.
Using their reserves of foreign currencies to buy, or sell, foreign currencies:
o To increase the value of the currency can use its reserves of foreign
currencies to buy its own currency on the foreign market – increase
demand and force up exchange rates
o To lower the value of the currency buys foreign currencies on the
foreign exchange market increasing its foreign reserves – increases the
supply and lowers exchange rates
By changing interest rates:
o To increase the value of the currency: raise the level of interest rates –
make the domestic interest rates relatively higher than those abroad
attract financial investment (investors will have to buy the country’s
currency increasing demand and exchange rates)
o To lower the value of the currency: lower the level of interest rates –
make domestic interest rates relatively lower than those abroad
make financial investment abroad more attractive (investors will have
to buy foreign currencies exchanging their own currency, increasing
supply and lower exchange rates)
9. Compare and contrast a fixed exchange rate system with a floating
exchange rate system.
Floating exchange rate system:
Advantages:
o Monetary policy can continue to be used as the government is not
intervening in the pricing of the currency the interest rate can be
manipulated to encourage growth as the currency is able to depreciate
freely
o Trade imbalances can naturally adjust: if the currency appreciates
because of the demand for exports increasing then this demand will
gradually fall because the price of exports increases as the currency
appreciates
o These exchange rate changes are smooth and continuous
o Speculation may be lower as there is no strict value that is perceived to
be ideal of the currency to be at, therefore, there is less opportunity to
make a profit on the changes in its value
o The central bank does not need to hold ass much in foreign reserves
Disadvantages:
o There is increased uncertainty as the exchange rate has no fixed value,
so investors, exporters and importers face greater risks and be less
confident in the market lower rates
o The government may be more likely to employ inflationary policies to
achieve short term growth
Fixed exchange rate system:
Advantages:
o There is less uncertainty as the currency maintain its fixed value safer
opportunity for investors
o Inflationary growth is not an option, so the government must act with
discipline in reaching its macroeconomic aims
o The exchange rate can be manipulated to combat high inflation
Disadvantages:
o The government cannot use monetary policy affect the exchange rate
o Expansionary fiscal policy cannot be used to finance a deficit - affect the
money supply and interest rates
o The exchange adjustments are abrupt which could be very disruptive
o Trade deficits cannot automatically be corrected, instead contractionary
fiscal policy may be necessary
o The central bank must keep large foreign exchange reserves so that they
can intervene in the exchange rate
