ECN 204 Chapter Notes - Chapter 18: Fixed Exchange-Rate System, Floating Exchange Rate, Purchasing Power Parity

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greyporcupine303

28 Jun 2018

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ECN – Chapter 18 – Exchange rates

Two pure types of exchange rate systems

Flexible or floating exchange rate system – demand and supply determine exchange

rates and in which no government intervention occurs

Fixed exchange rate system – governments determine exchange rates and make

necessary adjustments in their economies to maintain those rates

When the dollar price of a currency rises, the dollar has depreciated relative to the currency

When a currency depreciates, more units of it are needed to buy a single unit of another

currency

If the demand for a nations currency increases, that currency will appreciate

If the supply of a nations currency increases, that currency will depreciate

If a nations currency appreciates, some foreign currency depreciates relative to it

Determinants of exchange rates

Changes in taste – changes in preferences may alter demand

Relative income changes – currency likely to depreciate if its growth of national income

is more rapid than that of other countries

Relative inflation rate changes – changes in the relative rates of inflation of two nations

change their relative price levels and alter the exchange rate between their currencies

oPurchasing power parity theory – exchange rates should eventually adjust such

that they equate the purchasing power of various currencies

Relative interest rates – changes in relative interest rates between two countries may

alter their exchange rate

Changes in relative expected returns on stocks, real estate and production facilities

Speculation – people who buy and sell currencies with an eye toward reselling or

repurchasing them at a profit

Flexible exchange rates automatically adjust and eventually eliminate balance of payments

deficits or surpluses

Under fixed exchange rates, recover a shortage by selling official reserve, restricting trade,

implementing exchange controls or enacting a contractionary stabilization policy

Flexible exchange rates are often volatile and can change by a large amount in just a few weeks

or months

They often take substantial swings that can last several years or more

The risks and uncertainties associated with flexible exchange rates may discourage the flow of

trade

A decline in the international value of its currency will worsen a nations terms of trade

Flexible exchange rates may destabilize the domestic economy because wide fluctuations

stimulate and the depress industries producing exported goods

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Document Summary

Flexible or floating exchange rate system demand and supply determine exchange rates and in which no government intervention occurs. Fixed exchange rate system governments determine exchange rates and make necessary adjustments in their economies to maintain those rates. When the dollar price of a currency rises, the dollar has depreciated relative to the currency. When a currency depreciates, more units of it are needed to buy a single unit of another currency. If the demand for a nations currency increases, that currency will appreciate. If the supply of a nations currency increases, that currency will depreciate. If a nations currency appreciates, some foreign currency depreciates relative to it. Changes in taste changes in preferences may alter demand. Relative income changes currency likely to depreciate if its growth of national income is more rapid than that of other countries. Relative interest rates changes in relative interest rates between two countries may alter their exchange rate.

Related Questions

Just as with the price of a good, the price, or exchange rate, of a currency is determined by supply and demand. However, rather than using a traditional supply and demand analysis as shown in Marthinsen, currency traders often consider whether foreign funds will flow into or out of a country as a result of a particular economic circumstance. If foreigners wish to make domestic purchases or investments, the foreign currency must first be exchanged for the domestic currency. Thus, foreign funds flowing into a country increase the demand for the domestic currency and it appreciates. Funds flowing out reverse this process leading to depreciation of the domestic currency. In the table, place an X to indicate whether each economic condition will cause foreign funds to flow in or out of the country and whether the domestic currency will appreciate or depreciate.

Domestic circumstance	Funds flow in	Funds flow out	Currency appreciates	Currency depreciates
Real interest rates are higher than in other countries
Risk of civil war
Business taxes are raised above the world average				X
Expected stock market returns are better than elsewhere
Inflation increases
A large deposit of rare earth minerals is discovered
Rapidly growing manufacturing sector imports more foreign raw materials

ultramarinepug302

Just as with the price of a good, the price, or exchange rate, of a currency is determined by supply and demand. However, rather than using a traditional supply and demand analysis as shown in Marthinsen, currency traders often consider whether foreign funds will flow into or out of a country as a result of a particular economic circumstance. If foreigners wish to make domestic purchases or investments, foreign currency must first be exchanged for the domestic currency. Thus, foreign funds flowing into a country increase the demand for the domestic currency and it appreciates. Funds flowing out reverse this process leading to depreciation of the domestic currency. In the table, place an X to indicate whether each economic condition will cause foreign funds to flow in or out of the country and whether the domestic currency will appreciate or depreciate.

Domestic circumstance	Funds flow in	Funds flow out	Currency appreciates	Currency depreciates
Real interest rates are higher than in other countries
Risk of civil war
Business taxes are raised above world average
Expected stock market returns are better than elsewhere
Inflation increases
A large deposit of rare earth minerals is discovered
Rapidly growing manufacturing sector imports more foreign raw materials
World commodity prices (such as oil or grain) fall in a country that is a major commodity exporter
GDP increases
PI falls

orchidmosquito970

Which of the following statements is accurate in regards to the US dollar:

A.	The central bank is responsible for printing the domestic currency and the value of the currency is adjusted to maintain a fixed level to another currency.
B.	The central bank has no ability to print the domestic currency and dollarization was adopted to minimize domestic inflation.
C.	Banks are responsible for printing the domestic currency and there is a floating exchange rate.
D.	The central bank (e.g. Federal Reserve) is responsible for printing the domestic currency and there is a floating exchange rate.

Suppose that monetary policy in the United States leads to an increase in interest rates relative to those in Japan. Which of the following will occur in the capital account:

A.	The demand for yen will increase.
B.	The dollar will appreciate relative to the yen.
C.	The supply of dollars will increase.
D.	The dollar will depreciate relative to the yen.

An expansionary monetary policy by the Fed would tend to:

A.	Lower the U.S. inflation rate, make exports cheaper, make imports more expensive, and raise the value of the dollar.
B.	Raise the U.S. inflation rate, make exports more expensive, make imports cheaper, and lower the value of the dollar.
C.	Raise the U.S. inflation rate, make exports cheaper, make imports more expensive, and raise the value of the dollar.
D.	Lower the U.S. inflation rate, make exports more expensive, make imports cheaper, and lower the value of the dollar.

cerisecod404

ECN 204 Chapter Notes - Chapter 18: Fixed Exchange-Rate System, Floating Exchange Rate, Purchasing Power Parity

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