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Exchange Rate: The rate at which one currency can be exchanged for another.
Types of exchange rates:
1. A Floating Exchange Rate System
This is determined by market forces. If demand for the currency rises, this will raise
the exchange rate where as if the supply of the currency increases; the exchange rate
will fall in value. In a floating exchange rate the Purchasing Power Parity (PPP)
should apply. This states that the price of one good should cost the same price as
the same good in another country. This is because the exchange rate should adjust
until a unit of currency can buy exactly the same amount of goods and services as a
unit of another currency.
Advantages of a Floating Exchange Rate System
1. The exchange rate will automatically adjust so that supply of a currency will equal
demand, this will eliminate balance of payments deficits or surpluses without any
government intervention. For example, if imports rise then so will the supply of
the pound leading to a fall in the exchange rate. If the pound falls then exports
will become more competitive and imports will become less competitive
therefore there will be no more deficit.
2. The country operating with this exchange rate will not need a central bank to
keep foreign reserves.
3. As no government intervention is needed then it means that they can pursue
their own domestic policies.
4. Reduces imported inflation, this is because if a currency depreciates then I will
mean that imports will decrease and therefore imported inflation will decrease as
5. It possibly reduces speculation, because speculators might lose and so do not
take the risk.
Disadvantages of a Floating Exchange Rate System
1. It causes instability, which will deter investment and trade.
2. It can lead to inflation, this will lead to a fall in demand for its currency and a fall in
exchange rate. This makes its good competitive again but makes imports more
expensive, which in the long run will lead to more cost-push inflation.
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3. Speculation on future movements can lead to major changes in the rate.
4. Governments are not forced to control their economies, for example they do
not have to ensure that domestic inflation is in line with other countries to
ensure their firms are competitive (this is because the pound can depreciate).
2. A Fixed Exchange Rate System
This is one where the parity (exchange rate value, for example £1 = $1.50) of the
currency is pegged against other currencies.…read more
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Revaluation Over a short amount of time, or moved up by the government.
Appreciation Changed by supply and demand
A downward movement can be called a depreciation or devaluation.
Devaluation - Over a short amount of time, or moved up by the government.
Depreciation - Changed by supply and demand.
Causes of an appreciation or revaluation
Increase in demand for UK exports.
Decrease in UK demand for imports.…read more
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Long term investment FDI
Short term investment Flows of "Hot Money"
If interest rates in a country go up then you would want to invest in there but you would
need to exchange currencies therefore exchange rates increase. The demand for pounds is
provided for by those foreigners who wish to buy UK goods and therefore exchange their
currency for UK pounds.…read more