Week 10 Exchange Rates & BOP

Q1: What is meant by the devaluation of a currency? How is devaluation related to speculative
attacks?

Answer
When a currency is allowed to devalue, the government stops supporting it at a particular
exchange rate and instead, supports it at a lower exchange rate. This is called currency
devaluation. If the currency is being continually supported by the central bank, it is probably the
case that the fixed exchange rate has become vastly different from the long-term market rate for
the currency. This potential for devaluation creates a fundamental weakness within fixed
exchange rates: they are open to speculative attack. A speculative attack is a massive capital
outflow from an economy with a fixed exchange rate.

Q2: Explain the concept of purchasing power parity. What are the essential conditions for
purchasing power parity to occur?

Answer 
Purchasing power parity requires the nominal exchange rate to adjust in order to keep the real
exchange rate constant: when the price of a particular good in an economy rises, the nominal
exchange rate will change so that the good still costs the same across countries. For the real
exchange rate to be constant, the cost of moving goods from one country to another has to be
lower than the price differential between them.

Q3: What is meant by official financing?

 Answer
Official financing represents the extent to which the government has changed its foreign currency
reserves by intervening in the forex market.

Q4: What is a real exchange rate? How is the real exchange rate between the pound and the
euro calculated?

 Answer
The real exchange rate is the relative price of domestic and foreign goods measured in a
common currency. The real exchange rate = (€/£ exchange rate) × (£ price of UK goods/€ price
of eurozone goods)

Q5: Explain the concept of perfect capital mobility.

 Answer
Under perfect capital mobility, expected returns on all assets around the world will be zero.
Hence, interest parity holds. When interest parity holds, expected returns on all assets around
the world will be the same. If interest rates change, the exchange rate will also change,
equalizing the expected rate of return on the asset. Hence, interest rate differentials are offset by
exchange rate differentials.

Q6: Explain the benefits and drawbacks of fixed and floating exchange rates.
Answer 
In a fixed exchange rate regime, the government sets an exchange rate and then uses the
central bank to buy and sell currency to keep the market rate fixed. Fixed exchange rates, by
their inherent inflexibility, struggle to accommodate inflationary differences. Therefore, fixed
exchange rates force governments to take financial discipline seriously. The central bank cannot
commit to an indefinite purchase of the domestic currency because, in order to do this, it has to
have an infinite supply of foreign currency, such as US dollars and euros. 
Under a floating exchange rate system there is no impact on the central bank’s foreign currency
reserves as there is no intervention in the marketplace. Floating exchange rates are volatile in
the short run, but enable smooth adjustments in the exchange price in the long run. In contrast,
under fixed exchange rates, when the government suddenly devalues the currency under
pressure from speculative attack, it results in a dramatic change in the exchange price. 

Q7: What are the different accounts in a nation's balance of payments? Give examples of
transactions that are recorded under each of these accounts. 

Answer
The current account measures imports and exports and is further divided into visible and invisible
trade. Visible trade is the export and import of tangible or visible goods such as merchandise.
Invisible trade captures intangible services.  The financial account captures direct investment,
where for example a foreign company may buy a rival within another country; equally, the foreign
company may build its own offices or factory inside another economy. 

Q8: Explain the effectiveness of monetary and fiscal policy under fixed and under floating
exchange rates.

Answer 
Monetary policy is reinforced under floating exchange rates. A reduction in interest rates
stimulates domestic and international demand for domestic goods and services. Fiscal policy
instead will be neutralized by falling exports. 
Under a fixed exchange rate, the central bank seeks interest parity and so cannot change the
interest rate from that set by its international trading partners. Therefore, any increase in fiscal
policy will not be constrained by a tightening of monetary policy. Monetary policy will be less
effective than fiscal policy.

Q9: What are the criteria for the success of an optimal currency zone? Is Europe considered
an optimal currency zone?

Answer
An optimal currency zone is a group of countries better off with a common currency than keeping
separate currencies.
An important factor in the success of optimal currency zones is the degree of trade between
member countries of the currency zone. Trade integrates economies. The more willing a factor
resource, such as labour, is to move throughout the currency zone to find employment, the less
important is the need for specific national governments to deal with domestic problems. In the
case of Europe, the evidence tends to suggest that the eurozone is integrated to a degree, and
so could represent a successful currency zone.

Q10: What are the benefits and disadvantages of the UK joining the eurozone?
Answer
By adopting the Euro, price transparency is assured by common pricing and financial risks
associated with currency movements are reduced. However, if the UK joins the euro, monetary
sovereignty would have to be abandoned. Interest rate decisions would instead be passed to the
European Central Bank, which sets rates for the benefit of the entire eurozone.