Summary
Exchange rate systems involve understanding how currencies are valued and influenced by various factors. Key distinctions exist between fixed, managed, and floating exchange rate systems, each with different levels of government intervention.
- Exchange Rate — the rate at which one currency can be converted into another. Example: 1 USD might equal 0.85 EUR.
- Fixed Exchange Rate — a system where a currency's value is tied to another currency or commodity. Example: The UAE dirham is pegged to the US dollar.
- Managed Exchange Rate — a system where exchange rates are influenced by both market forces and government intervention. Example: Governments may buy or sell currency to stabilize rates.
- Floating Exchange Rate — a system where exchange rates are determined by market forces without government intervention. Example: The value of the euro against the dollar changes based on supply and demand.
- Equilibrium Exchange Rate — occurs when the demand for a currency matches its supply. Example: If $2 = 1 euro, and demand and supply are balanced, the rate is at equilibrium.
- Purchasing Power Parity — a theory suggesting that exchange rates adjust to equalize the price of identical goods in different countries. Example: If inflation is higher in one country, its currency may depreciate to maintain parity.
Exam Tips
Key Definitions to Remember
- Exchange Rate
- Fixed Exchange Rate
- Managed Exchange Rate
- Floating Exchange Rate
- Equilibrium Exchange Rate
Common Confusions
- Confusing fixed and managed exchange rates
- Misunderstanding how government intervention affects exchange rates
Typical Exam Questions
- If a central bank wants to increase the value of its currency so it is above the equilibrium value, how might it do that using its foreign currency reserves? By buying its own currency using foreign reserves.
- What effect will the 'winding down' of quantitative easing, by the central bank of the United States, have on the value of the dollar? It may increase the dollar's value as interest rates rise.
- Why is a widening current account deficit likely to cause the price of a currency to fall? Increased imports raise supply, decreasing currency value.
What Examiners Usually Test
- Understanding of different exchange rate systems
- Effects of government intervention on currency values
- Factors influencing floating exchange rates