Markets - Foreign exchange market
Worksheet - Exchange rates - fixed, floating or managed?
The purpose of this worksheet is to look at the determination of exchange rates - fixed systems, floating systems and managed exchange rates. The worksheet then goes on to look at the effects of exchange rate changes on imports, exports and the rest of the economy.
1. The exchange rate is the price of one currency in terms of another. As with any prices, it is therefore determined by supply and demand. What determines the supply and demand for sterling on the foreign exchange markets?
Demand
Supply
(6 Marks)
2. For each of the events below, show on the diagram the effects of the change on the exchange rate (by shifting either the supply or demand curve).
a) There is an increase in the UK interest rate.
b) There is an increase in the US interest rate.
c) Speculators in the UK believe that the value of sterling is about to fall.
d) There is a significant increase in UK export growth.
e) UK inflation increases compared to overseas inflation
f) The MPC are meeting next week against the background of a downturn in the economy.
(12 Marks)
3. Cross out the words in bold in the paragraph below as appropriate, so that it gives a good description of the way a fixed exchange rate system works.
A fixed exchange rate system is one where the value of the currency is fixed against another currency. To maintain a fixed rate, the government need a high / low level of reserves. If there was an increase in the demand for the currency, this would normally lead to the currency appreciating / depreciating. However, since the rate is fixed, this cannot happen. To prevent the exchange rate rising, the government will buy / sell sterling. This leads to the level of foreign currency reserves rising / falling.
(4 Marks)
4. The Monetary Policy Committee of the Bank of England will watch the value of the exchange rate carefully. How does the exchange rate affect the level of inflation?
(6 Marks)
5. Say that the exchange rate starts at £1 = $2, and market changes lead to it falling to £1=$1.50. Fill in the price of the imports and exports given at each exchange rate in the table below:
| Import / export prices | Price of exports to the US in $ | Price of imports into the UK in £ | ||
| At £1 = $2 | At £1 = $1.50 | At £1 = $2 | At £1 = $1.50 | |
| An export from a UK firm priced at £100 | ||||
| An import from the US priced at $100 | ||||
| An export from a UK firm priced at £350 | ||||
| An import from the US priced at $250 | ||||
| An export from a UK firm priced at £40 | ||||
| An import from the US priced at $60 | ||||
(12 Marks)
6. Circle the correct answers to the questions below:
- What happens to export prices as the exchange rate depreciates? Increase / Decrease
- What happens to import prices as the exchange rate depreciates? Increase / Decrease
(2 Marks)
7. Show on the diagram below what is likely to happen in the foreign exchange market (in terms of supply and demand) if rapid import growth leads to an exchange rate depreciation and the government decide to intervene to prevent the pound falling too far.
Write a short explanation of the changes below the diagram.
Explanation
(6 Marks)
8. On the diagrams below, show what effects you would expect on the level of aggregate demand, and the equilibrium level of income from a depreciation and an appreciation of the exchange rate.
Depreciation of the exchange rate
Appreciation of the exchange rate
(6 Marks)
9. What is the Marshall-Lerner condition?
(4 Marks)
10. In the table below, tick appropriate boxes to show the effects on the balance of payments of an appreciation or depreciation in the exchange rate.
| Balance of payments | |||
|---|---|---|---|
| Improves? | Deteriorates? | ||
| Marshall-Lerner condition applies | Exchange rate appreciates | ||
| Exchange rate depreciates | |||
| Marshall-Lerner condition doesn't apply | Exchange rate appreciates | ||
| Exchange rate depreciates | |||
(4 Marks)
11. What is meant by the 'J-curve effect'? Use the blank axes given to illustrate the effect, and also write an explanation below.
Explanation
(6 Marks)
Total Marks = 68
