Exchange rates and exchange rate policy: Exchange rate policy

Overview

Recall questions on Exchange rate policy.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a fixed exchange rate system?

   Model answer

   A fixed exchange rate system is one in which the government or central bank commits to holding the currency at a declared value against another currency or basket of currencies.

2. 2

   How does a central bank hold an exchange rate at its fixed value?

   Model answer

   It buys its own currency using foreign exchange reserves when the rate tends to fall and sells its own currency when the rate tends to rise, and it can adjust interest rates to attract or discourage capital flows.

3. 3

   State one advantage of a fixed exchange rate.

   Model answer

   It gives exporters and importers certainty about future prices, which encourages trade and long-term investment, and it imposes discipline on domestic inflation.

4. 4

   What is the main drawback of committing to a fixed exchange rate?

   Model answer

   Large foreign exchange reserves must be held to defend the rate, and monetary policy has to be devoted to the exchange rate rather than to domestic growth and employment.

5. 5

   State one advantage of a floating exchange rate.

   Model answer

   The rate adjusts automatically to trade imbalances without the need for reserves, leaving interest rates free to be used for domestic objectives.

6. 6

   What is the main drawback of a floating exchange rate?

   Model answer

   The rate can be volatile, creating uncertainty for firms trading internationally, and a sharp depreciation raises import costs and feeds inflation.

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