Cambridge International as and a level Economics Ebook

Hot money flows: 
flows of money moved around the world 
to take advantage of changes in interest rates and exchange 
rates.
KEY TERMS
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Chapter 4: The macroeconomy 
equilibrium value of the currency. Th
is is because 
it will only have to off set short-run – and possibly 
relatively small – fl uctuations. If, however, the 
exchange rate is overvalued, the central bank may be 
in danger of running out of reserves trying to keep 
the exchange rate at a level that does not refl ect its 
market value.
Indeed, one of the disadvantages of a fi xed exchange 
rate is the need to keep reserves. Th
is involves an 
opportunity cost as the foreign exchange or gold, for 
instance, could be used for other purposes. Th
ere is also 
the risk that a government may sacrifi ce other policy 
objectives in order to maintain the fi xed exchange 
rate. For instance, a central bank may raise the interest 
rate in a bid to keep the exchange rate at the price the 
government wants maintained. A higher interest rate 
may, however, reduce aggregate demand and increase 
unemployment.
Over time, market pressures may mean that the rate 
at which the currency is fi xed may have to be changed. 
A reduction in the value of a fi xed exchange rate to a lower 
level is known as devaluation. A revaluation occurs when 
the government raises the exchange rate to a new, higher 
fi xed rate.
A fi xed exchange rate does create certainty, which can 
promote international trade and investment. For instance, 
a foreign fi rm may be more willing to set up a branch in 
the country if it knows how much any revenue it earns will 
be worth in its own currency.
A fi xed exchange rate also imposes discipline 
on a government to keep infl ation low so that a loss 
of international price competitiveness does not put 
downward pressure on the exchange rate.