3.1.5 exchange rate changes Flashcards
What does a reduction in exchange rates do to exports? How is this inflationary?
Causes exports to become cheaper, which increases the number of them, assuming demand for exports is price elastic.
The increase in the price of imports, such as raw materials, causes costs for firms to increase, causing cost-push inflation.
What does the Marshall-Lerner condition state?
That a devaluation in a currency only improves the balance of trade if the absolute sum of long run export and import demand elasticities are greater than or equal to 1.
Why could there be a time lag in changing volume of exports and imports when currency devalues?
Could be due to trade contracts and the price inelasticity of demand for imports in the short run, whilst customers search for alternatives. In the long run, consumers might start purchasing domestic products, which helps improve deficit.
What happens to AD if the exchange rate appreciates? What does this depend on?
It is likely to fall since imports become cheaper and exports become more expensive. Households are likely to switch from buying domestically produced goods to imports.
However, it depends on the inflation rate. A lower domestic inflation rate, compared to other countries, might mean consumers still purchase domestic goods. It also depends on the PED for domestic goods and imports.
What are the societal effects of a weaker exchange rate?
Means domestic firms can increase their sales and increase their profits. Jobs might be created as a result.
What does a depreciation in the pound mean for UK exports? What can firms choose to do?
That they become more price competitive.
Firms can then reduce the price of the good in the export market to increase sales, or they can keep the price the same to increase their profit margins.
How does the rate of economic growth in the export market affect sales for domestic firms?
The higher the level of consumer and firm confidence (higher the economic growth), and the more disposable income they have, the more likely they are to buy exports.
What will happen to firms who are net importers of raw materials if the exchange rate depreciates?
This would make them less internationally competitive, as their prices will increase due to imports becoming more expensive.
What does a depreciation in the currency mean for FDI?
It means the country’s wages and production costs have fallen relative to other countries, making them more internationally competitive and it is likely to attract more FDI.
What is the Eurozone?
A monetary union, meaning members share the same currency and use the same interest rate. This is more economically integrated than a customs union and free trade area.
When was the Euro implemented?
In 1999, forming the Eurozone.
What does the Euro float against?
The US Dollar and the Pound Sterling.
What are member nations of the Eurozone required to follow? [4]
- Budget deficits cannot exceed 3% of GDP
- Gross National Debt has to be below 6% of GDP
- Inflation has to be below 1.5% of the 3 lowest inflation countries
- Average government bond yield has to be below 2% of the yield of the countries with the lowest interest rates, ensuring exchange rate stability
Why are current account deficits of greater concern in the Eurozone?
Because the countries have a fixed exchange rate, meaning they cannot devalue the currency to restore their level of international competitiveness.
What are the advantages of the Eurozone? [4]
- Participating countries have more currency stability, and the currency is less prone to speculative shocks. This gives future markets more certainty, so there is more investment and growth potential
- There are fewer admin fees and less red tape when travelling abroad or exchanging money
- Also benefits firms which trade with different member states. it is especially beneficial to small firms, who benefit from time and money saving of a common currency
- German monetary credibility might result in all member states having a lower interest rate. This might encourage more investment and spending, which might create more jobs
Where is the EU central bank?
Frankfurt, Germany.
What are the disadvantages of the Eurozone? [4]
- Labour mobility is limited across Europe due to language barriers. Moreover, differences in economic performance between member countries means common monetary policy might not be effective
- Exchange rate is not flexible to meet each country’s need, such as if they need a boost in exports
- Member nations lose sovereignty when there is a common monetary union, meaning that countries with a strong economy have to cooperate with countries that have weaker economies; cannot adapt their policies to meet each individual requirement
- The one-off cost of joining a currency union of changing labels and prices can be significant
