4.1 (4.1.8-4.1.9)

Question 1

What is an exchange rate ?

Answer 1

• the rate at which one country’s currency can be exchanged for other currencies in the foreign exchange market

Question 2

What is meant by effective exchange rates ?

Answer 2

• the weighted index of sterling’s value against a basket of currencies (weights based on importance of trade between the UK and each economy)

Question 3

Free floating currency ?

Answer 3

• where the external value of a currency depends wholly on market forces of supply and demand ➡️ no central bank intervention (allow the currency to find its own market level + does not alter interest rates or intervene directly by buying/selling currencies to influence the price)
• there is no target for the exchange rate
• eg. Norway, Australia, UK, Euro

Question 4

Managed floating currency ?

Answer 4

• when the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives BUT currency usually set by market forces (central bank gives a degree of freedom)
• eg. Sweden, Brazil, Japan, INDIA

Question 5

Fixed exchange rate ? ❗️

Answer 5

• when a govt or central bank that ties the country’s official currency exchange rate to another country’s currency or the price of gold ➡️ purpose is to keep a currency’s value within a narrow band

Question 6

Changes in exchange rates ?

Answer 6

• depreciation: a fall in the value of a currency in a floating exchange rate system
• devaluation: a fall in the value of a currency in a fixed exchange rate system
• appreciation: a rise in the value of a currency in a floating exchange rate system
• revaluation: a rise in the value of a currency in a fixed exchange rate system

Question 7

Factors causing changes in the currency in a floating system ?

Answer 7

• trade balances: countries that have strong trade + current account surpluses tend to see their currencies appreciate ➡️ money flows into the circular flow from exports of goods/ services + from investment income - demand for exports tends to affect the demand for currency curve (because if people overseas want to buy UK exports they will need to buy £s in order to pay for them) + demand for imports tends to affect the supply of currency (because we need to supply £s to the foreign exchange market to buy foreign currencies to pay for imports)
• FDI: an economy that attracts high net inflows of capital investment (i.e. long-term capital flows) from overseas will see an increase in currency demand + a rising exchange rate
• portfolio investment: strong inflows of portfolio investment into equities + bonds from overseas can cause
  a currency to appreciate
• interest rate differentials: countries with relatively high interest rates can expect to see ‘hot money’ (short term capital) flowing coming in + causing an appreciation of the exchange rate
• speculation: responsible for much of the day-to-day volatility

Question 8

How may a central bank intervene in managed floating system ?

Answer 8

• buying to support a currency ie. selling their FX reserves
• selling to weaken a currency ie. adding to their FX reserves
• changes in interest rates to affect hot money flows ie. increase rates to attract inflows of money into the banking system looking for a favourable rate of return

Question 9

How does currency become a key target of monetary policy in a managed floating system ?

Answer 9

• higher exchange rate might be wanted to control demand pull + cost push inflationary pressures
• a govt might want to engineer a competitive devaluation to improve export competitiveness

Question 10

Policy tools for managing floating exchange rates ?

Answer 10

• changes in interest rates ➡️ lower interest rates to depreciate the exchange rate + causes movements of hot money banking flows into/out of a country
• quantitive easing ➡️ increase liquidity in the banking system leading to lower interest rates (usually causes outflow of money - depreciation)
• direct buying/selling in the currency market ➡️ direct intervention
• taxation of overseas currency deposits + capital controls ➡️ taxation of foreign deposits in banks cut the profit from hot money inflows + controls on the free flow of capital into/out of a country

Question 10

Characteristics of a fixed exchange rate ?

Answer 10

• the govt/central bank fixes the currency value ➡️ external value is pegged to one or more currencies + the central bank must hold sufficient foreign exchange reserves in order to intervene in currency markets to maintain the fixed peg i.e. they may need to buy domestic currency using foreign currency to push up the value of their domestic currency (holding foreign exchange reserves can create an opportunity cost)
• pegged exchange rate becomes official rate ➡️ trade takes place at this official exchange rate but might be unofficial trades in shadow currency markets
• adjustable peg ➡️ occasional realignments may be needed eg. a devaluation or revaluation depending on economic circumstances – the currency may have drifted from the fundamental value

Question 10

Way exchange rates impact business activity ?

Answer 10

1. price of exports in international markets
2. cost of imports
3. revenues + profits earned overseas
4. converting cash receipts from customers overseas

Question 10

How can a central bank influence the value of a currency (chain of reasoning) ?

Answer 10

• in a managed floating currency system, one way that a central bank can influence the external value is by changing interest rates
• eg. if they want to achieve adepreciation, they might opt to lower their main monetary policy interest rate
• a fall in interest rates reduces the returns on overseas money held in a country’s banking system- the real return may become negative
• as a result, lower interest rates might
  cause an outflow of short-term “hot money” from commercial banks to other countries
• this will cause an outward shift of the supply curve for the currency as investors look for currencies with higher expected returns
• in this way, assuming other central banks have kept their rates constant, a fall in interest rates might lead to a depreciation

Question 11

What is competitive devaluations/ dirty floating ?

Answer 11

• occurs when a country deliberately intervenes to drive down the value of their currency ➡️ provide a competitive lift to demand, output + jobs in their export industries
• ✅ counties may try this when faced w/a deflationary recessions or to attract foreign investment
• ✅ may become an attractive option for nations with persistent trade deficits + rising unemployment BUT can be risky
• ❌ can be seen by other countries as a form of trade protectionism that invites some form of retaliatory action eg. import tariff
• ❌ cutting the exchange rate makes it harder for other countries to export negatively affecting their growth rate
  which in turn can damage the volume of trade that takes place between nations
• ❌ competitive devaluations of a currency go against the principles of trade based on comparative advantage

Question 12

Who benefits/loses from a lower exchange rate ?

Answer 12

winners:
- businesses exporting into international markets
- businesses earning substantial profits in overseas currencies

losers:
- businesses importing goods/services
- overseas businesses trying to compete in the domestic market

Question 13

REMEMBER SPICED

Answer 13

• strong pound imports cheaper exports dearer

Question 14

Impact of a currency depreciation ?

Answer 14

• usually has a similar effect on the macro-economy as a cut in interest rates + may help to provide a partial auto-correction of a large trade deficit

Question 15

Impact of a currency depreciation on macro objetives ?

Answer 15

• inflation: higher import prices = increased consumer prices
  ✅ may help a country to avoid deflation + also lowers real interest rates
  ❌ higher inflation threatens real living standards (especially those w/weak bargaining power in the labour market who are unable to bid for higher wages)
• economic growth:
  ✅ a weaker currency is usually a stimulus to GDP growth eg. from higher net exports BUT much depends on the PED for exports
  ❌ many exports require imported components which will have become more expensive as a result of the depreciation
• unemployment:
  ✅ more competitive currency will help to increase domestic production + perhaps create a positive export multiplier effect ➡️ will further stimulate AD + jobs
  ✅ may also be an upturn in tourism/ demand from overseas students to come to a country’s universities
• balance of trade: dependent on PED for X&M – possible J curve effect in the short run + the impact on export sales also depends in part on the strength of GDP growth in key export markets
• business investment:
  ✅ should help to improve profitability eg. a fall in the external of the £ increases the overseas earnings of UK plc in $ and Euros which will be now be worth more in £s
• wider effects: depreciation is similar to a cut in interest rates ie. an expansion of monetary policy BUT there
  are risks too incl. higher costs of importing components, raw materials + prices of important capital technologies
• FDI:
  ❌✅makes a country’s FDI assets (i.e. investments abroad that are denominated in foreign currency) appear more valuable when converted into the domestic currency + FDI liabilities (i.e. investments in the domestic economy from overseas, denominated in the domestic currency) appear less valuable to overseas investors ➡️ can ultimately therefore reduce inwards FDI

Question 16

How might a currency depreciation affect international competitiveness (chain of reasoning) ?

Answer 16

• a depreciation is a fall in the external value of a currency inside a floating exchange rate system
• as a result, exporters can reduce the foreign price of goods/ services sold overseas
• this makes UK exports relatively cheaper in overseas markets ➡️ relative export prices fall leading to improved
  competitiveness
• in addition, the UK price of imported products will increase £1 buys fewer euros eg. imported cars will be more expensive
• a rise in import prices will make domestic producers in the UK appear relatively more competitive purely in cost + price terms.

Question 17

What does a depreciation of the exchange rate stimulating AD depend on ?

Answer 17

1. the variable length of time lags as consumers + businesses respond
2. the scale of any change in the exchange rate i.e. a 5%, 10%, 20%
3. whether the change in a currency is temporary or longer-lasting
4. the coefficients of PED for X&M (relate this back to the Marshall-Lerner condition)
5. the size of any second-round multiplier + accelerator effects
6. when the currency movement takes place – i.e. which stage of an economic cycle (recession, recovery etc.)
7. the type of economy (e.g. the impact will be different for small developing nations v large advanced countries)
8. the degree of openness of the economy to international trade i.e. measured by the value of trade as a % of GDP

Question 18

Advantages of floating exchange rates ?

Answer 18

• ✅ reduces the need for a central bank to hold large amounts of currency reserves
• ✅ freedom to set monetary policy interest rates to meet domestic objectives
• ✅ may help to prevent imported inflation
• ✅ insulation for an economy after an external shock especially for export-dependent countries
• ✅ partial automatic correction for a current account deficit
• ✅ less risk of a currency becoming significantly over/undervalued

Evaluation:
- ❌ no guarantee that floating exchange rates will be stable
- ❌ volatility in a floating currency might be detrimental to attracting inward investment
- ❌ a lower (more competitive) exchange rate does not necessarily correct a persistent balance of
payments deficit - J curve theory + importance of non-price competitiveness

Question 19

Advantages of fixed exchange rates ?

Answer 19

-✅ certainty of currency value gives confidence for inward investment from overseas businesses
-✅ reduced costs of “currency hedging” for businesses eg. airlines
-✅ currency stability helps to control inflation – i.e. it is a discipline on businesses to keep labour costs low
-✅ a stable currency can lead to lower borrowing costs (i.e. lower yields on government bonds)
-✅ imposes responsibility on govt macro policies eg. to keep inflation under control
-✅ less speculation in the currency market if the fixed exchange rate is regarded by traders as credible

Evaluation:
-❌ reduced freedom to use interest rates for other macro objectives eg. stimulating GDP growth
-❌ many developing countries do not have sufficient foreign currency reserves to maintain a fixed exchange rate
-❌ difficult for countries to use a competitive devaluation of their fixed exchange rate ➡️creates political tensions + may lead to a protectionist response
-❌ devaluation of a fixed exchange rate can lead to a surge in cost-push inflation ➡️ damaging for competitiveness + has regressive effects on poorer families

Question 20

Floating v fixed exchange rates ?

Answer 20

• fixed rates may be optimal for developing countries wanting to control inflation
• export-dependent economies may favour a managed floating rate eg. to offset fluctuating world prices
• not every country has the reserves to influence currency
• choice of currency regime is hugely important for developing countries ➡️ come countries have opted to join
  a monetary union eg. the nineteen members of the Euro Zone

Question 21

What is external competitiveness ?

Answer 21

• the sustained ability to sell goods and services profitably at competitive prices overseas

Question 22

Price v non price competitiveness ?

Answer 22

Price/cost competitiveness:
- key measure: Differences in relative unit labour costs (ULCs)

Non-price competitiveness:
- product quality, innovation, design, reliability and performance, choice, after-sales services, marketing, branding, brand loyalty and the availability and cost of replacement parts

Question 23

Non- wage cost factors ?

Answer 23

1. environmental taxes eg. min prices on carbon emissions
2. employment protection laws & health and safety regulations
3. statutory requirements for employer pensions
4. employment taxes eg, employers’ national insurance costs

Question 24

What are relative unit labour costs ?

Answer 24

• labour costs per unit of output
• Unit labour costs = total labour costs / total output
• unit labour costs will tend to rise when wages are rising faster than productivity

Question 25

What are unit labour costs mainly determined by ?

Answer 25

1. average wages/salaries in a country’s labour market ➡️ one measure tracked is the hourly labour cost of employing people in the labour market
2. labour productivity ie. output per person employed or output per hour worked

Question 26

How to lower relative unit labour costs ?

Answer 26

Rise when:
- a country’s exchange rate appreciates
- wage costs rise relatively faster than other nations
- labour productivity growth is relatively slower

Fall when:
- monetary policy interventions aimed at a currency depreciation eg. a managed floating exchange rate
- wage controls eg. wage/pay freezes in the public sector
- supply-side measures designed to raise labour productivity/efficiency across many industries

Question 27

What are relative export prices ?

Answer 27

• one country’s export prices in relation to other countries, usually expressed as an index

Question 28

Indicators of global competitiveness ?

Answer 28

• effectiveness of institutions: protection of property rights/rule of law/corruption
• quality of infrastructure: transport, communications, energy etc
• macroeconomic performance: inflation, fiscal balance, govt debt, growth
• health & primary education: malaria incidence, prevalence of HIV, mortality rates
• higher education & training: quality of teaching + attainment eg. in maths
• efficiency of goods & labour markets: intensity of competition, tariffs, other barriers
• technological readiness: internet use, availability of latest technologies
• sophistication of business: supplier quality, business clusters
• innovation: patent applications, R&D spend

Question 29

When do relative export prices rise ?

Answer 29

1. there is an appreciation of the currency ➡️ causing export prices in overseas markets to rise
2. there is a period of high relative inflation in one country compared to others ➡️ tends to make exports appear more expensive when priced in an overseas currency
3. when export businesses experience higher costs eg. arising from environmental taxes, increased min
   wages ➡️ leads them to raise price to protect their profit margins
4. when exporters of goods/services are hit by import tariffs

Question 30

Policies to improve competiveness ?

Answer 30

1. competitive exchange rate ➡️ perhaps involving a managed floating currency
2. competitive tax environment ➡️ attract inward investment + encourage new business start-up’s
3. investment in human capital ➡️ improve the quality of the workforce
4. increased R&D ➡️ drive a faster pace of innovation
5. stronger market competition ➡️ raise factor productivity + lower relative export prices
6. stable macroeconomic environment ➡️ eg. maintaining low inflation with steady economic growth to support business confidence
7. investment in critical infrastructure ➡️ eg. better road, air and rail links, improved ports, faster broadband
   and fibre-optic internet connections

Question 31

How can fiscal policies be important in driving competitiveness ?

Answer 31

1. subsidies ➡️ lower the cost of research eg. in pharmaceuticals, life sciences, robotics + AI
2. tax incentives ➡️ can encourage the commercialisation of ideas eg. ideas coming out of unis
3. lower employment taxes ➡️ stimulate skilled migration from overseas
4. lower capital gains taxes ➡️ encourage small businesses/start-ups
5. special economic zones (SEZ) ➡️ attract research-intensive businesses

Question 32

What matters for competitiveness in the long run ?

Answer 32

Macro competitiveness has micro foundations
- competitive markets + innovative businesses
- skills, aptitudes + attitudes within a diverse workforce
- expanding opportunities for female entrepreneurs/refugees
- recognition that infrastructure + innovation are crucial ➡️ increasingly, competitiveness flows from smart urbanisation
- competitive advantage comes from having globally scaled businesses close to or at the technological frontier + a culture of innovative business start-ups/ social entrepreneurs + a financial system that can provide appropriate + affordable credit for education, business research & funding for business expansion
- reliance on currency depreciation/ devaluation + wage cuts is not a sustainable competitiveness strategy ➡️ the most competitive countries have the highest min wages, there is a continuous global battle for the most talented workers + races to the bottom” eg. in taxes & wages have a limited impact

Question 33

Benefits and drawbacks of international competitiveness ?

Answer 33

• ✅ improved living standards eg. measured by real GNI per capita (PPP)
• ✅ stronger trade performance from an increase in export sales
• ✅ virtuous circle of economic growth
• ✅ employment creation
• ✅ higher govt tax revenues
• ❌ trade surpluses might invite a protectionist response
• ❌ possible risks of demand-pull inflation
• ❌ competitiveness might be achieved at the expense of growing inequality of income & wealth
• ❌ higher productivity might be achieved at expense of a worsening work-life balance + increased
  incidence of mental health problems
• ❌ increased competitiveness might cause a country’s exchange rate to appreciate

Question 34

What is internal devaluation ?

Answer 34

• happens when a country seeks to improve price competitiveness through lowering their wage costs + increasing productivity and not reducing the external value of their exchange rate eg. Latvia and Greece, in the wake of a severe depression which followed the Global Financial Crisis
• requires several years of low relative inflation i.e. a country’s inflation rate lower than price increases in other countries
• can be brought about by fiscal austerity (via higher taxes + cuts in govt spending) and/or a sharp rise in real interest rates ➡️ both impose deflationary pressure on output & prices
• more likely to happen with a country that has a fixed exchange rate e.g. Ecuador has a fixed rate against the US dollar

Question 35

What is an external devaluation ?

Answer 35

• happens when a country operating with a fixed or semi-fixed exchange rate system decides to deliberately lower the external value of their currency against one or a range of other currencies
• a devaluation of the currency means a domestic currency buys less of a foreign currency ➡️ motivation is
  to make exports more price competitive in overseas markets + to make imports relatively more expensive than domestic supply
• linked aims incl. reducing the size of a trade deficit + to cut the real value of sovereign (debt owed to international creditors) In theory, currency devaluation is a fast way of improving price competitiveness than an internal devaluation
• eg. Egypt (a 16% fall v the US$ in 2016) & Ghana whose currency was devalued by 17% against the US$ in 2019

Question 36

Risk from an internal devaluation ?

Answer 36

1. severe loss of output + rising unemployment
2. fall in nominal wages reduces living standards
3. risks from sustained price deflation
4. real value of debt increases
5. danger of a country suffering a permanent loss of output (known as “hysteresis”)

Question 37

Drawbacks from an external devaluation ?

Answer 37

1. increase in cost-push inflation from higher import prices
2. reduces real incomes because of a rise in inflation
3. no guarantee that the trade deficit will improve (J Curve concept)
4. foreign creditors will demand higher interest rates on new issues of govt & corporate debt
5. currency uncertainty makes country less attractive to inward FDI