4.3 Exchange Rates

Question 1

Why do we need foreign currency?

Answer 1

to buy goods and services from another country

Question 2

What is the definition of an exchange rate?

Answer 2

An exchange rate is the price of one currency in terms of another

Question 3

How is the exchange rate determined?

Answer 3

• the exchange rate is determined by demand and supply
• demand from foreign consumers producers and governments
• supply is from UK consumers, producers and the government who want the opposing currency

Question 4

What are 4 reasons foreigners demand pounds?

Answer 4

1. to buy UK exports of goods and services
2. to save in UK bank accounts
3. to speculate on the pound (see if it increases in value)
4. To invest in the UK (FDI)

Question 5

What is the definition of appreciation?

Answer 5

appreciation means the price of one currency increases in terms of another

Question 6

what is the definition of depreciation?

Answer 6

depreciation means the price of one currency decreases in terms of another

Question 7

How can appreciation be caused?

Answer 7

• via a rightwards shift of demand or leftwards shift in supply for pounds
• increase in demand or decrease in supply of pounds

Question 8

What are the 4 reasons why foreigners may demand more pounds?

Answer 8

1. demand for UK exports rises as:
   - UK inflation is lower than other countries ( so goods and services seem cheaper)
   - income has increased in the other country
2. UK interest rates rise so foreigners want to save in the UK
3. Foreigners are speculating the sterling pound will rise in value in the future
4. The UK becomes more attractive for FDI( maybe due to fewer regulations)

Question 9

What are 4 reasons that UK residents may supply more pounds?

Answer 9

1. UK residents demand for imports increases
   - UK income has increased (economic boom)
   - other countries have relatively lower inflation than the UK so it appears cheaper
2. Foreign interest rates rise so UK residents want to save overseas
3. UK speculators think a foreign currency will increase in value
4. Foreign country becomes more attractive to UK FDI

Question 10

How does a depreciation in the pound affect current account balance and provide 1 evaluation point?

Answer 10

• the depreciation of the pound means that imports are more expensive to UK residents while exports are more attractive to foreigners
• this means the current account deficit will lower or the current account surplus will increase
• EVAL if the imports are necessities / inelastic demand this can worsen CAD as people will import no matter what

Question 11

how does a depreciation of the pound affect economic growth and provide 1 EVAL point

Answer 11

• depreciation means rise in exports and drop in imports so aggregate demand rises leading to short run economic growth
• EVAL may not lead to short run economic growth as net exports is only one factor in aggregate demand so other factors also depend

Question 12

how does a depreciation of the pound affect unemployment and provide 1 EVAL point

Answer 12

• because of higher aggregate demand due to higher net exports this will mean that more workers will be needed to produce this extra output
• therefore unemployment is likely to fall
• EVAL exchange rate changes may mean some industries exports increase and some don’t, which could lead to structural unemployment

Question 13

how does a depreciation of the pound affect inflation and provide 1 EVAL point

Answer 13

• due to higher aggregate demand we may see demand-pull inflation if demand outstrips the productive capacity of the economy
• we also may see cost-push inflation is inputs for production are imported which means cost of production increases as costs of imports have increased
• EVAL: depends on PED of imports and exports

Question 14

What are the 3 ways that depreciation can affect consumers/workers?

Answer 14

1. imported goods become much more expensive, so they cannot buy as many which may reduce SoL
2. depreciation may lead to inflation so this will hurt consumers real income
3. workers in some industries may benefit as this will lead to an increase in demand for the good or service, and since labour demand is derived they may be able to demand higher wages

Question 15

How does depreciation affect producers (3 ways)?

Answer 15

• benefits export industries and those competing with foreign firms as they are more attractive as exports are cheaper while imports are more expensive
• firms that import raw materials, costs of production increase
• demand pull and cost push inflation mean menu costs and worker wages will increase, and over time this will reduce competitiveness of British exports

Question 16

how does a depreciation of the pound affect the government?

Answer 16

• if short run economic growth takes place then the government is likely to earn a higher tax revenue
• depreciation may also cause a fall in unemployment so benefit payments are likely to fall
• this will all the budget deficit to decrease