Affect of depreciation on macroeconomy (Paper 2/3)

Question 1

Impact on AD and Current account

KAA1

Answer 1

DEFINITION
Exchange rates are the value of one currency in terms of another. A depreciation is caused when there’s an increase in supply or decrease in demand for currency on free floating exchange rate system

WPIDEC
Exports:
-A fall in the value of the British exports cheaper for foreign buyers-UK goods and services are more price competitive in foreign markets-increase in exports-Increase in net exports-increase AD-reduced negative output gap-reduced cyclical unemployment-increase in actual economic growth

increase in injections injto the circular flow of income-positive MULTIPLIER effect-further increases in AD

increase in exports-increase in export revenue-improved current account deficit

Application:
current account deficit=£20 billion pounds
Net exports=1% of UK AD
UK govt’s main macroeconomic objectives (Economic Growth and BoP Stability)

Diagram:
AS/LRAS diagram
outwards shift of AD
inwards shift of LRAS

Question 2

Eval 1

Answer 2

Marshall lerner condition:the combined PED of imports and exports must be greater than one for a depreciation in the currency to lead to an improvement in the current account deficit-if this is not met-worsening

J-curve shows time lag-it takes time (inelastic) to find cheaper alternatives in the short run-worsening in the current account deficit in the short run

Increase in import prices-deterioration in the terms of trade

Question 3

Cost Push and Demand Pull Inflation

KAA2

Answer 3

Knowledge/Analysis
-Increased cost of production for importing firms-cost-less ability to afford resources-inwards shift of LRAS-cost-push inflation-passed onto consumers in the form of higher prices

Increases in AD due to higher exports-demand pull inflation-if economy is at full capacity of keynesian LRAS-infaltion can’t be met with an increase in real GDP (Inflationary pressures)

Application:
Firms reliant on oil and metal imports
Shell,BP,Tata Steel
Post-Brexit,a depreciation in the pound led to higher cost of imports leading to higher prices in retail and services industries
-One of the UK govt’s main macroeconomic objectives (1-3%)
-Current inflation is 3.7%

YOU CAN REFER TO THE AD/LRAS CURVE YOU ALREADY DREW IN THE FIRST KAA

Question 4

Corrective measures or inflation evaluations

Eval

Answer 4

Bank of England could increase interest rates-increase in hot money inflows-increase demand for UK pounds-appreciation in the currency-reduction in the price of UK imports

Low inflation rates of trading partners-(switerzerland <1%)-import prices may not increase by too much

Government can subsidise importing firms to help become more price competitive in international markets

Cost push inflation-leads to lower unemployment according to the SHORT RUN PHILIPS CURVE-due to an increase in AD-higher derived demand for labour