Exchange rates Flashcards
the marshal Lerner condition definition
following a depreciation of an exchange rate the balance of trade will only improve if the sum of price elasticities of demand for export and imports is elastic (greater than 1)
the marshal Lerner condition calculation
PED x + PED m> 1
exchange rates
the price of a currency in terms of another Currency
3 factors causing an appreciation of a currency
- increased interest rates in a domestic country
- low inflation compared to other countries
- speculation
how can government intervention devalue the exchange rate
how may a government fix an exchange rate
China have bought a lot of US dollars to increase the value of the dollar compared to the yuan.
This keeps the Chinese currency undervalued and their exports become more competitive as a result.
purchasing power parity (real exchange rate)
The exchange rate that equalises the purchasing power in two economies
It means at this exchange rate you can buy the exact same basket of goods.
3 reasons why can’t ppp be achieved
- trade barriers
- transport costs
- political agreements
how can exchange rates be used to control the economy
devaluing the exchange rate= export led growth
revaluing the exchange rate limits growth and inflation
how does a country devalue its exchange rate
for example china bought lots of dollars with yuan
What does the financial account include
BOP
- portfolio investments (trading bonds and shares)
- Foreign direct investment
- reserves of money
What must the balance of payments do
balance
What is it called when something money comes into the UK
Credit
what is it called when money leaves the UK
Debit
why do countries (such as the US) operating on a current account deficit have a Financial account surplus
- as these countries with a current account surplus (China) have massive reserves of cash which can be used to invest in US portfolio.
as dollars have no value in china, Chinese firms may be forced to reinvest via FDI and a financial account surplice may occur
3 demand side causes of a current account deficit
- overvalued pound (imports become cheaper)
- high consumer spending
- lack of competitiveness
3 examples is a current account deficit ok
- when the current account deficit is financed by FDI in the financial account
- when the current account deficit is as a result of growth.
- if the economy is near full capacity and may prevent inflation
give an example where the current account deficit was financed by FDI
As incomes were rising in the UK in the 1980’s we bought lots of Japanese electronics such as TV using pounds.
This meant the Japanese had lots of pounds which was invested back into the UK through FDI.
Such as the Toyota factory which was set up in 1989 which employs around 3000
industries which have been uncompetitive in the UK
- bakeries
- game development
- car manufacturing.
3 supply side causes of a current account deficit
- low productivity
- high labour costs
- low investment
Which may lower competitiveness causing people to buy abroad
problems with a current account deficit
- falling in ad and reduction in growth
2. causes a depreciation in the exchange rate causing cost push inflation as imports become more expensive
problems with using the exchange rate as monetary policy
- has an asymmetric impact on the economy. those who import (eg tourism) more will better benefit from a weak pound
- Can cause international trade wars (eg China and the USA)
reasons a exchange rate may depreciate
- high inflation
- lower interest rates discourage hot money flows
- poor quality products
what’s the benefit of a fixed exchange rate
- if the exchange rate is fixed at a low price is may attract exports and prevent imports.
Export led growth may be caused as result - gives investors certainty
why may the current account deficit be financed by FDI
if US were to buy Chinese toys using dollars. The Chinese must reinvest the dollars back into the US economy as they have no value elsewhere.
what occurs if the Marshall- Lerner condition holds
A currency depreciation will lead to an improve balance of trade.
This will make the cost of exports cheaper and export revenue greater.
this will also make imports more expensive and import sending will fall
evaluation of the ML condition
ML condition tends not to hold un the short run so a currency depreciation to make the balance of trade worse first. For most countries, it will get better eventually.
Draw J curve
nf
why doesn’t the ML condition hold in the short run
- information failure
- contracts
they both prevent buyers from switching suppliers to the cheapest possible alternative
how can a government help solve a current account deficit
- expenditure switching
2. expenditure reducing.
when is expenditure reducing most effective
- when there is an inflationary output gap
when would expenditure reducing not be effective
- when current account deficit is caused by an overvalued exchange rate ( a rise in interest is likely to make this worse)
- if industries are uncompetitive- by lowering domestic demand firms are less able to make profits to reinvest into their business
how can expenditure be reduced
- higher interest
2. higher income tax
how can expenditure be switched
- protectionist measures
- subsidising domestic firms
- devaluing the domestic currency
when would expenditure switching be the most effective
- if industries are uncompetitive. Supply side policies may improve the productivity of uncompetitive industries and price may fall as a result as labour cost per unit decrease and profit margins can be maintained.
define balance of payments
record of a country’s transactions with the rest of the world
when is a floating exchange rate good
- Monetary policy can be used independently- in a fixed exchange rate the interest rates will be used to manage the exchange rate rather than the domestic economy
- automatic stabiliser (less vulnerable to external shocks)
how does the automatic stabiliser work
- when there is a current account deficit there is an outward shift in the supply of pounds as UK consumers may demand euros to buy foreign goods
- this may cause a depreciation of the pound from 1.18 to 1 euros
- as the cost of imports becomes cheaper
eg the Uk are increasing spending on oil as it is inelastic and having this automatic stabiliser prevents the current account deficit from occurring
evaluation of fixed exchange rate
- we may not want to devalue it as inflation is so high at 7%
- it may be difficult to set it at the right level as the government has imperfect information.
- may be beneficial if the country is super reliant on international trade
negatives of a fixed exchange rate
- it may make domestic reliant on the exchange rate and they may become uncompetitive in the long term.
- may make imports more expensive if the exchange rate is weakened
semi fixed exchange rate system
when the exchange rate is allowed to fluctuate day to day between a specified range
why may the current account not be financed by FDI
- the economic climate in the UK is uncertain with party gate and investors are unsure as to what policies may be implemented and may be reluctant to invest
- low confidence
when is a current account deficit bad
- Poor international competitiveness
- Domestic industries may be struggling
- When not financed by inflows of investment a current account deficit will put downward pressure on your currency
evaluation of a depreciating exchange rate
not all firms in the UK will be reliant on imports so the extent it may cause cost push inflation can be questioned
