Exchange rates Flashcards
Exchange rates
The price of one currency in terms of another
What causes an appreciation of the pound
- demand for the pound increases
- exports increasing
- investment/FDI increasing
- inflation decreasing
- interest rates increasing (hot money inflows = people want to save in UK banks)
- speculation that ER will rise
What are the implications of the pound appreciating?
- exports expensive
- imports cheaper
- hot money inflows
What causes a depreciation of the pound?
- supply for pound increases (supplying more of the pound on the foreign exchange market
- imports increasing
- investments/FDI decreasing
- inflation increasing
- interest rates decreasing (hot money outflows = people want to save in oversea banks)
- speculation that the ER will fall
What are the implications of the pound depreciating?
- exports cheaper
- imports expensive
- hot money outflows
Floating exchange rate
A system in which the exchange rate is permitted to find its own level in the market
Advantages of a floating exchange rate
1. Provides a mechanism for external economic shocks
- If there is a decrease in demand for exports due to a recession abroad, exchange rate will depreciate
- exchange rate appreciates, exports cheaper so increase
- Overall exports won’t decrease as much
2. The balance of payments will be automatically corrected
- imports increase so BOP worsens so depreciation of pound
- prices of imports expensive and exports cheaper
- exports increase so BOP improves
3. Allows room for monetary policy to be effective
- if IR is lowered consumption increases and investment increases
- hot money outflows increases so depreciation
- net exports increases as demand for exports increase
4. Can freely achieve other macroeconomic objectives
- can set policies based on what the economy needs rather than the impacts it has from the exchange rate
- can reach key macroeconomic objectives without taking too much time
- don’t have to be worried about being impacted by any other countries
5. Reduced speculation over the countries currency
- reflects the purchasing power parity
- The value of the currency has the same amount of power of other currencies around the world
- Value is true and realistic (not artifically changed)
Disadvantages of a floating exchange rate
1. Potential reliance on low valued exchange rates
- may rely on low ER to remain competitive
- may not invest in SSP, so if price increases, wont have productive capacity ro lower prices
- FDI may not come in to invest as unstable
2. Extra freedom over domestic policy may not be a good thing
- can lead to increase in inflation as the central bank maily focus on lowering interest rates
3. Some sectors more sensitive to exchange rate changes
- especially sectors who have elastic demand as more than proportional decrease when price increases
- if exchange rate depreciates, imports more expensive so cant export key raw materials
Fixed exchange rate
A system in which the government agrees to fix the value of their currency against another currency
Advantages of a fixed exchange rate
1. Reduces exchange rate uncertainty
- Reduces the risk of trading as it allows the price of imports and exports to remain the same so incentivizes more trade
- Consumer demand will stay constant as prices stay constant and consumers can now plan their expenditure
- Consumer and firm confidence increases
2. Reduces the cost of trade
- There is no need for businesses to offset the risk of the exchange rate decreasing by buying currencies or future markets
3. Imposes discipline on domestic firms
- When the country has a fixed exchange rate the raw materials they buy are fixed
- incentivized to stay productive and keep cop low as another country with a floating exchange rate may have lower prices raw materials, so more competitive due to their changing ER
- incentivized to be productive to remain competitive with them cannot rely on exchange rate to be low
Disadvantages of a fixed exchange rate
1. International retaliation
- if artificially decreased exchange rates, initially benefit but other countries will start putting protectionist policies in place
- can lead to trade wars
2. Need a high level of foreign exchange reserves
- need high levels to participate in the foreign exchange
- this causes a lot of opportunity cost as this money could be used elsewhere
- very expensive to maintain
3. Loss of control over monetary policy
- there is a lack of freedom
- cant implement monetary policy as if you change interest rates this impacts exchange rates
4. Speculative attacks on the currency
- in fixed exchange rate system something needs to be done as it won’t self adjust like floating
- exchange rate may depreciate/appreciate by such a large amount that it will be worth nothing
- destabilizes the entire economy and may have to take a loan from the IMF
The J-curve Effect
A situation following a devaluation of the pound in which the current account deficit moves further into a deficit before improving
Reasons why a depreciation will not straight away improve net exports
1. Information Failure
- people won’t realize straight away that they exchange rate has changed so they won’t change consumption habits
2. Contracts
- goods that are imported and exported are usually done on contracts so they need to wait for the contract to finish before they change consumption
3. Necessity Status
- even if prices have gone up and there’s a depreciation of the pound people are still going to demand imports that are cecessities and raw materials
The Marshall-Lerner Condition
Devaluation will have a positive effect on the current account only if the sum of the elasticity of imports and exports is greater than 1
What happens when there is a depreciation of the currency but the PED for imports is inelastic?
The value of import expenditure will increase
