Exchange Rates Flashcards
Factors that affect ER
-Interest rates – higher interest rates encourage hot money flows and demand for currency. This causes an appreciation.
-Economic growth – cause an appreciation in the currency, this is because markets expect higher interest rates – when growth is rapid.
-Inflation – higher inflation makes exports less competitive and reduces demand for currency. This causes a depreciation.
-Confidence in the economy/currency.
-Current account deficit/surplus. A large CA deficit is more likely to cause a depreciation in the value of the currency because money is leaving the economy to buy imports.
Effects of appreciation
-Exports expensive
-imports cheaper
-lower x-m
-lower inflation
-monetary policy
Why does an appreciation decrease inflation
-import prices are cheaper. The cost of imported goods and raw materials will fall after an appreciation, e.g. imported oil will decrease, leading to cheaper petrol prices.
-Lower AD leads to lower demand-pull inflation.
-With export prices more expensive, manufacturers have greater incentives to cut costs to try and remain competitive.
Why does an appreciation encourage monetary policy
Central Bank more willing to cut interest rates.
-An appreciation reduces inflationary pressure so interest rates can be lower.
-higher interest rates would cause the currency to rise even more. If the Central Bank thought appreciation was too rapid, they may cut rates to reduce the value of the currency.
What’s does the effect of an appreciation determine on
-Elasticity
-situation of the economy
Why does the effect of an appreciation depend on elasticity?
-The Marshall Lerner condition stations that an appreciation will worsen the current account if (PEDx + PEDm >1)
-Elasticity varies over time. In the short run, we often find demand for exports and imports is inelastic, so an appreciation improves current account. But, over time, demand becomes more elastic as people switch to alternatives.
Why does the effect of an appreciation depend on the situation of the economy
If the economy is in a recession, then an appreciation will cause a significant fall in aggregate demand, and will probably contribute to higher unemployment. However, if the economy is in a boom, then an appreciation will help reduce inflationary pressures and limit the growth rate without too much adverse impact.
Effects of an depreciation
-Exports cheaper
-import expensive
-increase AD due to cheaper goods
-Inflation due to cp inflation or AD increasing causing DP inflation
-exports become cheaper so less incentive to cut costs.
improve CA :
-wages
-falling real wages
What’s does the effect of a depreciation depend on
-Elasticity of demand for export and import
-state of the global economy
-Inflation reduced due to recession
-depends on the what currency is being devalued
Why does the effect of a depreciation depend on the elasticity of demand for exports and imports
-demand is price inelastic, then a fall in the price of exports will lead to only a small rise in quantity. Therefore, the value of exports may actually fall. An improvement in the current account on the balance of payments depends upon the Marshall Lerner condition and the elasticity of demand for exports and imports
If PEDx + PEDm > 1 then a devaluation will improve the current account
The impact of a devaluation may take time to influence the economy. In the short term, demand may be inelastic, but over time demand may become more price elastic and have a bigger effect.
Why does the effect of a depreciation depend on the state of the economy
-global economy is in recession, then a devaluation may be insufficient to boost export demand. If growth is strong, then there will be a greater increase in demand. However, in a boom, a devaluation is likely to exacerbate inflation.
Effects of devaluation of the pound 2026 post brexit
-Higher prices of imported goods.
-Inflation. However, UK inflation was low to start off with
-Inflation combined with real wage growth (e.g. public sector pay freeze of 1%) – has seen a fall in real incomes causing lower consumer spending.
-Exports should see a rise in demand because of the falling value of Sterling. However, the rise in exports may be muted by weak growth in the Eurozone and global economy. If global growth is low, we may see less growth in exports than we might usually expect. Demand may prove inelastic.
-The Pound is falling which boosts exports, but the low wage growth means the strongest effect is the decline in real wages which damages economic prospects.
